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Basel iii Compliance Professionals Association (BiiiCPA)
1200 G Street NW Suite 800 Washington, DC 20005-6705 USA Tel: 202-449-9750 Web: www.basel-iii-association.com

Dear Member, There are some interesting job openings and descriptions:

Vice President - Bank Regulatory Policy / Basel

Manhattan, NY, Salary $120,000-$180,000 / yr., Full -Time “This individual will assist in interpreting and developing firm policy for U.S. and international banking regulations related to capital and and other regulatory reporting matters. They are seeking individuals with prior Basel II and III and bank capital regulations experience.”

Finance and Risk Solution Architect

London, Salary £80,000 - £115,000 + Bonus “We are currently looking for profiles with a consulting or business stream background in the following areas for a new business practice in the finance sector: we are looking for individuals with the following background or experience: Risk Management in Capital or Liquidity requirements, Financial Industry Regulatory Reporting such as FSA, Dodd Frank, Basel II/III & Industry Best Practice, reporting strategies & Global Transactions. Individuals will have a Business/Technical Architectural Background ideally with some Business Analysis & Consulting background.”

Business Analyst with Basel III Job

“We are actively seeking a contractor to lead a team in documentation, design, and traceability of requirements in support of Basel III implementation. This includes defining solutions to business/systems
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problems and ensuring the integrity of delivery through customer acceptance and final disposition of solution for the Basel III project. This is a minimum 6-8 month project with strong possibility of extension or conversion to full time” employment.” Very interesting job descriptions… … and very interesting salary.

Dealing with financial systemic risk: the contribution of macroprudential policies
Panel remarks by Jaime Caruana, General Manager of the Bank for International Settlements, Central Bank of Turkey/G20 Conference on "Financial systemic risk", Istanbul

Abstract
There are important two-way interactions between macroprudential policy and other areas of public policy. These interactions put a premium on cooperative institutional frameworks that recognise the complementarities between policy actions. This means that, within a single jurisdiction, macroprudential authorities should be independent and should focus primarily on mitigating systemic risk while recognising that other policies will have an impact on the same objective. Cooperation between macroprudential policies across national borders starts from the high level set by various international regulatory standards and is improving with the explicit macroprudential frameworks recently introduced for countercyclical capital buffers and the higher loss absorbency requirements for systemically important banks.

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Greater cooperation, however, does not mean that we should disregard that individual policies have specific objectives and that some hierarchy of action is necessary.

Full speech
Let me thank the Central Bank of the Republic of Turkey and the G20 presidency of Mexico for having invited me to attend such an interesting conference addressing the topic of financial systemic risk. In my remarks today, I would like to explain how macroprudential policies can greatly contribute to dealing with systemic risk and fostering financial stability. I will highlight a few key issues that we should focus on in order to make this effective.

1. Trend towards strengthening the macroprudential orientation of policy
The term "macroprudential" has gained currency in policy discussions during the past four years. Indeed, the recent financial crisis has given rise to a general trend towards strengthening the macroprudential orientation of policy in countries with very diverse institutional frameworks and financial structures. This is very welcome: recent experience has taught us that we need to be more focused on addressing system-wide risk, and this is precisely what macroprudential policy is all about. Macroprudential frameworks may be new, but mainly in the sense of becoming explicit. Many countries have been using prudential instruments to address system-wide vulnerabilities without making reference to macroprudential policies.

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For example, variable ceilings for loan-to-value (LTV) ratios have been used repeatedly in Hong Kong and other Asian economies to slow down frothy mortgage lending and ensure that banks do not overexpose themselves to property risk. Nevertheless, the more recent introduction of formal structures brings to the fore issues of definition, delineation of responsibilities and governance. In my remarks today, I would like to underscore a critical aspect of macroprudential policy and to offer a word of caution. The critical aspect I am referring to is the strong two-way interactions between macroprudential policy and other areas of public policy. These interactions put a premium on cooperative institutional frameworks that recognise the complementarities between policy actions, both within and across jurisdictions. This is a particularly important issue at the national level; but cooperative frameworks are also essential at the international level, requiring both sufficient information-sharing and reciprocity. The word of caution is that we should be mindful that individual policies have specific primary objectives and that some hierarchy of action is necessary. Let me explain.

2. Macroprudential policy is not the only area of policy that influences systemic risk
Many other policies can affect the resilience of the financial system and its ability to provide valuable services to the economy. Quite apart from microprudential policy, the influence of monetary, fiscal and tax policies, of financial reporting standards and of legal frameworks is also very strong.

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For instance, prolonged periods of low policy rates affect leverage, encourage financial market participants to take on risks and may at times fuel asset price bubbles. Conversely, instruments and actions aimed at mitigating and managing systemic risk can have very important effects on the macroeconomy and thus impinge on the objective of other policies. For example, tightening capital requirements to protect banks from the build-up of systemic risk during a credit boom can also cool down credit expansion and, by extension, aggregate demand. To be sure, a more stable, more resilient and less procyclical financial system will improve the effectiveness of monetary and other policies. So there are externalities in the interaction of different policies: there can be positive complementarities when the policies are mutually reinforcing, but also negative spillovers when one policy weakens the effectiveness of another. Hence, there is a need for coordination. This is true both within a given jurisdiction and across borders.

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The need for coordination within a single jurisdiction

Let me talk first about coordination within a single jurisdiction. The interactions between policies suggest a few principles for instrument design and deployment. One such principle is that macroprudential policy instruments should be in the hands of an independent authority with the explicit objective of maintaining financial stability. This is important, for two reasons: the lack of precise measurement to quantify this objective, and policymakers' inevitable reliance on judgment in pursuing it.

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Measurement presents a serious challenge for the design, governance and accountability of macroprudential policy. There are no readily available and widely accepted metrics of systemic risk to help calibrate instruments or gauge policy performance, even ex post, with much precision. And it is notoriously difficult to answer the counterfactual question of how things would have evolved had an alternative action plan been adopted. As a result, more than ever, policy needs to rely on a significant degree of judgment. One telling example relates to anticyclical policies. All anticyclical policies have to work with real-time information that is incomplete and imprecise. Decisions rely on judgment to interpret the multitude of inputs. This is not unique to macroprudential policy, but it is particularly evident in this case: current technology provides far less in the way of robust quantitative models to guide macroprudential policy in addressing both the time and the cross-sectional dimensions of systemic risk. As regards the time dimension, only recently have researchers been attempting to be specific about what the financial cycle is and how to characterise it. A few features are worth mentioning: It is possible to identify a well defined financial cycle that is best characterised by the co-movement of medium-term cycles in credit and property prices. Such financial cycles are longer and more severe than business cycles. The duration and amplitude of the financial cycle has increased since the mid-1980s: financial cycles last, on average, around 16 years; but when
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considering only cycles that peaked after 1998, the average duration is nearly 20 years, compared with 11 for previous ones. Peaks in the financial cycle are closely associated with systemic banking crises (henceforth "financial crises" for short). Finally, the financial cycle and the business cycle are different phenomena, but they are related. Recessions associated with financial disruptions tend to be longer and deeper. As regards the cross-sectional dimension of systemic risk, we are also uncertain about how best to map the systemic importance of financial institutions onto their size, the extent and density of their links to others, and the uniqueness of their economic function. The need for judgment, combined with the need to resist powerful political economy pressures, puts a premium on operational independence. Pressures may be high because the future rewards of macroprudential policy actions tend to be uncertain, difficult to quantify and distant in the future, whereas the costs are immediate and can be easily exaggerated. Operational independence is easier to achieve if the relevant authority has a clear mandate. And it has to go hand in hand with accountability and clarity of communication. Policymakers need to be transparent about how policy decisions relate to their mandate and to their economic assessments. This helps anchor the public's expectations and the holding of the authorities to account. From this perspective, it is key to ensure the adequate involvement of the central bank.

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One may even argue that it is preferable for the central bank to be the macroprudential authority. A second principle is that the control over instruments should be commensurate with the objective of managing systemic risk. Not many tools are purely macroprudential. The vast majority are simply prudential tools tailored for use from a macroprudential perspective through adjustments to their design and calibration. Capital requirements are a key tool but are not sufficient. They need to be complemented with other instruments and more intrusive supervision. Given that we have to deal with human behaviour that is imperfectly understood, combining instruments is more promising than relying on a single one. Liquidity requirements and instruments such as loan-to-value ratios or limits on exposures have all been used and proven effective. In addition, explicit resolution plans are also important: they address the source of the problem, as they reduce the costs of (disorderly) failure. More generally, all tools are inadequate in the absence of effective and at times intrusive supervision: the incentives for regulatory arbitrage are simply too powerful. This means that there is a need for coordination in the use of various instruments, through both the sharing of information and the communication of assessments. Moreover, this should be supported by a framework that allocates responsibilities and accountability clearly.

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4.

The international dimension

Let me now turn to the international dimension. As long as we have open financial systems, risks in one country can affect others. Similarly, macroprudential policy can have spillovers across borders. To what extent does this call for formal coordination? Countries are developing their own policy frameworks to deal with the cross-sectional and the time dimensions of systemic risk. They are introducing arrangements to assess the banks that are systemically important from a domestic perspective. They are also introducing policy measures linked to rough indicators of banks' systemic significance. I would argue that, despite being the new kid on the block, macroprudential policy is one of the economic policy areas in which international coordination has gone furthest. To be sure, we started from a very good basis, namely the existing international regulatory framework for markets and institutions. A number of independent international committees have proposed, and countries around the globe have adopted, minimum prudential standards for banks and market infrastructures. And, importantly, more recently there have been concerted efforts to promote consistent implementation across jurisdictions. The Basel Committee on Banking Supervision has conducted significant work in this area under the leadership of Stefan Ingves. For my part, I would simply like to highlight two examples of coordination in the macroprudential area: as regards its time dimension, the design of the countercyclical capital buffers; and, as regards the
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cross-sectional dimension, the imposition of capital surcharges for systemically important banks. The countercyclical buffer is intended to counterbalance the procyclical behaviour of banks by building up buffers in good times that can absorb losses in times of stress. It is a prudential instrument calibrated to achieve a macroprudential objective. Critically, the level of the buffer depends on the state of the financial cycle in a given jurisdiction. The framework allows for a large degree of judgment and tailoring to local circumstances - there is no one-size-fits-all solution. It also provides for international reciprocity: supervisors of foreign banks should apply the same surcharge on these banks' exposures as the supervisor in the host jurisdiction demands of the local banks. This levels the playing field and addresses regulatory arbitrage. A similar degree of coordination applies to the treatment of systemically important banks. The Basel Committee and the Financial Stability Board have developed a framework to assess the banks that are globally systemically important (G-SIBs). By necessity, the assessment of capital surcharges and their application to those banks comprise a joint decision at the international level, since the relevant system is global. Furthermore, the proposed framework to deal with the banks that are systemically important from a domestic perspective (these are more numerous than the G-SIBs) sets out principles that govern the interaction between the assessment and actions of a bank's host supervisor and those of its home supervisor. Cooperation is built into the framework.

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Macroprudential policy may be a recent addition to the toolbox of policymakers, but it already embeds international cooperation. I believe that this approach to international cooperation is a good one. It fully recognises international spillovers while preserving national room for manoeuvre in applying agreed principles. Coordination is advanced through information-sharing, common minimum standards and reciprocity.

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The hierarchy of action

Let me now close by offering a cautionary remark concerning the interaction between macroprudential policy and other policies. As I noted earlier, macroprudential policy may have macroeconomic effects. Attempts to mitigate the financial cycle are likely to influence the business cycle. Prudential tools may affect credit and asset price dynamics and, by extension, aggregate demand. Because of that, it is essential to ensure that the hierarchy of policy tools is clarified. Macroeconomic management should first rely on macroeconomic tools (monetary and fiscal policies) before asking for help from macroprudential policy. Financial stability is already a large enough job for macroprudential policy. It should remain focused on its main objective rather than trying to smooth the business cycle.

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The temptation to bend prudential tools away from their primary objective of financial stability to tackle shorter-term macroeconomic fluctuations can be quite strong. Given measurement uncertainties, the case for doing so is less compelling than it appears. It is in situations like these that the independence and accountability of macroprudential frameworks are particularly valuable. Moreover, financial stability is too big a burden to rest exclusively on prudential and macroprudential policies; it needs the cooperation of other policies: a more symmetrical monetary policy across the financial cycle, fiscal policies that create additional space in financial booms, etc. Finally, let me finish on a positive note. Despite our limited knowledge about the impact of macroprudential policies, there is significant room for effective action - for at least three reasons: First, potential policy conflicts are usually exaggerated. It seems likely that, in most circumstances, macroprudential policy and monetary policy will be complementary, tending to support each other instead of conflicting. It is important to realise that the financial cycles that matter for prudential policy are of a much lower frequency than business cycles. This suggests that, most of the time, monetary policy should be able to treat macroprudential policy developments as a relatively slow-moving background. However, it also requires monetary policy to keep an eye on developments over longer horizons in order to take into account the effects of the gradual build-up and unwinding of financial imbalances. This longer horizon diffuses some of the possible tensions between monetary policy and macroprudential decisions.
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Second, there is already a growing body of research and experience that has led to significant progress being made both conceptually and operationally, for instance in the design and calibration of macroprudential tools. Third, some tools and indicators seem to produce reasonable results certainly better than doing nothing. In particular, the credit gap indicator embedded in the Basel III countercyclical capital buffer seems to provide good guidance for action. Simulations indicate that following this indicator would help to produce meaningful action (eg raising capital) at an early stage, before the beginning of a financial crisis. For example, the United States and the United Kingdom would have started setting aside more capital in 1999, and the 2.5% buffers would have been completed by 2002 and 2006 respectively, ie well before the financial crisis. Spain would have started even earlier, in 1997 (with the 2.5% buffer completed in 1999). Of course, the indicator would not have worked so well in some other countries. For instance, in the case of the Netherlands, it would have peaked too early compared to the evolution of the financial cycle; nonetheless, healthy buffers would have been built. Also, the credit gap indicator has proved to be noisy for some large emerging market economies such as Brazil and Turkey. To be sure, this indicator can be supplemented with the information coming from the analysis of other indicators. These are just a few examples of the possibilities of one of the instruments of macroprudential policies.

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They illustrate the potential but also the need to continue to work on how the macroprudential approach can be formalised and applied to different institutional frameworks in a way that strengthens other policies and mitigates systemic risk.

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Chairman Ben S. Bernanke At the "Challenges of the Global Financial System: Risks and Governance under Evolving Globalization," A High-Level Seminar sponsored by Bank of Japan-International Monetary Fund, Tokyo, Japan

U.S. Monetary Policy and International Implications
Thank you. It is a pleasure to be here. This morning I will first briefly review the U.S. and global economic outlook. I will then discuss the basic rationale underlying the Federal Reserve's recent policy decisions and place these actions in an international context.

U.S. and Global Outlook
The U.S. economy has faced significant headwinds, and, although the economy has been expanding since mid-2009, the pace of our recovery has been frustratingly slow. The headwinds include the effects of deleveraging by households, the still-weak U.S. housing market, tight credit conditions in some sectors, spillovers from the situation in Europe, fiscal contraction at all levels of government, and concerns about the medium-term U.S. fiscal outlook. In this environment, households and businesses have been quite cautious in increasing spending. Accordingly, the pace of economic growth has been insufficient to support significant improvement in the job market; indeed, the unemployment rate, at 7.8 percent, is well above what we judge to be its long-run normal level.

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With large and persistent margins of resource slack, U.S. inflation has generally been subdued despite periodic fluctuations in commodity prices. Consumer price inflation is running somewhat below the Federal Reserve's 2 percent longer-run objective, and survey- and market-based measures of longer-term inflation expectations have remained well anchored. The global economic outlook also presents many challenges, as you know. Fiscal and financial strains have pushed Europe back into recession. Japan's economy is recovering from last year's tragic earthquake and tsunami, and it continues to struggle with deflation and persistent weak demand. And in the emerging market economies, the rapid snap-back from the global financial crisis has given way to slower growth in the face of weak export demand from the advanced economies. The soft tone of global activity is yet another headwind for the U.S. economy. Looking ahead, economic projections of Federal Open Market Committee (FOMC) participants prepared for the Committee's September meeting called for the economic recovery to proceed at a moderate pace in coming quarters, with the unemployment rate declining only gradually. FOMC participants generally expected that inflation was likely to run at or below the Committee's inflation goal of 2 percent over the next few years.

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The Committee also judged that there were significant downside risks to this outlook, importantly including the potential for an intensification of strains in Europe and an associated slowing in global growth.

Federal Reserve's Recent Policy Actions
All of the Federal Reserve's monetary policy decisions are guided by our dual mandate to promote maximum employment and stable prices. With the disappointing progress in job markets and with inflation pressures remaining subdued, the FOMC has taken several important steps this year to provide additional policy accommodation. In January, the Committee noted that it anticipated that economic conditions were likely to warrant exceptionally low levels of the federal funds rate at least through late 2014--a year and a half later than in previous statements. In June, policymakers decided to continue through year-end the maturity extension program (MEP), under which the Federal Reserve purchases long-term Treasury securities and sells short-term ones to help depress long-term yields. At its September meeting, with the data continuing to signal weak labor markets and no signs of significant inflation pressures, the FOMC decided to take several additional steps to provide policy accommodation. It extended the period over which it expects to maintain exceptionally low levels of the federal funds rate from late 2014 to mid-2015. Moreover, the Committee clarified that it expects to maintain a highly accommodative stance of monetary policy for a considerable period after the economic recovery strengthens.

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The FOMC coupled these changes in forward guidance with additional asset purchases, announcing that it will purchase agency mortgage-backed securities (MBS) at a pace of $40 billion per month, on top of the $45 billion in monthly purchases of long-term Treasury securities planned for the remainder of this year under the MEP. The FOMC also indicated that it would continue to purchase agency MBS, undertake additional asset purchases, and employ other tools as appropriate until the outlook for the labor market improves substantially in a context of price stability. The open-ended nature of these new asset purchases, together with their explicit conditioning on improvements in labor market conditions, will provide the Committee with flexibility in responding to economic developments and instill greater public confidence that the Federal Reserve will take the actions necessary to foster a stronger economic recovery in a context of price stability. An easing in financial conditions and greater public confidence should help promote more rapid economic growth and faster job gains over coming quarters. As I have said many times, however, monetary policy is not a panacea. Although we expect our policies to provide meaningful help to the economy, the most effective approach would combine a range of economic policies and tackle longer-term fiscal and structural issues as well as the near-term shortfall in aggregate demand. Moreover, we recognize that unconventional monetary policies come with possible risks and costs; accordingly, the Federal Reserve has generally employed a high hurdle for using these tools and carefully weighs the costs and benefits of any proposed policy action.

International Aspects of Federal Reserve Asset Purchases
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Although the monetary accommodation we are providing is playing a critical role in supporting the U.S. economy, concerns have been raised about the spillover effects of our policies on our trading partners. In particular, some critics have argued that the Fed's asset purchases, and accommodative monetary policy more generally, encourage capital flows to emerging market economies. These capital flows are said to cause undesirable currency appreciation, too much liquidity leading to asset bubbles or inflation, or economic disruptions as capital inflows quickly give way to outflows. I am sympathetic to the challenges faced by many economies in a world of volatile international capital flows. And, to be sure, highly accommodative monetary policies in the United States, as well as in other advanced economies, shift interest rate differentials in favor of emerging markets and thus probably contribute to private capital flows to these markets. I would argue, though, that it is not at all clear that accommodative policies in advanced economies impose net costs on emerging market economies, for several reasons. First, the linkage between advanced-economy monetary policies and international capital flows is looser than is sometimes asserted. Even in normal times, differences in growth prospects among countries--and the resulting differences in expected returns--are the most important determinant of capital flows. The rebound in emerging market economies from the global financial crisis, even as the advanced economies remained weak, provided still greater encouragement to these flows. Another important determinant of capital flows is the appetite for risk by global investors.
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Over the past few years, swings in investor sentiment between "risk-on" and "risk-off," often in response to developments in Europe, have led to corresponding swings in capital flows. All told, recent research, including studies by the International Monetary Fund, does not support the view that advanced-economy monetary policies are the dominant factor behind emerging market capital flows. Consistent with such findings, these flows have diminished in the past couple of years or so, even as monetary policies in advanced economies have continued to ease and longer-term interest rates in those economies have continued to decline. Second, the effects of capital inflows, whatever their cause, on emerging market economies are not predetermined, but instead depend greatly on the choices made by policymakers in those economies. In some emerging markets, policymakers have chosen to systematically resist currency appreciation as a means of promoting exports and domestic growth. However, the perceived benefits of currency management inevitably come with costs, including reduced monetary independence and the consequent susceptibility to imported inflation. In other words, the perceived advantages of undervaluation and the problem of unwanted capital inflows must be understood as a package--you can't have one without the other. Of course, an alternative strategy--one consistent with classical principles of international adjustment--is to refrain from intervening in foreign exchange markets, thereby allowing the currency to rise and helping insulate the financial system from external pressures.

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Under a flexible exchange-rate regime, a fully independent monetary policy, together with fiscal policy as needed, would be available to help counteract any adverse effects of currency appreciation on growth. The resultant rebalancing from external to domestic demand would not only preserve near-term growth in the emerging market economies while supporting recovery in the advanced economies, it would redound to everyone's benefit in the long run by putting the global economy on a more stable and sustainable path. Finally, any costs for emerging market economies of monetary easing in advanced economies should be set against the very real benefits of those policies. The slowing of growth in the emerging market economies this year in large part reflects their decelerating exports to the United States, Europe, and other advanced economies. Therefore, monetary easing that supports the recovery in the advanced economies should stimulate trade and boost growth in emerging market economies as well. In principle, depreciation of the dollar and other advanced-economy currencies could reduce (although not eliminate) the positive effect on trade and growth in emerging markets. However, since mid-2008, in fact, before the intensification of the financial crisis triggered wide swings in the dollar, the real multilateral value of the dollar has changed little, and it has fallen just a bit against the currencies of the emerging market economies.

Conclusion
To conclude, the Federal Reserve is providing additional monetary accommodation to achieve its dual mandate of maximum employment and price stability.
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This policy not only helps strengthen the U.S. economic recovery, but by boosting U.S. spending and growth, it has the effect of helping support the global economy as well. Assessments of the international impact of U.S. monetary policies should give appropriate weight to their beneficial effects on global growth and stability.

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The new UK Regulator: The Financial Conduct Authority
The Financial Conduct Authority (FCA) will be the new regulator whose vision it is to make markets work well so consumers get a fair deal. It will be responsible for requiring firms to put the well-being of their customers at the heart of how they run their business, promoting effective competition and ensuring that markets operate with integrity. The FCA will start work in 2013, when it will receive new powers from the Financial Services Bill that is currently going through parliament. The Journey to the FCA sets out how we will approach our regulatory objectives, how we intend to achieve a fair deal in financial services for consumers and where we are on this journey.

Changes to authorisations
The UK regulatory structure will be changing in 2013, when the FSA will split into two regulatory bodies the Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA).

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In April 2012, Supervision adopted the internal-twin peaks structure, and now Authorisations are implementing a similar structure, with assessments carried out by both the Prudential Business Unit (PBU) and the Conduct Business Unit (CBU). This change will only affect firms that will be dual regulated in future. The application submission process will not change and we will continue to seek to meet our statutory deadlines. What will change is how the application is processed internally. There will be a CBU case officer and a PBU supervisor responsible for each application and they will coordinate to minimise duplication or the impact on applicant firms and individuals. The final decision will need to be agreed by both the PBU and the CBU to ensure a single FSA decision during transition to the new regulatory structure. These changes will allow us to start to deliver, as far as possible, a model that will mirror the future authorisation procedures in the PRA and the FCA.

What is happening to the FSA Handbook?
At legal cutover, the FSA Handbook will be split between the FCA and the PRA to form two new Handbooks, one for the PRA and one for the FCA. Most provisions in the FSA Handbook will be incorporated into the PRA’s Handbook, the FCA’s Handbook, or both, in line with each new regulator’s set of responsibilities and objectives. Users of the Handbook will be able to access the following online:

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1. The PRA Handbook, displaying provisions which apply to PRA-regulated firms 2. The FCA Handbook, displaying all provisions which apply to FCA-regulated firms; and 3. To support the transition, a central version which will show the provisions of both Handbooks, with clear labels indicating which regulator applies a provision to firms. The new Handbooks will reflect the new regulatory regime (for example, references to the FSA will be replaced with the appropriate regulator), and in some areas more substantive changes will be made to reflect the existence of the two regulators, their roles and powers. (This is likely to include such aspects as the future processes for permissions, passporting, controlled functions, threshold conditions and enforcement powers.) The more substantive changes will be consulted on before the PRA and the FCA acquire their legal powers. Changes to the FSA Handbook as a result of EU legislation and FSA policy initiatives will continue throughout this work. After acquiring their powers, the FCA and the PRA will amend their own suites of policy material as independent bodies in accordance with the processes laid down in the Financial Services Bill, including cooperation between them and external consultation.

What does this mean for firms?
This approach to the Handbooks for the FCA and the PRA has been planned to ensure a safe transition for firms and the new regulators as the new regime is introduced. Firms will have a new regulator or regulators, and will consequently need to assess how the new Handbooks of these bodies will apply to them.
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Dual regulated firms will need to look to both the PRA and the FCA Handbooks, and FCA regulated firms to the FCA Handbook.

When will the changes be in the Handbook?
We expect to publish the new Handbooks before legal cutover. This will allow firms and others time to adjust to the application of the new Handbooks before the FCA and the PRA are fully operational. The new Handbooks will not be available in detail before this. Alongside the publication, we will publish material on how to interpret the application of the Handbooks, where this is not dealt with in the Handbooks themselves. The FSA will continue to make changes to its Handbook in accordance with the normal procedure, until the new bodies acquire their legal powers. The FSA Handbook will remain in force until the FCA and PRA acquire their legal powers.

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Launch of the Journey to the FCA
Speech by Martin Wheatley - Managing Director, FSA, and CEO Designate, FCA at the Launch of the Journey to the FCA event Good morning. I would like to thank the Minister Greg Clark for joining us today, for his supportive words – and for demonstrating the Government’s commitment to working alongside us to deliver better conduct regulation. I would also like to thank Thomson-Reuters for hosting this morning. Today is a big step forward on the road to becoming the new regulator, and I am glad that you are all here to join us as we launch the Journey to the FCA. The FCA offers a huge opportunity for the regulator and firms to start afresh, and work in partnership to reset how we deal with conduct in financial services. We see it as the role of the regulator to not only make the relevant markets work well but also to help firms get back to putting their customers at the heart of how they do business. Regulation has a huge impact on the people and businesses that rely on financial services, and we should never forget this. We have approached the creation of the FCA in a thoughtful and considered way, as the document we are sharing with you today shows. We will regulate one of our most successful industries, central to the health of our economy and a provider of two million UK jobs. This makes our job an important one, and it will mean that we carry out our work in a way that is as open and accountable as possible. We spent the summer engaging with consumer organisations, and 500 firms from all areas of financial services, as we developed our thinking on the FCA.
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This allowed us to gather useful feedback and we will continue this open working in the FCA. We aim in the Journey to the FCA to demonstrate what our new organisation will mean for the firms we regulate and the consumers we are here to help protect. I encourage you all to read it, and to give us your views. We are clear about the type of regulator we want to become, and we want to work with all of our stakeholders to get there and deliver regulation that works better. You have not yet had a chance to read the document, so let me explain a bit more about what the FCA is going to be about. The FCA has been set up to work with firms to ensure they put consumers at the heart of their business. Underlining this are three outcomes: 1. Consumers get financial services and products that meet their needs from firms they can trust. 2. Firms compete effectively with the interests of their customers and the integrity of the market at the heart of how they run their business. 3. Markets and financial systems are sound, stable and resilient with transparent pricing information. Reforming regulation is not just good for consumers, it will also be good for firms. The industry’s standing has suffered as the mis-selling scandals and other problems have taken their toll. This has damaged the reputation of firms across the industry, whether directly involved or not. We need to work with you to put that right. While much of what we will do is new, we will also build on what has worked well under the FSA.

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We will keep up our policy of credible deterrence, pursuing enforcement cases to punish wrongdoing. And our markets regulation will continue to promote integrity and carry on the FSA’s fight against insider dealing, which has secured 20 criminal convictions since 2009. We will continue to keep unauthorised firms from trying to take advantage of consumers. We will set high expectations for those firms that want to enter financial services, while still allowing innovation and good ideas to flourish. And we will take forward a strong interest in the fair treatment of customers – an agenda that has been around for many years, but is still key to the FCA. There will, however, be important changes, and our approach will be more forward-looking, better informed, and we will have a greater appetite to get things done. A new department will act as the radar of our new organisation – combining better research into what is happening in the market, and analysis of the risks to our objectives. This will then feed into our policymaking and our supervision of firms. We want to really understand what is happening to your customers, the deal they are getting and the issues they face. This will include getting a better understanding of why consumers act in the way they do, so we can adapt our regulation to their common behavioural traits. Fewer firms will have regular direct contact with supervisors, as we shift resources to allow us to deal more quickly and effectively with emerging issues, and run more cross-industry projects to get to the root cause of problems.

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We will have new partners to work with and our relationship with the new Prudential Regulation Authority will be crucial, and driven by a culture of cooperation. We will aim to bring our expertise to international debates, so that EU and international policymaking works for UK consumers and firms. All of this will be delivered by a new culture in the FCA. We will encourage our staff to be more confident in making bold, firm and predictable decisions. To help us do our job, the Government intends to give the FCA new tools to ensure that consumers get products that meet their needs. This builds on one of the key lessons from past problems, which is that regulation is often more effective if it steps in early to pre-empt and prevent widespread harm. We will reflect this in our supervision work when we look at how firms design and sell their products. But a key new power will mean that we can step in and ban the sale of products that pose unacceptable risks to consumers for up to 12 months, without consulting first. We will also be able to ban misleading advertising. We will use these new tools in a measured way – and while we will act sooner, and more decisively, our approach will be based on a proper understanding of the issues and a full consideration of the potential solutions. So whilst there may be times when we have to act rapidly, this is not something that firms should be afraid of. Firms selling the right products, in the right way, to the right consumers have little to fear. Our new approach will mean that we will take competition into account in all our work.
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We will weigh up the impact on competition of new measures we propose. We will also consider whether competition could lead to better results than other action we could take. In our work here, and in other areas, I am very conscious that we have to work with firms. Making regulation work better for us is also about allowing firms room to try new ideas and develop their business. Promoting competition will play an important part in this. We are not here to stand in the way of progress that will be of benefit to consumers. Our goals as the FCA are clear: we will work for an industry that is better at serving the needs of its customers. I see this as an opportunity – not just for us but for the industry. We can do our job better if we work with you, and I am pleased that so many of the chief executives that I speak to are talking the same language and have committed to rebuilding confidence and trust, and reconnecting with their customers. It is great hearing about these good intentions, but the difficult bit for us all is to make sure this change actually happens. There are challenges and opportunities for both us the regulator, and you the industry. It is a journey we have to walk together, as we put consumers back at the heart of what we do.

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Andrew G Haldane: The Bank and the banks

Speech by Mr Andrew G Haldane, Executive Director, Financial Stability, Bank of England, at Queen’s University, Belfast
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The views expressed within are not necessarily those of the Bank of England or the Financial Policy Committee. I would like to thank Bethany Blowers, Forrest Capie, John Keyworth, Victoria Kinahan, Emma Murphy, Varun Paul, Richard Roberts, and the staff of the Bank’s archives for their comments and contributions. In the light of the financial crisis, there is much to explain. Doing so is not just important for reasons of accountability to the public. Explaining and understanding errors of the past is absolutely essential if policymakers are to learn lessons for the future. To misquote someone none of you have ever heard of, those who forget the errors of the past are doomed to repeat them. During the course of its 318-year history, the Bank of England has had plenty of crisis experience. And encouragingly, on my reading of history, there is evidence of it having learnt from this experience. In response, radical reform of the Bank’s policymaking framework has been commonplace. There are few better examples than the radical reform of the Bank’s transparency and accountability practices over the past twenty-five years.
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Those reforms are continuing to the present day. A wholly new framework for financial stability policy is being put in place in the UK, perhaps the most radical in the Bank’s history. I will discuss that framework later on. This framework can be seen as an evolutionary response to crisis experience, not just this crisis but a great many previous ones. It is impossible to know if this framework will proof us against future crises. But in remembering those errors of the past, it gives us a fighting chance of not repeating them. So I want to take you on an historical journey charting the Bank of England’s role in financial crises and its response to them. Now, I know what you are thinking. The evolution of financial stability in the UK viewed through the lens of the Bank of England sounds deadly dull. So I am going at least to try to add a touch of colour to the events and personalities of the time.

The very beginning
Let’s start at the very beginning. The Bank of England was put on earth, way back in 1694, to do none of the things it does today – namely, preserving monetary and financial stability.
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Instead, it was a confection of the then monarchs, William III and Mary II, to pay for their war debts. At the time the Bank was little more than a branch, with a mere twenty staff. Pretty early in its life, however, the Bank began to involve itself in the business of banking. It began to grow its balance sheet by taking deposits from and extending loans to other banks, typically by the practice of “discounting” bills of exchange. The Bank also issued its own notes which, due to the implicit backing of the government, circulated as currency with the public. At this stage, the Bank was far from being the nationalised, policymaking body we know today. Rather, the Bank was a quasi-private bank conducting its business for quasi commercial ends. Other banks at the time were engaged in similar commercial pursuits, including often issuing their own notes. Except, of course, they lacked the government as guarantor. This made for a competitive, and at times rather antagonistic, relationship between the Bank and the commercial banks. This strained relationship lasted for the whole of the 18th and a good chunk of the 19th centuries. Was the Bank friend or foe, collaborator or competitor?

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The commercial banks did not know. And the Bank – private in name but public in finances – was itself in a state of mild schizophrenia. These psychological flaws were exposed in the middle of the 19th century. By then, the Bank had been granted monopoly rights to issue currency. Quite literally, this cut the commercial banks out of a lucrative money-making scheme. This did little to ease competitive tensions between the Bank and the banks. This tension bubbled over in the famous case of Overend and Gurney Bank. In the early part of the 19th century, Overend had grown rapidly to become the largest discount house in London. If not too big to fail, it was certainly large enough to look after itself – as the Bank found out in 1860. Two years earlier, the Bank had abolished the right of other banks to come to it for cash by discounting bills. The banks took umbrage. With Overend and Gurney playing the role of shop steward, they collectively withdrew £1.6 million from the Bank over three days in an attempt to bring the Bank, if not to its knees, then at least to its senses. Dark, anonymous messages were sent to the Bank, presumably not by Twitter, warning: “Overends can pull out every note you have”. In the event Overend eventually caved, returning to the Bank the notes they had withdrawn apologetically – or at least semi-apologetically, as the notes actually came back cut in half.

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Six years later in 1866, when Overend and Gurney asked the Bank for an emergency loan of £400,000, the answer was “No”. The Bank won this battle, but was to lose decisively the war. Overend and Gurney failed. The City shook. Panic took hold. The Bank was forced to lend £4 million – ten times the initial sum – to support other banks. There was a chorus of disapproval. The Bank’s role in crisis management would never be the same again.

Supporting the financial system
Criticism of the Bank’s role in the Overend crisis came prominently from Walter Bagehot, then-editor of The Economist and Bank-of-England basher of his day. He lambasted the Bank’s acting “hesitatingly, reluctantly and with misgiving”. Henry Gibbs, Governor of the Bank from 1875 to 1877, highlighted the Overend experience as “the Bank’s only real blunder”. Yet the Bank had also learned from this experience. It had discovered that its role could be neither commercial nor competitive. Instead its role was as guardian of the financial system as a whole, protecting banks from what is today called systemic risk.

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In Bagehot’s words, the Bank should act as last resort lender to solvent institutions against good collateral at a penalty rate. It has done so ever since. The Bank did not have to wait long to put its new-found role into practice. On Saturday 8 November 1890 the Bank Governor of the day, William Lidderdale, summoned his Directors. This itself aroused suspicion. Bank directors were never seen at work at the weekend. They typically departed for the country around Friday lunchtime. (Let me tell you, things have changed for Bank of England Directors since then.) What Lidderdale told his Directors was electric. There were serious liquidity problems at another big and famous bank, Baring Brothers and Company. But the Bank had not the faintest clue as to Barings’ true financial position. To rectify that, Lidderdale ordered an accountant’s report on Barings to be brought to him with immediate effect. And with that, he departed to London Zoo with his son. The accountant’s report showed a solvent but illiquid Barings. Back from the Zoo, Lidderdale began to construct a financial “lifeboat” for Barings, with a contribution from the Bank but also from the commercial banks. This was the system acting in support of the system.
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The lifeboat was launched and Barings was saved, in what has become known as the “crisis that never became a drama”. The Bank’s lifeboat has since been re-launched on more than one occasion. A second financial lifeboat – different in detail, but identical in principle – was launched by the Bank of England in the early 1970s. Then, it was intended to save the small banks rather than the large. It, too, steadied some sinking ships. Third time, however, was not so lucky. On 24 February 1995, it was Barings Bank who were again knocking on the Bank of England’s door for help. Bank Directors were again summoned on a Saturday. I myself was caught by a TV crew entering the Bank on that Saturday morning, arousing suspicion something was amiss. In fact, I had not been recalled to save the day. (I believe I was filmed wearing a tracksuit.) And I was as blissfully unaware of Barings’ problems as most of the rest of the world. (I was at the Bank completing a research paper on “A Structural Vector Autoregressive Model of the Monetary Transmission Mechanism”.) Life was easier then.

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Nick Leeson, at the time a despised and corrupt rogue-trader, today a much-admired reality- TV star and after-dinner speaker, had put a huge hole in the Barings boat. Over the weekend, then-Governor Eddie George tried hard to assemble a lifeboat. All visits to London Zoo were cancelled. But the lifeboat failed and with it Barings. That Barings was allowed to fail, and did so without rupturing the system, is a key lesson for today, to which I will return later. So what does this tell us about how the Bank of England’s role had evolved on entering the 20th century? The Bank now spoke and acted as steward of the financial system, marshalling its own and others’ financial resources to keep the financial system panic-free. The Bank was at the frontline of crisis management. But these episodes also contained lessons. When the first Barings crisis came, the Bank had been reactive and backfoot. It had been blindsided by the risk to its own and the financial system’s balance sheet. The Bank was finding its feet as a crisis-container. But in attitude and expertise, it was a world away from being an effective crisis-preventer.

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Supporting the economy
Fast forward to the start of the First World War. William Lidderdale had been replaced as Bank Governor by Walter Cunliffe. Cunliffe was not what would these days be called an equal opportunities employer. The Bank’s staff rules were stifling and sexist – although were ahead of their time compared to other City firms. The Bank went 150 years without employing any women at all. When they did, it was to do the work of 15–18 year old boys, sorting and listing returned notes. On getting married, women at the Bank were required to resign their position. The Bank was “Old Lady” by name but “Young Lady” by nature. Cunliffe’s greatest achievement was his contribution to solving the financial panic of 1914. On Friday 24 July, the City woke to the threat of war as Austria made an ultimatum to Serbia. There was a worldwide scramble for the safety of cash. Mass-selling led to stock markets closing in Europe, then New York, then Australia. London was not exempt. By 31 July, the London Stock Exchange had closed for the first time in its near 150-year history.
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Panic soon spread to the money markets, sucking liquidity and life out of the financial system. Unable to finance themselves, lending by the banks began to drain away, starving the economy of credit and causing it too to crater. This was truly a credit crunch. Cunliffe’s plan, hatched with the Treasury, was to lift the liquidity burden on the banks by purchasing the IOUs they were holding from overseas borrowers which had become understandably illiquid on the outbreak of war. These bills were bought by the Bank and stored in its vaults, in what became known as the “cold storage” scheme. By freeing the banks’ balance sheets in this way, the cold storage scheme was intended to stimulate credit. It was only a limited success, with the banks still fearful about making new loans because of the rising risk of default by overseas borrowers. In response, the government announced an extension to the scheme, with the government effectively insuring the banks against the credit risk on these assets too. It worked. Within a couple of months, money market conditions had stabilised and credit was once more flowing. Cunliffe’s cold storage plan had averted a credit crisis. The cold storage scheme was a piece of clever financial engineering by the Bank, designed to support credit and the wider economy.

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In the past few years, with credit growth and the economy weak, the Bank has been in the vanguard of creating new pieces of machinery to serve a similar end. In 2008, the Bank introduced a Special Liquidity Scheme, or SLS, to help finance UK banks’ legacy asset portfolio. Over £180 billion of support was provided to the banks and has since been repaid. The SLS bears more than a passing resemblance to the first phase of the cold storage scheme. In June this year, the Bank announced a second scheme, the Funding for Lending Scheme, or FLS. It provides liquidity support to UK banks on terms which depend on their lending to the UK economy, thereby acting as a direct incentive to stimulate new lending. The FLS bears some resemblance to the second phase of cold storage. The SLS and FLS may be less famous than JLS, the London R&B boy-band. But they are an important recognition of the Bank’s role in supporting credit intermediation. That role began in the early part of the 20th century with schemes like cold storage. The Bank’s role had expanded beyond its own doorstep, on which the banks stood, to the doorsteps of households and companies up and down the country seeking credit.

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Supporting financial infrastructure
Yet one thing at least had stayed the same: in 1914, the Bank had only acted when jolted into doing so by war. Its role was still as crisis-container rather than preventer. During the 1920s and 1930s, the Bank of England became Montagu Norman’s Bank. And Norman set about changing that. Norman was not Cunliffe’s greatest fan and the feeling was clearly mutual. “There goes that queer-looking fish with the ginger beard again”, Cunliffe is said to have observed about Norman. “Do you know who he is? I keep seeing him creep about this place like a lost soul with nothing better to do.” Nor would Norman necessarily have ingratiated himself to today’s army of Bank economists. “You are not here to tell us what to do, but to explain why we have done it” is the way Norman rebuked the Bank’s Chief Economist of the day. Norman saw the Bank’s role in expansive terms, as provider not just of emergency help but as builder of infrastructure and supporter of industry. The Bank became part of the post-war reconstruction effort. Having spent 200 years tending to its back garden, the Bank began to explore pastures new.
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To take one example, in 1928 the Lancashire cotton industry was on its knees. These problems risked ricocheting back to the financial system, with at least two of the big five UK banks up to their neck in cotton. A plan was conceived involving consolidating the industry into a Lancashire Textile Corporation. This was to be financed with debt and shares issued and supported by – you’ve guessed it – the Bank of England. It was a bold and cunning plan. Unfortunately, it flopped. The share issue by the Corporation in 1931 was a resounding failure, leaving the underwriter with a large chunk of the shares. The Bank ended up having to support the market. It, too, found itself up to its neck in cotton. Undaunted, the stage had nonetheless been set for the Bank’s on-going involvement in financial infrastructure. This came not a moment too soon. In the immediate post-war period, the UK faced pressing financial infrastructure problems – the so-called “Macmillan gaps”. These gaps referred the inability of small firms to finance themselves with long-term loans. If these gaps sound strangely familiar, then they should. The post-war Bank set about closing these Macmillan gaps with gusto.

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In 1945 it set up two new financing entities – the Finance Corporation for Industry (FCI) and the Industrial and Commercial Finance Corporation (ICFC). These were financially supported by banks and institutional investors, providing a platform for the supply of longer term funding and venture capital finance to small firms. In 1973, the two corporations combined to form Finance for Industry (FFI). During the early 1980s, the company was rebranded as Investors in Industry, commonly known as 3i. In 1987, the entity went public as 3i Group. This was not a flop. Arguably, 3i and its predecessors were one of the largest feathers in the Bank’s post-war cap, helping support generations of new businesses and start-ups. And those MacMillan gaps? Regrettably, the crisis has re-opened them. Today, small firms are once more starved of finance, including many here in Northern Ireland. Once again, the quest is on for a new financial infrastructure to help close these gaps. Through the 1980s and 1990s, there were further examples of the Bank stepping in to close structural financial gaps. When the UK’s high-value payment system started creaking in the early 1980s, the Bank designed and built a new, bullet-proof system.
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Given the Bank’s somewhat chequered record on gender diversity up to that point, it was rather unfortunately named CHAPS. And indeed still is. In 1993, the Bank stepped-in to rescue a flagging project to upgrade the securities settlement process in the UK. The Bank designed and built a new, safety-first, system which again exists to this day. Fortunately, we did not call this one BLOKES, but rather the gender-neutral CREST. Most recently, in the light of the crisis, the Bank has been at the forefront of the debate about re-organising the structure of banking, with a ring-fence or firewall between the basic retail and investment banking sides of the business. This structural approach is increasingly finding favour both in the UK (through the proposals of the Vickers Commission) and internationally (for example, through the Volcker proposals in the US and the recent Liikanen proposals in Europe). For the past half-century, the Bank’s structural agenda has become a central feature. But at the time it marked a radical departure from the Bank’s past. Designing what are in effect financial public goods is a front-foot activity. The Bank had grown a new limb, augmenting its crisis-management right arm with a crisis-prevention left arm.

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Stitching it all together
So far, I have made no real mention of monetary policy. That is because, for much of its life up to the early 1970s, monetary control at the Bank of England was pretty simple. It came care of fixing the exchange rate – first to gold under the Gold Standard and latterly in the post war period to the dollar. With the demise of the dollar standard in the early 1970s, however, the exchange rate anchor had been tossed overboard. At the Bank of England, as elsewhere, the search was on for a new nominal anchor. Into this vacuum stepped Andrew Duncan Crockett. Crockett joined the Bank in 1966 as a graduate entrant, just before the break-up of the Bretton Woods dollar standard. He set to work on the biggest problem of the day, locating a new nominal anchor. In so doing, he began working alongside another young(ish) new Bank entrant, Charles Goodhart. The result was a joint paper published in the Bank’s Quarterly Bulletin in June 1970. It was titled “The Importance of Money”. Re-reading it now, it was a prophetic piece of work. In the UK, it laid some of the analytical foundations for what, during the late 1970s and 1980s, became monetarism.
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More than that, the paper placed commercial bank money and credit at the centre of the macro-economy. It could as well have been titled “The Importance of Credit” or indeed “The Importance of Banks”. After a successful spell at the IMF, Crockett returned to the Bank of England in 1989. In 1994, he then became General Manager of the Bank for International Settlements, the central banks’ central bank. In central bank circles, change was in the air. Monetary policy was embarking on a path which targeted inflation and which, unlike monetarism before it, downplayed money and credit. And the regulation of banks, long the preserve of central banks, was in many countries being hived off to separate regulatory agencies. What happened next was truly extra-ordinary. Whether by coincidence or causality, the world experienced the largest banking bubble in history. Between 1990 and 2007, global bank balance sheets rose by a factor four. On the eve of the crisis they had reached around $75 trillion, or almost 1.5 times the annual output of the entire planet. At the Bank for International Settlements, Andrew Crockett saw trouble brewing. In 2000, he gave a speech calling for a “macro-prudential” approach to regulation.

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Crockett argued that central banks needed to look at, and act on, developments across the whole financial system if systemic risk was to be headed-off. Credit booms, the like of which was occurring for real at the time, sowed the seeds of that systemic risk. The rest is of course history, as pre-crisis credit boom turned to shuddering bust. Or rather it would be history were it not for the fact that this crisis, whose seeds were sown in the credit boom, is still with us. Output in the UK is still well below its 2007 level. The so-called Great Recession in the UK is already as severe as the Great Depression of the 1930s. In response, the policy framework has, once more, been radically augmented. Macroprudential policy is the next big thing. It is now widely acknowledged as the missing policy link during the pre-crisis period, the essential bridge between monetary policy and regulation. As I discuss below, this bridge is now being constructed through new frameworks in the UK and internationally.

The Bank tomorrow
So where does all of this leave the Bank today and, indeed, tomorrow? In the light of the crisis, we are moving to a wholly new structure for financial policymaking in the UK.
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In many important respects, this can be seen as building on the lessons of history. To illustrate that, let me set out some of its main features. First, there is to be a radical shift in the organisation and approach to supervising individual financial institutions. The UK will move to a so-called “twin-peaks” regime. That means in practice separating the safety and soundness aspects of the regulation (so-called prudential) from the consumer protection aspects (so-called conduct). The prudential part will from next year sit in the Bank of England in a new Prudential Regulatory Authority, or PRA. This is much more than deck-chair rearrangement. Accompanying this change will be a rootand-branch change in our approach to supervision. There will be a focus on the big risks – the Barings of yesteryear, the RBS of yesterday. Supervision will be front-foot, testing for stress before it strikes and visits to the zoo need to be cancelled. It will be also tolerant of bank failure – Barings Mark 2 rather than Mark 1 – so that market discipline can work its magic. Second, during the course of the crisis, there has been a radical, if underplayed, rethink of the Bank’s approach to supplying liquidity to the banking system.

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While not quite a change on the scale of the Overend and Gurney crisis, this allows banks to access the Bank’s facilities against a much wider range of collateral. The Bank’s liquidity menu is now crystal clear, from which banks can now themselves choose. Third, an entirely-new piece of policy machinery has been introduced – new not just for the UK, but internationally too. In the UK, this is called the Financial Policy Committee or FPC. It was put on earth to do macro-prudential policy, to act as the bridge, to provide the missing link, to monitor the punchbowl before it is emptied and before aspirin needs administering. A year on, the FPC is doing just that. Most recently the FPC has been navigating a particularly hazardous course. The financial system and economy are suffering the hangover from hell. The FPC’s task is to keep the system safe in the face of heightened risks of a relapse, while at the same time keeping the banks’ credit arteries open to support the economy. Both objectives are steeped in the Bank’s history – and both objectives are embodied in the FPC’s remit. The FPC has a remit, too, to strengthen the structural fabric of the financial system, including through improved financial infrastructure. That objective has a place deep in the Bank of England’s heart – from Lancashire cotton mills of the 1930s, to 3i of the post-war years, to CHAPs of the 1980s, to Vickers of the past few years.
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Supporting and executing these new responsibilities will be a massive task. First and foremost, it will require the Bank to have a rich and diverse set of skills. Historically at least, the Bank has been skills-rich but diversity-poor. But I am pleased to say that, too, has been changing for the better. This year’s graduate intake has close to a 50/50 gender split. One in seven of the intake is drawn from ethnic minorities. Only a fifth come from Oxford or Cambridge. The PRA’s arrival next year will broaden further the diversity of the Bank’s skills and experience – legal, accountancy, banking, insurance. The Bank’s policy committees, meanwhile, bring diversity of experience and expertise to the decision-making table, from academe and the private sector. There has been a transformation, too, in the Bank’s approach to external communications and transparency. Think back twenty years. Then, there were no quarterly Inflation Reports, no six-monthly Financial Stability Reports and certainly no press conferences to accompany both. Twenty years ago, there were no minutes of the deliberations of the Bank’s policy committees (today, the MPC and FPC). Back then, press interviews were rare and scripted to within an inch of their life.

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In the past year, Bank officials gave around 65 speeches and over 200 press interviews. In Montagu Norman’s day, the combined total was one. The days of “keeping the Bank out of the press and the press out of the Bank” are well and truly gone. Earlier this year, the Governor gave the Bank’s first live peacetime radio address to the nation for 73 years. The Bank Tweets, fortunately with rather less vigour than your average Premiership footballer. Soon we will have, for the first time in history, published minutes of the Bank’s Court of Directors. The Governor has appeared before the Treasury Committee on no less than 47 occasions since he took office. In 2011, a word search of “Mervyn King” in the press revealed more hits than “Kylie Minogue”. To my knowledge, this is the first time a sitting Bank of England Governor has toppled the Aussie pop princess in the media opinion polls. Given its new responsibilities, the Bank cannot fail to remain in the public’s eye in the period ahead. Transparency and accountability will remain the watchwords – and rightly so.

Conclusion
When pressed by the Macmillan Committee in 1930 to explain the Bank’s actions, Montagu Norman replied: “Reasons, Mr Chairman? I don’t have reasons, I have instincts”.
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I suspect such an answer would work less well with today’s Treasury Committee, to say nothing of today’s media. All public policymakers have an obligation to explain. And all policymakers have an obligation to learn from past crises and past mistakes. That is the only way credibility can be built: not the avoidance of crises and mistakes, which is impossible, but the recognition by the public that, when they do happen, the crises are contained and the mistakes are honest ones. The Bank of England is embarking on the latest chapter in its 318-year history. We cannot avoid a crisis but, as with Barings in 1890, we can endeavour to prevent it becoming a drama. We will certainly be doing our best to prevent it becoming a tragedy like that of the past few years. If nothing else, this new chapter will have learnt from, and will build on, the lessons of history. Thank you.

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The Federal Reserve Board

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

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

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A revised version of these historical data, reflecting the latest information, will be published along with the scenarios.

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

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

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The SCAP was a forward-looking exercise designed to estimate revenue, losses, and capital needs under an adverse economic and financial market scenario. By looking at the broad capital needs of the financial system and the specific needs of individual companies, these stress tests provided valuable information to market participants, reduced uncertainty about the financial condition of the participating bank holding companies under a scenario that was more adverse than that which was anticipated to occur at the time, and had an overall stabilizing effect. Building on the SCAP and other supervisory work coming out of the crisis, the Board initiated the annual Comprehensive Capital Analysis and Review (CCAR) in late 2010 to assess the capital adequacy and the internal capital planning processes of large, complex bank holding companies and to incorporate stress testing as part of the Board’s regular supervisory program for assessing capital adequacy and capital planning practices at large bank holding companies. The CCAR represents a substantial strengthening of previous approaches to assessing capital adequacy and promotes thorough and robust processes at large banking organizations for measuring capital needs and for managing and allocating capital resources. The CCAR focuses on the risk measurement and management practices supporting organizations’ capital adequacy assessments, including their ability to deliver credible inputs to their loss estimation techniques, as well as the governance processes around capital planning practices. In the wake of the financial crisis, Congress enacted the Dodd-Frank Act, which requires the Board to issue regulations that require bank holding companies with total consolidated assets of $50 billion or more (large bank holding companies) and nonbank financial companies that the Financial Stability Oversight Committee has designated to be supervised by the Board (together, covered companies) to conduct stress tests semi-annually, and requires other financial companies with total
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consolidated assets of more than $10 billion and for which the Board is the primary federal financial regulatory agency to conduct stress tests on an annual basis (company-run stress tests). The Act requires that the Board issue regulations that: (i) Define the term “stress test” (ii) Establish methodologies for the conduct of the company-run stress tests that provide for at least three different sets of conditions, including baseline, adverse, and severely adverse conditions (iii) Establish the form and content of the report that companies subject to the regulation must submit to the Board (iv) Require companies to publish a summary of the results of the required stress tests. On January 5, 2012, the Board invited public comment on a notice of proposed rulemaking (proposal or NPR) that would implement the enhanced prudential standards required to be established under section 165 of the Dodd-Frank Act and the early remediation requirements established under Section 166 of the Act, including proposed rules regarding company-run stress tests. The proposed rules would have required each bank holding company, state member bank, and savings and loan holding company with more than $10 billion in total consolidated assets to conduct an annual company-run stress test using data as of September 30 of each year and the three scenarios provided by the Board. In addition, each state member bank, bank holding company, and savings and loan holding company would be required to disclose a summary of the results of its company-run stress tests within 90 days of submitting the results to the Board.

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The Dodd-Frank Act mandates that the OCC and the FDIC adopt rules implementing stress testing requirements for the depository institutions that they supervise, and the OCC and FDIC invited public comment on proposed rules in January of 2012. The Board is finalizing the stress testing frameworks in two separate rules. First, the Board is issuing this final rule, which implements the company-run stress testing requirements applicable to bank holding companies with total consolidated assets greater than $10 billion but less than $50 billion and savings and loan holding companies and state member banks with total consolidated assets greater than $10 billion. Second, the Board is concurrently issuing a final rule implementing the supervisory and semi-annual company-run stress testing requirements applicable to large bank holding companies and nonbank financial companies supervised by the Board.

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

A. Delayed compliance date
Commenters suggested that companies with total consolidated assets less than $50 billion that have not previously been subject to stress-testing requirements need more time to develop the systems and procedures to be able to conduct company-run stress tests and to collect the information that the Board may require in connection with these tests. In response to these comments and to reduce burden on these institutions, the final rule requires most bank holding companies, savings and loan holding companies, and state member banks to conduct their first stress test in the fall of 2013. In addition, the final rule requires bank holding companies, savings and loan holding companies, and state member banks with less than $50 billion in total consolidated assets to begin publicly disclosing their stress test results in 2015 with respect to the stress test conducted in the fall of 2014. Banking organizations that become subject to the rule’s requirements after November 15, 2012 must comply with the requirements beginning in the fall of the calendar year that follows the year the company meets the asset threshold, unless that time is extended by the Board in writing. For example, a company that becomes subject to the rule on March 31, 2013 must conduct its first stress test in the fall of 2014 and report the results in 2015.

B. Tailoring
The proposed rule would have applied consistent annual company-run stress test requirements, including the compliance date and the
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disclosure requirements, to all banking organizations with total consolidated assets of more than $10 billion. The Board sought public comment on whether the stress testing requirements should be tailored, particularly for financial companies that are not large bank holding companies. Several commenters expressed concern that the NPR that would have applied stress testing requirements previously applicable only to large bank holding companies, such as those conducted under the CCAR, to smaller, less complex banking organizations with smaller systemic footprints. The Board recognizes that bank holding companies, savings and loan holdings companies, and state member banks with total consolidated assets less than $50 billion are generally less complex and pose more limited risk to U.S. financial stability than larger banking organizations. As a result, the Board has modified the requirements in the final rule for these institutions, and expects to use a tailored approach in implementation. The final rule modifies the requirements for smaller banking organizations in a number of ways. First, as noted above, most banking organizations, other than state member bank subsidiaries of the large bank holding companies that participated in the SCAP, are not required to conduct their first stress test until 2013. The final rule also provides a longer period for smaller banking organizations to conduct their stress tests. Under the final rule, smaller banking organizations, other than state member bank subsidiaries of SCAP bank holding companies, are not required to report the results of the stress test until March 31.
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The final rule also modifies the public disclosure requirements, generally requiring less detailed disclosure for smaller banking organizations than for larger banking organizations. Separately, the Board intends to seek comment on reporting forms that smaller banking organizations would use in reporting the results of their stress tests to the Board, which are expected to be significantly more limited than the reporting forms applicable to large banking organizations. Banking organizations may be required to include additional components in their adverse and severely adverse scenarios or to use additional scenarios in their stress tests. The Board expects to apply such additional components and additional scenarios to large, complex banking organizations. For example, the Board expects to require large banking organizations with significant trading activities to include global market shock components in their adverse and severely adverse scenarios, and may require large or complex banking organizations to use additional components in the adverse and severely adverse scenarios or to use additional scenarios that are designed to capture salient risks to specific lines of business. Finally, the Board plans to issue supervisory guidance to provide more detail describing supervisory expectation for company-run stress tests. This guidance will be tailored to banking organizations with total consolidated assets greater than $10 billion but less than $50 billion.

C. Coordination
Many commenters emphasized the need for the federal banking agencies to coordinate stress testing requirements for parent holding companies and depository institution subsidiaries and more generally in regard to stress testing frameworks.
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Commenters recommended that the Board, the Office of the Comptroller of the Currency (OCC), and the Federal Deposit Insurance Corporation (FDIC) coordinate in implementing the Dodd-Frank Act stress testing requirements in order to minimize regulatory burden. Commenters asked that the agencies eliminate duplicative requirements and use an interagency forum, like the Federal Financial Institutions Examination Council, to develop common forms, policies, procedures, assumptions, methodologies, and application of results. The Board has coordinated closely with the FDIC and the OCC to help to ensure that the company-run stress testing regulations are consistent and comparable across depository institutions and depository institution holding companies and to address any burden that may be associated with having multiple entities within one organizational structure subject to stress testing requirements. The Board anticipates that it will continue to consult with the FDIC and OCC in the implementation of the final rule, and in particular, in the development of stress scenarios. The Board plans to develop scenarios each year in close consultation with the FDIC and the OCC, so that, to the greatest extent possible, a common set of scenarios can be used for the supervisory stress tests and the annual company-run stress tests across various banking entities within the same organizational structure.

D. Consolidated publication and group-wide systems and models
In addition to requesting better coordination, commenters inquired as to whether a company-run stress test conducted by a parent holding company would satisfy the stress testing requirements applicable to that holding company’s subsidiary depository institutions.

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Commenters recommended that, in order to reduce burden, the Board develop and require the use of a single set of scenarios for a bank holding company and any depository institution subsidiary of the bank holding company, if the Board imposed separate stress testing requirements on both the bank holding company and bank. In order to reduce burden on banking organizations, the final rule provides that a subsidiary depository institution generally will disclose its stress testing results as part of the results disclosed by its bank holding company parent. Disclosure by the bank holding company of its stress test results and those of any subsidiary state member bank generally will satisfy any disclosure requirements applicable to the state member bank subsidiary. Moreover, a state member bank that is controlled by a bank holding company may rely on the systems and models of its parent bank holding company if its systems and models fully capture the state member bank’s risks. For example, under those circumstances, the bank holding company and state member bank may use the same data collection processes and methods and models for projecting and calculating potential losses, pre-provision net revenues, provision for loan and lease losses, and pro forma capital positions over the stress testing planning horizon.

Description of the Final Rule Scope of Application
The final rule applies to any bank holding company with average total consolidated assets of greater than $10 billion but less than $50 billion, and any state member bank and savings and loan holding company that have average total consolidated assets of more than $10 billion (“asset threshold”).
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Average total consolidated assets is based on the average of the total consolidated assets as reported on bank holding company’s or savings and loan holding company’s four most recent Consolidated Financial Statement for Bank Holding Companies (FR Y-9C) or a state member bank’s four most recent Consolidated Report of Condition and Income (Call Report). If the bank holding company, savings and loan holding company, or state member bank has not filed the FR Y-9C or Call Report, as applicable, for each of the four most recent quarters, average total consolidated assets will be based on the average of the company’s total consolidated assets, as reported on the company’s FR Y-9C or Call Report, as applicable, for the most recent quarter or consecutive quarters. In either case, average total consolidated assets are measured on the as-of date of the relevant regulatory report. Once a bank holding company, savings and loan holding company, or state member bank meets the asset threshold, the company will remain subject to the final rule’s requirements unless and until the total consolidated assets of the company are less than $10 billion, as reported on four consecutively filed FR Y-9C or Call Report, as applicable (measured on the as-of date of the relevant FR Y-9C or Call Report, as applicable). A bank holding company, state member bank, or savings and loan holding company that has reduced its total consolidated assets to below $10 billion will again become subject to the requirements of this rule if it meets the asset threshold again at a later date. However, if a bank holding company’s total consolidated assets equal or exceed $50 billion or a savings and loan holding company becomes designated as a nonbank financial company supervised by the Board, such companies will be required to conduct stress tests under subpart G of the Board’s Regulation YY (12 CFR Part 252 Subpart G).

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Such a company will be required to comply with this final rule until it is required to conduct stress tests under subpart G. The final rule does not apply to foreign banking organizations. The Board expects to issue a separate rulemaking on the application of enhanced prudential standards to foreign banking organizations. A U.S.-domiciled bank holding company subsidiary of a foreign banking organization that has total consolidated assets of $10 billion or more is subject to the requirements of this rule.

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

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

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

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

2. First Stress Test for Bank Holding Companies and State Member Banks Subject to Stress Testing Requirements After December 31, 2012
Commenters similarly expressed concern that bank holding companies, state member banks, and savings and loan holding companies met the rule’s asset threshold after the effective date of the final rule would not have sufficient time to build the systems, contract with outside vendors, recruit experienced personnel, and develop stress testing models that are unique to their organization under the proposed compliance date. In addition, the Federal Advisory Council recommended that the Board phase in disclosure requirements to minimize risk, build precedent, and allow banks and supervisors to gain experience, expertise, and mutual understanding of stress testing models. In response to these comments, the Board extended the compliance date applicable to bank holding companies and state member banks that exceed the final rule’s asset threshold after December 31, 2012. Under the final rule, these companies will be required to conduct their first stress tests beginning in the fall of the calendar year after they meet the asset threshold, unless that time is extended by the Board in writing.

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

Annual Stress Tests Requirements
Timing of Stress Testing Requirements
The Board proposed the following timeline for company-run tests in the NPR. The Board would have required an as-of date of September 30 of information to be submitted to the Board. By no later than mid-November of each calendar year, the Board would provide bank holding companies, state member banks, and savings and loan holding companies with scenarios for annual stress tests. By January 5 of the following calendar year, these companies would be required to submit regulatory reports to the Board on their stress tests. By early April of that calendar year, companies would be required to make public disclosure of results. Several commenters provided suggestions on the proposed timeline. Those comments focused on the as-of date for data to be submitted by bank holding companies, state member banks, and savings and loan holding companies, the date for submitting results to the Board, and the dates when public disclosures of stress test results are to be made.

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For instance, some commenters suggested that the Board should use data collected at as-of dates other than September 30, such as June 30 or December 31, and make corresponding changes to the timing of public disclosure in order to reduce burden on companies during the year-end period. One commenter suggested having a floating submission date, allowing organizations to submit their results at the point in the year when it is most convenient. Some commenters also requested that the Board release the scenarios earlier to provide banking organizations more time to prepare the required reports for the stress tests. The final rule maintains the as-of date for data for the purposes of the annual company-run stress tests so that the same set of scenarios can be used to conduct annual company-run stress tests for large bank holding companies and their subsidiary state-member banks. The Board believes, and several commenters noted, that such alignment is beneficial. Furthermore, using the same scenarios for all firms subject to stress testing requirements will decrease market confusion, minimize burden on institutions, and provide for comparability across institutions. As stated in the concurrent final rule for covered companies, it was necessary to maintain the September 30 as-of date for stress test requirements for large bank holding companies in order to align the stress testing requirements with the capital planning requirements applicable to these institutions under section 225.8 of the Board’s Regulation Y. Commenters requested that the Board release the scenarios earlier in the annual stress test cycle to provide banking organizations more time to prepare the reports for company-run stress tests.
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Under the final rule, the Board will provide descriptions of the baseline, adverse, and severely adverse scenarios generally applicable to companies no later than November 15 of each year, and provide any additional components or scenarios by December 1. The Board believes that providing scenarios earlier than November could result in the scenarios being stale, particularly in a rapidly changing economic environment, and that it is important to incorporate economic or financial market data that are as current as possible while providing sufficient time for companies to incorporate the scenarios in their annual company-run stress tests. Commenters suggested that smaller banking organizations be allowed additional time to conduct their company-run stress tests in light of resource constraints faced by these institutions. In response to these comments, the Board has delayed the timing of report submission to the Board for most banking organizations. Consistent with the requirements imposed on large bank holding companies under subpart G, the final rule requires a state member bank that is controlled by a bank holding company that has average total consolidated assets of $50 billion or more and a savings and loan holding company that has average total consolidated assets of $50 billion or more to conduct its stress test and submit its results to the Board by January 5, unless that time is extended by the Board in writing. All other bank holding companies, savings and loan holding companies, and state member banks are required to conduct their stress tests and submit the results to the Board by March 31. Commenters also noted that the proposed public disclosure deadlines would interfere with so-called “quiet periods” that some publicly traded banking organizations enforce in the lead up to earnings announcements.

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These quiet periods are designed to limit communications that could disseminate proprietary company information prior to earnings announcements. In light of these comments, the Board adjusted the disclosure date to avoid interfering with firms’ quiet periods. Under the final rule, a savings and loan holding company with total consolidated assets of $50 billion or more or a state member bank that is a subsidiary of a bank holding company with total consolidated assets of $50 billion or more is required to disclose the results of its stress tests between March 15 and March 31 of each year. All other banking organizations will be required to disclose their results between June 15 and June 31.

Scenarios
The proposal provided that the Board would publish a minimum of three different sets of economic and financial conditions, including baseline, adverse, and severely adverse scenarios, under which the Board would conduct its annual analyses and companies would conduct their annual company-run stress tests. The Board would update, make additions to, or otherwise revise these scenarios as appropriate, and would publish any such changes to the scenarios in advance of conducting each year’s stress test. Commenters suggested that significant changes in scenarios from year to year could cause a banking organization’s stress testing results to dramatically change. To ameliorate this volatility, commenters suggest that the federal banking agencies have a uniform approach for identifying stress scenarios or establish a “quantitative severity limit” in the final rule to ensure that scenarios do not drastically change from year to year.
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Commenters pointed out that consistency in annual scenario development will make comparability of stress test results between institutions and across time periods more accurate, increase market confidence in the results of stress tests, and make for more dependable capital planning by banking organizations. Commenters also requested the opportunity to provide input on the scenarios. The Board believes that it is important to have a consistent and transparent framework to support scenario design. To further this goal, the final rule clarifies the definition of “scenarios” and includes definitions of baseline, adverse, and severely adverse scenarios. In the final rule, “scenarios” are defined as those sets of conditions that affect the U.S. economy or the financial condition of a bank holding company, savings and loan holding company, or state member bank that the Board annually determines are appropriate for use in the company-run stress tests, including, but not limited to, baseline, adverse, and severely adverse scenarios. The baseline scenario is defined as a set of conditions that affect the U.S. economy or the financial condition of a bank holding company, savings and loan holding company, or state member bank, and that reflect the consensus views of the economic and financial outlook. The adverse scenario is defined as a set of conditions that affect the U.S. economy or the financial condition of a bank holding company, savings and loan holding company, or state member bank that are more adverse than those associated with the baseline scenario and may include trading or other additional components. The severely adverse scenario is defined as a set of conditions that affect the U.S. economy or the financial condition of a bank holding company,
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savings and loan holding company, or state member bank and that overall are more severe than those associated with the adverse scenario and may include trading or other additional components. In general, the baseline scenario will reflect the consensus views of the macroeconomic outlook expressed by professional forecasters, government agencies, and other public-sector organizations as of the beginning of the annual stress-test cycle. The Board expects that the severely adverse scenario will, at a minimum, include the paths of economic variables that are generally consistent with the paths observed during severe post-war U.S. recessions. Each year, the Board expects to take into account of salient risks that affect the U.S. economy or the financial condition of a bank holding company, savings and loan holding company, and state member bank that may not be observed in a typical severe recession. The Board expects that the adverse scenario will, at a minimum, include the paths of economic variables that are generally consistent with mild to moderate recessions. The Board may vary the approach it uses for the adverse scenario each year so that the results of the scenario provide the most value to supervisors, given the current conditions of the economy and the banking industry. Some of the approaches the Board may consider using include, but are not limited to, a less severe version of the severely adverse scenario or specifically capturing, in the adverse scenario, risks that the Board believes should be understood better or should be monitored. The scenarios will consist of a set of conditions that affect the U.S. economy or the financial condition of a bank holding company, savings and loan holding company, or state member bank over the stress test planning horizon.
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These conditions will include projections for a range of macroeconomic and financial indicators, such as real Gross Domestic Product (GDP), the unemployment rate, equity and property prices, and various other key financial variables, and will be updated each year to reflect changes in the outlook for economic and financial conditions. The paths of these economic variables could reflect risks to the economic and financial outlook that are especially salient but were not prevalent in recessions of the past. Depending on the systemic footprint and scope of operations and activities of a company, the Board may require that company to include additional components in its adverse or severely adverse scenarios or to use additional scenarios or more complex scenarios that are designed to capture salient risks to specific lines of business. For example, the Board recognizes that certain trading positions and trading-related exposures are highly sensitive to adverse market events, potentially leading to large short-term volatility in certain companies’ earnings. To address this risk, the Board will require companies with significant trading activities to include market price and rate “shocks,” as specified by the Board, that are consistent with historical or other adverse market events. The final rule also provides that the Board may impose this trading shock on a state member bank that is subject to the Board’s market risk rule (12 CFR part 208, appendix E) and that is a subsidiary of a bank holding company subject to the trading shock under the final rule or under the Board’s company-run stress test rule for covered companies (12 CFR 252.144(b)(2)(i)). The Board is making this modification to allow for coordination of the trading shock between a bank holding company and any state member bank subsidiary that is subject to the market risk rule.
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In addition, the scenarios, in some cases, may also include stress factors that may not be directly correlated to macroeconomic or financial assumptions but nevertheless can materially affect covered companies’ risks, such as factors that affect operational risks. The process by which the Board may require a company to include additional components or use additional scenarios is described under section D.2 of this preamble. Some commenters suggested that the Board adopt a tailored approach to scenarios to better capture idiosyncratic characteristics of each company. For example, commenters representing the insurance industry suggested that any stress testing regime applicable to insurance companies incorporate shocks relating to the exogenous factors that actually impact a particular company, such as a shock to the insurance company's insurance policy portfolio arising from a natural disaster, and de-emphasize shocks arising from traditional banking activities. In the Board’s view, a generally uniform set of scenarios is necessary to provide a basis for comparison across companies. However, the Board expects that each company’s stress testing practices will be tailored to its business model and lines of business, and that the company may not use all of the variables provided in the scenario, if those variables are not appropriate to the firm’s line of business, or may add additional variables, as appropriate. In addition, the Board expects banking organizations to consider other scenarios that are more idiosyncratic to their operations and associated risks, as part of their ongoing internal analyses of capital adequacy.

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FEDERAL RESERVE SYSTEM

Supervisory and Company-Run Stress Test Requirements for Covered Companies AGENCY: Board of Governors of the Federal Reserve System (Board). ACTION: Final rule.
SUMMARY: The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act or Act) requires the Board to conduct annual stress tests of bank holding companies with total consolidated assets of $50 billion or more and nonbank financial companies the Financial Stability Oversight Council (Council) designates for supervision by the Board (nonbank covered companies, and together, with bank holding companies with total consolidated assets of $50 billion or more, covered companies) and also requires the Board to issue regulations that require covered companies to conduct stress tests semi-annually. The Board is adopting this final rule to implement the stress test requirements for covered companies established in section 165(i)(1) and (2) of the Dodd-Frank Act. This final rule does not apply to any banking organization with total consolidated assets of less than $50 billion. Furthermore, implementation of the stress testing requirements for bank holding companies that did not participate in the Supervisory Capital Assessment Program is delayed until September 2013. DATES: The rule is effective on November 15, 2012

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

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By looking at the broad capital needs of the financial system and the specific needs of individual companies, these stress tests provided valuable information to market participants, reduced uncertainty about the financial condition of the participating bank holding companies under a scenario that was more adverse than that which was anticipated to occur at the time, and had an overall stabilizing effect. Building on the SCAP and other supervisory work coming out of the crisis, the Board initiated the annual Comprehensive Capital Analysis and Review (CCAR) in late 2010 to assess the capital adequacy and the internal capital planning processes of large, complex bank holding companies and to incorporate stress testing as part of the Board’s regular supervisory program for assessing capital adequacy and capital planning practices at large bank holding companies. The CCAR represents a substantial strengthening of previous approaches to assessing capital adequacy and promotes thorough and robust processes at large banking organizations for measuring capital needs and for managing and allocating capital resources. The CCAR focuses on the risk measurement and management practices supporting organizations’ capital adequacy assessments, including their ability to deliver credible inputs to their loss estimation techniques, as well as the governance processes around capital planning practices. On November 22, 2011, the Board issued an amendment (capital plan rule) to its Regulation Y to require all U.S bank holding companies with total consolidated assets of $50 billion or more to submit annual capital plans to the Board to allow the Board to assess whether they have robust, forward-looking capital planning processes and have sufficient capital to continue operations throughout times of economic and financial stress. In the wake of the financial crisis, Congress enacted the Dodd-Frank Act, which requires the Board to implement enhanced prudential supervisory standards, including requirements for stress tests, for covered companies to mitigate the threat to financial stability posed by these institutions.
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Section 165(i)(1) of the Dodd-Frank Act requires the Board to conduct an annual stress test of each covered company to evaluate whether the covered company has sufficient capital, on a total consolidated basis, to absorb losses as a result of adverse economic conditions (supervisory stress tests). The Act requires that the supervisory stress test provide for at least three different sets of conditions—baseline, adverse, and severely adverse conditions—under which the Board would conduct its evaluation. The Act also requires the Board to publish a summary of the supervisory stress test results. In addition, section 165(i)(2) of the Dodd-Frank Act requires the Board to issue regulations that require covered companies to conduct stress tests semi-annually and require financial companies with total consolidated assets of more than $10 billion that are not covered companies and for which the Board is the primary federal financial regulatory agency to conduct stress tests on an annual basis (collectively, company-run stress tests). The Act requires that the Board issue regulations that: (i) Define the term “stress test”; (ii) Establish methodologies for the conduct of the company-run stress tests that provide for at least three different sets of conditions, including baseline, adverse, and severely adverse conditions; (iii) Establish the form and content of the report that companies subject to the regulation must submit to the Board; and (iv) Require companies to publish a summary of the results of the required stress tests.

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On January 5, 2012, the Board invited public comment on a notice of proposed rulemaking (proposal or NPR) that would implement the enhanced prudential standards required to be established under section 165 of the Dodd-Frank Act and the early remediation requirements established under Section 166 of the Act, including proposed rules regarding supervisory and company-run stress tests. Under the proposed rules, the Board would conduct an annual supervisory stress test of covered companies under three sets of scenarios, using data as of September 30 of each year as reported by covered companies, and publish a summary of the results of the supervisory stress tests in early April of the following year. In addition, the proposed rule required each covered company to conduct two company-run stress tests each year: an “annual” company-run stress test using data as-of September 30 of each year and the three scenarios provided by the Board, and an additional company-run stress test using data as of March 31 of each year and three scenarios developed by the company. The proposed rule required each covered company to publish the summary of the results of its company-run stress tests within 90 days of submitting the results to the Board. Together, the supervisory stress tests and the company-run stress tests are intended to provide supervisors with forward-looking information to help identify downside risks and the potential effect of adverse conditions on capital adequacy at covered companies. The stress tests will estimate the covered company’s net income and other factors affecting capital and how each covered company’s capital resources would be affected under the scenarios and will produce pro forma projections of capital levels and regulatory capital ratios in each quarter of the planning horizon, under each scenario.

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The publication of summary results from these stress tests will enhance public information about covered companies’ financial condition and the ability of those companies to absorb losses as a result of adverse economic and financial conditions. The Board will use the results of the supervisory stress tests and company-run stress tests in its supervisory evaluation of a covered company’s capital adequacy and capital planning practices. In addition, the stress tests will also provide a means to assess capital adequacy across companies more fully and support the Board’s financial stability efforts. The Dodd-Frank Act mandates that the OCC and the FDIC adopt rules implementing stress testing requirements for the depository institutions that they supervise, and the OCC and FDIC invited public comment on proposed rules in January of 2012. The Board is finalizing the stress testing frameworks in two separate rules. First, the Board is issuing this final rule, which implements the supervisory and company-run stress testing requirements for covered companies (final rule). Second, the Board is concurrently issuing a final rule implementing annual company-run stress test requirements for bank holding companies, savings and loan holding companies, and state member banks with consolidated assets greater than $10 billion that are not otherwise covered by this rule. The Board is issuing this final rule implementing the stress testing requirements in advance of the other enhanced prudential standards and early remediation requirements in order to address the timing of when the stress testing requirements will apply to various banking organizations

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and to require large bank holding companies to publicly disclose the results of their company-run stress tests conducted in the fall of 2012.

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

Scenarios
The proposal provided that the Board would publish a minimum of three different sets of economic and financial conditions, including baseline, adverse, and severely adverse scenarios, under which the Board would conduct its annual analyses and companies would conduct their annual company-run stress tests. The Board would update, make additions to, or otherwise revise these scenarios as appropriate, and would publish any such changes to the scenarios in advance of conducting each year’s stress test. Commenters suggested that significant changes in scenarios from year to year could cause a banking organization’s stress testing results to dramatically change. To ameliorate this volatility, commenters suggest that the federal banking agencies have a uniform approach for identifying stress scenarios or establish a “quantitative severity limit” in the final rule to ensure that scenarios do not drastically change from year to year. Commenters pointed out that consistency in annual scenario development will make comparability of stress test results between institutions and across time periods more accurate, increase market
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confidence in the results of stress tests, and make for more dependable capital planning by banking organizations. Commenters also requested the opportunity to provide input on the scenarios. The Board believes that it is important to have a consistent and transparent framework to support scenario design. To further this goal, the final rule clarifies the definition of “scenarios” and includes definitions of baseline, adverse, and severely adverse scenarios. Scenarios are defined as those sets of conditions that affect the U.S. economy or the financial condition of a covered company that the Board, or with respect to the mid-cycle stress test, the covered company, annually determines are appropriate for use in the company-run stress tests, including, but not limited to, baseline, adverse, and severely adverse scenarios. The baseline scenario is defined as a set of conditions that affect the U.S. economy or the financial condition of a covered company and that reflect the consensus views of the economic and financial outlook. The adverse scenario is defined as a set of conditions that affect the U.S. economy or the financial condition of a covered company that are more adverse than those associated with the baseline scenario and may include trading or other additional components. The severely adverse scenario is defined as a set of conditions that affect the U.S. economy or the financial condition of a covered company and that overall are more severe than those associated with the adverse scenario and may include trading or other additional components. In general, the baseline scenario will reflect the consensus views of the macroeconomic outlook expressed by professional forecasters,
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government agencies, and other public-sector organizations as of the beginning of the annual stress-test cycle. The Board expects that the severely adverse scenario will, at a minimum, include the paths of economic variables that are generally consistent with the paths observed during severe post-war U.S. recessions. Each year the Board expects to take into account of salient risks that affect the U.S. economy or the financial condition of a covered company that may not be observed in a typical severe recession. The Board expects that the adverse scenario will, at a minimum, include the paths of economic variables that are generally consistent with mild to moderate recessions. The Board may vary the approach it uses for the adverse scenario each year so that the results of the scenario provide the most value to supervisors, given the current conditions of the economy and the banking industry. Some of the approaches the Board may consider using include, but are not limited to, a less severe version of the severely adverse scenario or specifically capturing, in the adverse scenario, risks that the Board believes should be understood better or should be monitored. The scenarios will consist of a set of conditions that affect the U.S. economy or the financial condition of a covered company over the stress test planning horizon. These conditions will include projections for a range of macroeconomic and financial indicators, such as real Gross Domestic Product (GDP), the unemployment rate, equity and property prices, and various other key financial variables, and will be updated each year to reflect changes in the outlook for economic and financial conditions.

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The paths of these economic variables could reflect risks to the economic and financial outlook that are especially salient but were not prevalent in recessions of the past. Depending on the systemic footprint and scope of operations and activities of a company, the Board may use, and require that company to use, additional components in the adverse and severely adverse scenarios or additional or more complex scenarios that are designed to capture salient risks to specific lines of business. For example, the Board recognizes that certain trading positions and trading-related exposures are highly sensitive to adverse market events, potentially leading to large short-term volatility in covered companies’ earnings. To address this risk, the Board may require covered companies with significant trading activities to include market price and rate “shocks” in their adverse and severely adverse scenarios as specified by the Board, that are consistent with historical or other adverse market events. In addition, the scenarios, in some cases, may also include stress factors that may not be directly correlated to macroeconomic or financial assumptions but nevertheless can materially affect covered companies’ risks, such as factors that affect operational risks. The process by which the Board may require a covered company to include additional components in its adverse and severely adverse scenarios or to use additional scenarios is described under section III.E.2 of this Supplementary Information. The Board plans to publish for comment a policy statement that describes its framework for developing scenarios. Some commenters suggested that the Board adopt a tailored approach to scenarios to better capture idiosyncratic characteristics of each company.

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For example, commenters representing the insurance industry suggested that any stress testing regime applicable to insurance companies incorporate shocks relating to the exogenous factors that actually impact a particular company, such as a shock to the insurance company's insurance policy portfolio arising from a natural disaster, and de-emphasize shocks arising from traditional banking activities. In the Board’s view, a generally uniform set of scenarios is necessary to provide a basis for comparison across companies. However, the Board expects that each company’s stress testing practices will be tailored to its business model and lines of business, and that the company may not use all of the variables provided in the scenario, if those variables are not appropriate to the firm’s line of business, or may add additional variables, as appropriate. In addition, the Board expects banking organizations to consider other scenarios that are more idiosyncratic to their operations and associated risks as part of their ongoing internal analyses of capital adequacy and include company-specific vulnerabilities in their scenarios when complying with the Board’s requirements for mid-cycle company-run stress test.

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EBA publishes follow-up review of banks’ transparency in their 2011 Pillar 3 reports
The European Banking Authority (EBA) published today a follow-up review aimed at assessing the disclosures European banks’ made in response to the Pillar 3 requirements set out in the Capital Requirements Directive (CRD). Overall, the EBA welcomes efforts made by banks to improve their disclosure practices and to comply with the new requirements introduced with CRD 3. Nevertheless, the report notes that there is still room for improvements in Banks’ Pillar 3 disclosures, and the EBA intends to continue to press for such improvements.

Main findings
Weaknesses remain in the areas of banks disclosures of credit risk – on Internal Ratings Based approaches (IRB) and securitisation activities – and market risk. The introduction of new disclosure requirements in CRD 3 in particular in the areas of securitisation and market risk may explain some of the weaknesses identified. But the EBA has also noted that weaknesses already identified in its previous assessments remain and calls for further action. Beyond assessing compliance with CRD disclosures requirements, the EBA has also performed an analysis of banks’ Basel III implementation disclosures, in particular as regards the impact on own funds, and of the 2011 EBA Capital Exercise related disclosures. Information provided by credit institutions in these two areas were found to be of varying quality.
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In all disclosure areas, the EBA has identified some best practices which credit institutions are encouraged to follow, in order to enhance the general quality of Pillar 3 information. With a view of both facilitating compliance with the requirements as well as enhancing the quality and comparability of disclosures, the EBA will this year supplement information on best practices with further explanations on the objective and content of the disclosure requirements, which banks are also encouraged to consider while preparing their Pillar 3 disclosures. Some improvements in the quality of disclosures were noted in the area of remuneration and own funds. On the latter, credit institutions provided appropriate details of capital items and a meaningful breakdown of deductions. With regards to the timing, formats or verification of disclosures, no significant changes have been made in banks’ practices of reporting Pillar 3 information. However, information was generally published nearer to the reporting date of banks’ annual accounts and annual report but the EBA will still push for publication of these reports at the same time to allow investors to have the complete set of publicly available information at once.

Next steps
Based on the findings and content of this report, the EBA, throughout 2012 and in 2013, plans to implement a strategy for enhanced transparency and to that end will i) Keep on identifying best practices of public disclosures in the publications as well as the CRD requirements for which compliance has to be improved and ii) Will work on these improvements, including in the area of comparability of disclosures. In this respect, the EBA will consult and engage with the industry and users where it is needed.
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Background
The analysis, carried out in 2012 and covering a sample of nineteen European banks, focussed mainly on those areas where the need for improvement had already been identified in previous assessments as well as on areas where new disclosure requirements have been introduced with CRD3. The conclusions of this review will serve as essential input for defining and developing the EBA’s strategy in enhancing the area of transparency. The European Banking Authority was established by Regulation (EC) No. 1093/2010 of the European Parliament and of the Council of 24 November 2010. The EBA has officially come into being as of 1 January 2011 and has taken over all existing and ongoing tasks and responsibilities from the Committee of European Banking Supervisors (CEBS). The EBA acts as a hub and spoke network of EU and national bodies safeguarding public values such as the stability of the financial system, the transparency of markets and financial products and the protection of depositors and investors.

Executive summary
One of the EBA’s regular tasks is to assess Pillar 3 reports of European banks / credit institutions1 and monitor their compliance with the requirements of the Capital Requirements Directive (CRD). This analysis continues from Pillar 3 assessments that have been carried out annually since 2008. It focuses particularly on areas where the need for improvement was already identified in previous assessments.

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It also covers areas where new disclosure requirements entered into force in 2011. The current analysis was carried out in 2012 and covers the 2011 Pillar 3 reports of nineteen European banks. No significant changes in banks’ practices were noted this year in the practical aspects of the publication of Pillar 3 information (e.g. timing, formats or verification of disclosures), although the EBA noted that banks have generally published their Pillar 3 information nearer to the reporting date of their annual accounts and publication of their annual reports. The EBA would prefer the Pillar 3 information to be published at the same time as these annual reports and accounts, and expects the situation to improve as a result of compliance with the new Capital Requirements Regulation (CRR). As far as remuneration disclosures are concerned, if these are not actually included in the Pillar 3 reports or annual reports, the EBA would also prefer them to be published at the same time and provide cross-references between the reports. This would then ensure that Pillar 3 report users (investors and other users) have timely access to the complete set of publicly available information that is essential for assessing credit institutions’ risk profiles. Disclosures on own funds were generally assessed as comprehensive, with credit institutions providing details of capital items and a meaningful breakdown of deductions. Cases of non-compliance were mostly related to disclosures on the grandfathering of instruments, qualitative details about the capital instruments or breakdowns of capital items. The EBA also believes that comparability of disclosures on own-funds will be significantly improved by the implementation of the CRR and of the related EBA‘s implementing technical standards on own funds disclosures, which will provide common definitions and templates for disclosures.
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However, the analysis of information on credit risk – Internal Ratings Based (IRB) approach and securitisation risk – revealed certain weaknesses as well as the need for improvements and more explanation on the rationale for and the expected content of disclosure requirements. In particular, credit institutions are expected to increase the back-testing disclosures. Half of the banks in the sample failed to comply with the relevant CRD requirement, and many of the banks provided confusing information about the assumptions underlying internally developed models. In this context, the EBA also notes that to allow meaningful and reliable conclusions to be drawn on the functioning of the model, disclosures of a comparison between expected losses against actual losses should be provided for a period of at least three years - a best practice that is not followed by the majority of the banks. As far as securitisation risk is concerned, the small number of disclosures assessed as adequate was mainly due to the introduction of new qualitative and quantitative disclosures requirements with the implementation of CRD III. Significant improvement is therefore needed for new disclosures on risk management and exposures in the trading book or related to special purpose entities (SPEs). However, there were also failures to comply with disclosure requirements which were related to pre-CRD III requirements. Market risk was another area where many new disclosure requirements were introduced and here the analysis also identified certain areas where significant improvements were needed. These included disclosures on back-testing of internal models, stress testing, valuation models, adequate breakdown of market risk capital requirements, stressed VaR measure, the new incremental risk charge as well as the comprehensive risk measure.

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On the other hand, significant improvements were noted in the area of remuneration disclosures with a total of 57% of the banks in the sample assessed as providing adequate disclosures or disclosures that captured the spirit of the CRD requirements. In all these disclosure areas, the EBA identified some best practices which credit institutions are encouraged to follow to enhance the quality of Pillar 3 information. In addition to the assessment results and detailed findings as set forth in this report, there are two other sections. The EBA decided to add further analysis that was not limited to a compliance exercise, but touched upon disclosure related issues, outside the Pillar 3 framework. The EBA therefore carried out a thematic study reviewing and comparing Basel III implementation disclosures, focusing on information provided by banks about the resulting impact on own funds, and on disclosures for the EBA 2011 capital exercise. It was found that all credit institutions provided some disclosures, but the content and presentation of these greatly varied. Some institutions only disclosed qualitative elements while others supplemented these qualitative disclosures with some quantitative data. Data were however not comparable, due to differences in terms of granularity and of hypotheses used to estimate the impacts of regulatory changes on own-funds. As last year, the EBA noticed that one of the main challenges of Pillar 3 information, regardless the requirements considered, was comparability of disclosures between credit institutions. The EBA still believes greater comparability or some standardisation would enhance the benefits of Pillar 3 information for users, including the ESAs and the ESRB.

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The conclusions of the report are the result of productive discussions between the National Supervisory Authorities and the EBA, informed by inputs from preparers and users of Pillar 3 disclosures. These conclusions have highlighted topics where further discussions should be encouraged between those preparing and those using of Pillar 3 information and the NSAs/EBA to enhance of quality of disclosures in these areas. The EBA will use these conclusions as a basis for initiating discussions and also as essential input for defining and developing its strategy in enhancing the area of transparency. Indeed, as a result to the findings from this report, the EBA will in 2012 and 2013 : - Keep on identifying best practices of public disclosures in the publications - Keep on identifying the CRD requirements for which compliance has to be improved and those that should be improved, and work on these improvements, including in the area of comparability - Consult and work with industry and users to improve transparency in areas where it is needed

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

Introduction
I am delighted to be back at the School to deliver the Stamp Memorial Lecture. Lord Stamp was eminent in the worlds of both academic and public life. Among other achievements, he was an alumnus and a governor of the School, and a Director of the Bank of England. Following his untimely death, in an air raid in 1941, he was succeeded at the Bank by John Maynard Keynes. Keynes and Stamp often broadcast live discussions on the BBC which were published a week later in The Listener. Their conversations during the 1930s, at the height of the Great Depression, are eerily reminiscent of the enormous challenges we face today, as you can see from the following exchange in 1930: KEYNES: Is not the mere existence of general unemployment for any length of time an absurdity, a confession of failure, and a hopeless and inexcusable breakdown of the economic machine? STAMP: Your language is rather violent. You would not expect to put an earthquake tidy in a few minutes, would you? I object to the view that it is
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a confession of failure if you cannot put a complicated machine right all at once. KEYNES: In my opinion the return to the gold standard in the way we did it set our currency system an almost impossible task ... If prices outside this country had been going up since 1925 that would have done something to balance the effect on this country of the return to the gold standard. STAMP: Hush, Maynard; I cannot bear it. Remember, I am a Director of the Bank of England. In some respects our experience today is no different: putting right our economic machine is proving a slow and difficult task. But in the 1920s the Government made the task substantially harder by reinstating the gold standard at a rate that left sterling overvalued. Today, monetary policy is part of the solution, not part of the problem. That is thanks, in large part, to the monetary framework we have had in place since 1992. Twenty years ago today, on 9 October 1992, the newspapers reported that for the first time monetary policy in Britain would be based on an explicit target for inflation. Three weeks earlier, sterling had been forced out of the European Exchange Rate Mechanism (ERM). A new framework for monetary policy was needed. After keen debates within the Treasury and the Bank of England, the answer emerged – the inflation target.

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The essence of this new approach was the combination of a numerical target for inflation in the medium term and the flexibility to respond to shocks to the economy in the short run – and so the framework became known as flexible inflation targeting. It is time to reflect on twenty years’ experience of inflation targeting; fifteen years of stability and five years of turbulence – the Great Stability and the Great Recession, shown in Table 1 and Charts 1-3.

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Over that period, monetary policy around the world has changed radically.
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Inflation targeting has spread to more than 30 countries. And the results in terms of low and stable inflation have been impressive. There have been pronounced reductions in the mean, variance and persistence of inflation in Britain and elsewhere. During the past twenty years, annual consumer price inflation in this country has averaged 2.1%, remarkably close to the 2% target and well below the averages of over 12% a year in the 1970s and nearly 6% a year in the 1980s. But did we pay too high a price for this achievement in lowering inflation? After fifteen years of apparent success, the past five years of financial crisis and turmoil in the world economy have raised serious questions about the adequacy of inflation targeting. We don’t have to look far to see that the costs of financial instability are huge. In Britain, total output is today some 15% below an extrapolation of its pre-crisis trend, and that gap is likely to persist for some time yet. In the light of such costs, should monetary policy go beyond targeting price stability and also target financial stability? And should the present financial crisis lead us to question the intellectual basis of monetary policy as practised in most of the industrialised world today? Those questions are the subject of tonight’s lecture.

The story of inflation targeting
But let us start at the beginning. Shortly after the adoption of inflation targeting, my predecessor but one,
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Lord Kingsdown (Robin Leigh-Pemberton as he then was), gave an important speech at the London School of Economics – indeed in this room – entitled “The Case for Price Stability”. I remember it vividly – for I had been involved in drafting it. It was an exciting time; we were reconstructing British monetary policy after the trauma of forced exit from the ERM. In those days, of course, the Chancellor set monetary policy and the Bank of England played only a behind the scenes role. But the role of the Bank was about to change – first with the Inflation Report in February 1993, which gave the Bank its own public voice, and then with independence for the Bank and the creation of the Monetary Policy Committee (MPC) in 1997. The inflation target was born out of the experience that high and variable inflation was very costly to reduce and that only a policy based on domestic considerations would be credible. The objective of monetary policy in the medium term would unambiguously be price stability. As the then Chancellor of the Exchequer, Norman Lamont, put it “we wish to reduce inflation to the point where expected changes in the average price level are small enough and gradual enough that they do not materially affect business and household financial plans”. The idea that there is a long-run trade-off between price stability and employment had long since been abandoned. That intellectual revolution, associated with the names of Friedman, Phelps and Lucas, had stood the test of time and formed the foundations of inflation targeting.

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The initial reception of the inflation target among economists and commentators alike was distinctly mixed. As the Financial Times put it in a leader published twenty years ago today, “the Chancellor's speech was as economically thin as it was politically disappointing”. The critics argued that the new framework was inadequate to control inflation. They were to be proved wrong. Over the previous twenty years inflation had been the single biggest problem facing the UK economy, peaking at 27% a year in 1975. Over the subsequent twenty years, inflation, as I mentioned earlier, would average only 2.1%. From the outset, inflation targeting was conceived as a means by which central banks could improve the credibility and predictability of monetary policy. The overriding concern was not to eliminate fluctuations in consumer price inflation from year to year, but to reduce the degree of uncertainty over the price level in the long run because it is from that unpredictability that the real costs of inflation stem. The improvement in credibility of policy is shown by the fact that whereas in 1992 expected inflation, as measured by the difference between yields on conventional and index-linked gilts, was close to 6%, today the same measure is around 2½ %. Predictability of the price level is greater because over a long period inflation has on average been close to the target.

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Even if inflation deviates from target – as will often be the case – it is expected to return to target, and so inflation expectations are anchored. That is why since 2007 the UK has been able to absorb the largest depreciation of sterling since the Second World War, as well as very large rises in oil and commodity prices, with an increase in inflation to an average of only 3.2% over the past five years and without dislodging long-term inflation expectations. So the framework has been tested and has proved its worth. But the current crisis has demonstrated vividly that price stability is not sufficient for economic stability more generally. Low and stable inflation did not prevent a banking crisis. Did the single-minded pursuit of consumer price stability allow a disaster to unfold? Would it have been better to accept sustained periods of below or above target inflation in order to prevent the build up of imbalances in the financial system? Is there, in other words, sometimes a trade-off between price stability and financial stability?

The intellectual foundations of monetary policy
The experience of the past five years suggests that we reassess the intellectual framework underpinning monetary policy. The emergence of inflation targeting, and the successful results in the form of the Great Stability, coincided with the development of the so-called New Keynesian consensus on macroeconomic theory.

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This framework offered a theoretical foundation for flexible inflation targeting. Central to the New Keynesian view is the assumption that some prices are “sticky” and adjust slowly. That assumption has two implications. First, high inflation produces inefficient changes in relative prices. As a result, there is a cost to inflation. Second, when central banks change nominal interest rates they also affect real interest rates, and so encourage households and businesses to switch expenditure from today to tomorrow or, as in present circumstances, the other way round. In this way, central banks can, in the model at least, offset shocks to aggregate demand. But there are shocks to supply as well as demand. External cost shocks sometimes drive inflation away from the target, as we saw in recent years with rises in world energy and food prices. Because other prices are “sticky”, attempts to keep inflation at target all the time would result in inefficient fluctuations in output. There is, therefore, a trade-off between stabilising inflation and stabilising output. Following a cost shock, it is sensible to bring inflation back to target gradually. In this, by now conventional, framework, the proper objective of monetary policy is to minimise the variability of inflation around the
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target rate and the variability of output (or employment) around a sustainable path consistent with stable inflation. Such an objective means that the central bank is effectively choosing a trade-off between the volatility of inflation and the volatility of output. This is sometimes described as choosing a point on the Taylor frontier showing, as in Chart 4, the combinations of lowest volatility of inflation for a given volatility of output.

That optimal choice leads to a policy reaction function describing how the central bank responds to shocks hitting the economy. The success of the New Keynesian framework was that it showed how the long run objective of price stability could be implemented by an appropriate central bank policy reaction function. It stressed the importance of expectations and credibility, to which too little attention had been paid during the inflationary episodes of the
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1970s and 1980s. But inevitably, as with all models, the basic New Keynesian model omits a number of key factors. The treatment of expectations is simplified, and neglects the possibility that expectations themselves may be a source of fluctuations, rather than simply reflecting changes elsewhere in the economy. Sentiment can vary, misperceptions occur, and people can change the heuristics they use to cope with a complex world. And it lacks an account of financial intermediation, so money, credit and banking play no meaningful role. Those omissions obviously limit the ability of the model to help us understand the trade-offs between monetary policy and financial stability. Although there is a, by now extensive, literature on financial frictions, including attempts to incorporate them in New Keynesian models, it turns out that such extensions make little difference to the propagation of shocks, to optimal policy, or to the quantitative conclusion that overwhelmingly the most important objective remains inflation stabilisation. There is no doubt that financial frictions such as asymmetric information, credit constraints, and costly monitoring of borrowers, to name but a few, are an important part of the story of how crises happen and why they impact on output. But those models do not provide a convincing account of the gradual build-up of debt, leverage and fragility that characterises the run-up to financial crises. Existing models, then, do not tell us why stability today may come at the expense of instability tomorrow.
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Perhaps we should heed the advice of Ricardo Caballero, who has written that “macroeconomic research has been in ‘fine-tuning’ mode within the local maximum of the dynamic stochastic general equilibrium world, when we should be in ‘broad-exploration’ mode”. So let me now move into broad exploration mode and give three examples in which a trade-off between monetary and financial stability might arise, and which could in theory justify a policy of aiming off the inflation target in order to reduce the risk of future financial instability, before I turn to whether such a policy would have been appropriate before the crisis. The first is where misperceptions about future incomes persist and are embodied in key prices, such as the exchange rate and long-term interest rates. Households, businesses, and banks can all make big mistakes when forming judgements about the future, and make spending decisions today which they will come to regret when their true lifetime budget constraints are revealed. There is no mechanism for ensuring that misperceptions about the sustainable level of spending are corrected quickly. It may take many years before those beliefs are invalidated by experience. So an equilibrium pattern of spending and saving can emerge that is stable temporarily but not sustainable indefinitely. And misaligned prices may reinforce mistaken beliefs if people are using market prices to extract signals about future incomes and consumption opportunities. Evidence of the persistence of misperceptions can be seen in the imbalances in the world, and especially the European, economies.

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I do not mean to imply that when economic agents make these mistakes they are behaving irrationally. Rather that in a world of intrinsic uncertainty it is far from obvious how to make decisions. The assumption of rational expectations is very helpful for economists when trying to understand the implications of their own models – it is a discipline to prevent the drawing of arbitrary conclusions. In practice, however, households are on their own in a highly uncertain and complex world where they are learning from experience. When it comes to decisions about how much to spend and how much to save, expectations of future incomes are crucial. In the absence of a complete set of markets for future consumption goods – and labour – there is no mechanism to ensure that decisions today, and so the implied plans for tomorrow, will be consistent with the possibilities available in the future. If revisions to expectations of future incomes are uncorrelated across households, then aggregate spending will be relatively stable. The problem comes when many households have similarly over-optimistic views about the future. Aggregate spending and borrowing can then be unsustainably high and lead to an inevitable correction at an unpredictable date when reality dawns. Financial markets both reflect and propagate that common degree of optimism. Sentiment and animal spirits can change very quickly.

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Examples include the extrapolation of past growth rates of incomes or asset prices into the future when in fact they reflect an adjustment of the level of income or asset price to a new equilibrium. At the time, the MPC argued that the rise in the ratio of house prices to incomes in the years leading up to 2007 reflected a fall in long-term real interest rates – in other words, an adjustment to a new equilibrium house price to income ratio. But if households extrapolated past increases in house prices into the future, then they may have mistakenly inferred that future incomes too would be higher, and so spending and borrowing more than could be sustained. Similar arguments could be made about the reaction of businesses and households to the rise in the sterling effective exchange rate in the late 1990s, and I shall return to this later. Since long-term interest rates in financial markets are, if anything, even lower today the question of sustainability has not yet been resolved. Misperceptions mean that unsustainable levels of spending, and associated levels of debt, can build up over many years. When those misperceptions are eventually corrected, they lead to sudden large changes in asset values, a synchronised de-leveraging of balance sheets, a large downward correction to spending and output, and defaults. Keynesian policies to smooth the path of adjustment by supporting aggregate demand can help in the short run, but their effectiveness is limited by the fact that a significant adjustment to spending – from consumption to investment – is required.

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If policymakers can, first, identify misperceptions, and, second, correct them by changes in monetary policy – both highly uncertain empirically – then there is indeed a trade-off between hitting the inflation target and reducing the chance of a financial crisis down the road. But are central banks less prone to misperceptions than others? My second example concerns what Masaaki Shirakawa, Governor of the Bank of Japan calls the ‘cycle of confidence’. He argues that success breeds confidence, and eventually over-confidence and complacency, leading to collapse. Such ideas are closely associated with the work of Hyman Minsky and others. Minsky set out a ‘financial instability hypothesis’ in which a period of stability encourages exuberance in credit markets and subsequent instability. Perhaps the experience of unprecedented stability in the UK and world economies before the crisis dulled the senses and bred complacency about future risks. I talked about this when I christened the period leading up to 2003 the nice (non-inflationary consistently expansionary) decade. The point of that speech was that the following decade was unlikely to be as nice. And, of course, it wasn’t. But the point didn’t get home, and the financial system became more and more fragile as the leverage of our banking system rose to unprecedented levels. The experience of continuing stability may have sowed the seeds of its own destruction.
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That idea has been explored recently in an interesting new book by Nassim Taleb. He argues that the opposite of fragility is not resilience or robustness, but “antifragility”, that is a state in which people or institutions thrive on volatility, shocks to the system and risk. We go to the gym to stress our muscles in order to strengthen them; occasional seismic activity may prevent a more damaging earthquake. Frequent exposure to shocks and surprises may improve the way people learn about and manage risks. In a complex world, we are “better at doing than we are at thinking”, in Taleb’s words. Unless we train and practice at coping with bad outcomes we may fail to respond in the right way to adverse shocks when they come. “Antifragility” does not imply that it might be desirable to engineer small recessions in order to head off a deep depression. We know far too little about the economy to attempt any such strategy, and in a world of intrinsic uncertainty we rely on heuristics – simplified rules of thumb – to guide our behaviour. But it offers a warning of the dangers of believing that the role of monetary policy is to offset all shocks. Rather than pretend that we can forecast the future, a more intelligent response is to reinforce the resilience of those parts of the financial system that we cannot permit to fail and encourage entry and exit in a free market in other parts. It is clear that we need to understand more about how stability affects risk-taking, leverage, and the ‘cycle of confidence’.
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My third example relates to the so-called ‘risk taking’ channel of monetary policy. Short-term policy rates, especially when they are, as now, exceptionally low, may encourage investors to take on more risk than they would otherwise wish as they ‘search for yield’. Financial institutions with long-term commitments (pension funds and insurance companies, for example) need to match the yield they promised on their liabilities, with the yield on their assets. When interest rates are high, they can invest in safe assets to generate the necessary revenue. When interest rates are low, however, they are forced to invest in riskier assets to continue to meet their target nominal rate of return. That tends to push down risk premia and lower the price of borrowing. Other investors too find it difficult to accept that in a world of low nominal and real interest rates equilibrium rates of return will not meet their previous expectations. If these mechanisms are important, the financial cycle may be heavily influenced by monetary policy, especially when interest rates are low. That also creates the possibility of a trade-off between monetary and financial stability. All three examples suggest that the conventional analysis of the trade-off between the volatility of inflation and the volatility of output is likely to be far too optimistic. Does this add up to a case for ‘leaning against the wind’ of rising asset prices rather than waiting to ‘mop’ up after the bust?

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Certainly we have seen that monetary policy cannot fully offset the effects of financial crises for two reasons. First, crises may impact output before the response of monetary policy is felt. Second, crises typically reduce potential supply growth, for example by disrupting the supply of credit to productive firms. A failure to take financial instability into account creates an unduly optimistic view of where the Taylor frontier lies, especially when it is based on data drawn from a period of stability. Relative to a Taylor frontier that reflects only aggregate demand and cost shocks, the addition of financial instability shocks generates what I call the Minsky-Taylor frontier, shown in Chart 5.

This reflects the influence of misperceptions, financial cycles and the search for yield.

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

A Counter-Factual Monetary Policy 1997-2007
I want to ask whether, with the benefit of hindsight, monetary policy should have been set differently during the period of the so-called Great Stability. Should interest rates have been higher during that period in order to mitigate some of the growth of credit, rise in asset prices, and increase in the leverage of the banking system? Many commentators today seem to think that the answer is clearly yes – though I seem to remember that fewer said so at the time – and most of the pressure on the MPC, both from without and within, was for lower rather than higher levels of Bank Rate.

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Before trying to answer the question, let me remind you of two key facts about the Great Stability. First, the growth rate of GDP over the period prior to the onset of the crisis in 2007 was 2.9%, very close to its previous long-run average of 2.8% (see Table 2).

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

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But if the rate of growth was sustainable, its pattern was not. In the late 1990s, there had been a substantial, and not entirely explicable, rise in sterling of around 25% against most other currencies, leading to the emergence of imbalances in the UK economy. These took the form of a shift in the composition of output away from manufacturing and towards services, and a shift in demand away from exports towards domestic demand. National saving fell to unsustainably low levels. In the early years of the MPC there was an intense debate about these imbalances, and how they should affect monetary policy. In a speech in April 2000, I argued that “it is important not to let domestic demand grow too rapidly for too long. The longer the correction is left, the sharper the required adjustment will be”. The question was how much to stimulate domestic demand, at the cost of exacerbating the imbalances, in order to compensate for weak external
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demand, and the minutes of the MPC in 2001 and 2002 explicitly discussed the case for accepting inflation below target over the two-year horizon. The Committee rejected the case, and during that period most of the dissenting votes on the MPC were for lower rates (see Table 3). The dilemma, and the MPC’s resolution of it, was summed up by my predecessor Eddie George in 2002 when he said “So in effect we have taken the view that unbalanced growth in our present situation is better than no growth – or as some commentators have put it, a two-speed economy is better than a no-speed economy.” Was that the right choice? As in some other industrialised countries, asset prices, including house prices, had been pushed up by falls in long-term real interest rates (see Chart 7).

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

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

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Certainly, there seemed good reason at the time to imagine that slower growth at home might mean that hot money would return to countries experiencing stronger growth. As a result, the current exchange rate would have fallen from O to P in Chart 8 and then been expected to follow the path PB consistent with uncovered interest rate parity. The result would have been higher external demand to offset weaker domestic demand. After a time, we might have attained ‘one-speed’ growth, so avoiding the unpalatable choice between ‘two-speed’ and no growth. The other view was that higher interest rates would not have altered the expected long-run equilibrium value of sterling, but would have led to an immediate upwards jump in the exchange rate, as the greater interest rate differential with other countries would have shifted up the uncovered interest rate parity path from OA to QA in Chart 8. That would have meant even weaker external demand, and a more depressed domestic economy.
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Higher interest rates would have moderated domestic credit growth and asset prices, but only at the expense of slower output growth, rising unemployment and a prolonged undershoot of the inflation target. Everything would have hinged on the success of the strategy in bringing down the expected equilibrium level of sterling in the long run to avoid a further rise in sterling in the short run and a damaging recession. At best, persistently higher interest rates would have implied an initial slowing of growth, a deliberate attempt to weaken sterling, and an under-shooting of the inflation for a period. At worst, we would have seen the exchange rate appreciate further. The decade would have been characterised by rising unemployment and very low inflation. To have deviated from our statutory remit in a direction that would have imposed real costs to output and employment would have been a big gamble. But the costs of the ensuing crisis have been so great that we cannot stop there and say that nothing could have been done. Was there a better alternative to a strategy of higher interest rates? The natural first line of defence against financial crises is macro-prudential policy. In principle, such policies can shift the Minsky-Taylor curve closer to the original Taylor curve. With hindsight, before 2007 there should have been a cap on the leverage of banks (see Chart 9).

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And the cap should have tightened as asset prices increased and the likely exposure to losses increased. That is why we now have a macro-prudential policy regime in the UK. It will be overseen by the Bank of England’s Financial Policy Committee, which will have the power to direct, and make recommendations to, regulators about capital and leverage in the UK financial system. In my judgement, the big challenge to monetary policy before the crisis was a serious mis-pricing in long-term interest and exchange rates, and the imbalances that resulted. Much of this was outside the control of UK policy-makers and reflected developments in the world economy.
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It is arguable, though not certain, that in the absence of a macro-prudential regime or tighter fiscal policy, persistently higher interest rates might have been a second-best strategy. It would, though, have been a big gamble. As the Chairman of the Federal Reserve, Ben Bernanke has remarked, “the issue is not whether central bankers should ignore possible financial imbalances – they should not – but, rather, what is ‘the right tool for the job’ to respond to such imbalances”. So it is vital that macro-prudential tools and micro-prudential regulation are part of the armoury of a central bank to mitigate, if not prevent, the build up of excessive leverage and risk-taking in the banking and wider financial sector. From next year, the Bank of England will have those responsibilities, and the new Financial Policy Committee is already up and running. But macro-prudential tools deal with symptoms rather than the underlying problems of misperceptions and mispricing. Although we think the new tools given to the Bank would have helped to alleviate the last crisis, it would be optimistic to rely solely on such tools to prevent all future crises. It would be sensible to recognize that there may be circumstances in which it is justified to aim off the inflation target for a while in order to moderate the risk of financial crises. Monetary policy cannot just ‘mop up’ after a crisis. Risks must be dealt with beforehand.

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I do not see this as inconsistent with inflation targeting because it is the stability of inflation over long periods, not year to year changes, which is crucial to economic success. The key principles underlying flexible inflation targeting are credibility, predictability and transparency of decision-taking, and they will remain the cornerstone of successful monetary policy in the future.

Conclusions
Governor Leigh Pemberton’s 1992 lecture concluded with a message for the LSE: “in a world of price stability you might not think of inviting the Governor of the Bank of England to address you”. Had price stability guaranteed financial stability, and had I achieved my long-held ambition of being boring, that might have been true. Unfortunately, it is not how things have worked out! What I have tried to show tonight is that the case for price stability is as strong today as it was twenty years ago – both in theory and in practice. The clarity and simplicity of the inflation target helps to anchor inflation expectations on the target. We forget the lessons of the 1970s and 1980s at our peril. In the end, the essence of central banking is to maintain confidence in, and the value of, paper money. It is far too soon to bury inflation targeting. Together with central bank independence, it played a key role inbringing price stability to the UK.

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As the Times reported 20 years ago, “the pound's firmer tone, and softer German money market rates, could tempt the Chancellor to shave half a point off base rates to coincide with the Prime Minister's speech at Brighton today”. The party conference season is no longer a time for speculation about changes in interest rates. No doubt we shall learn a great deal about the appropriate allocation of responsibilities to monetary policy, on the one hand, and macro-prudential policy, on the other, over the next twenty years. But we should not throw out the baby with the bathwater. Low and stable inflation is a pre-requisite for economic success. Much of what I have said is, I hope, a call to arms for economists, and especially younger economists, to rethink the foundations of our macroeconomic theories. Not to abandon rigorous modelling – after all, in the words of last year’s Nobel Prize winner Tom Sargent “it takes a model to beat a model” – but to recognize that in our present models the way we think of human behaviour in the face of irreducible uncertainty is seriously incomplete. Ideas matter far more than is usually recognised in the public discussion of monetary policy which concentrates too much on personalities. Keynes and Stamp both knew that. In February 1929, Josiah Stamp went to Paris as a member of the Young Committee to assess whether the reparations debts run up by Germany could be repaid – the similarities with the present situation in Europe are too poignant to dwell on. In a letter to Keynes, Stamp compared these international meetings to a conjuror trying to pull a rabbit out of the hat:
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“It is still a madhouse, in a way – but all are mad in a very genteel way, the main occupation being elaborate proofs, from different angles, of sanity. One half sit round a hat saying with Coué reiteration: there is a rabbit – there is. The other half try to make a noise like a succulent lettuce. There is a general conviction that the more eminent the conjurors convened, the more certainty is there of the existence of the rabbit”. The only escape from madness is the power of ideas. Today, we understand less than we would wish about how the economy works. The challenge of trying to understand more, and of developing those new ideas, belongs to you – the next generation of students and academics at the LSE and elsewhere. Go to it!

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Solvency II – monitoring the ongoing appropriateness of internal models
Julian Adams, Director, Insurance In June 2012 I wrote to all firms in our internal model approval process to share our thinking on the way we will monitor the ongoing appropriateness of internal models after approval. This letter gives an update on the development of early warning indicators and reiterates the purpose and intended use of the indicators. Our underlying concern is that, if not adequately monitored and updated, the solvency standard delivered by internal models can deteriorate over time. The implementation of internal models inherently rests on a great number of judgements and assumptions, both explicit and implicit. Our experience suggests that, over time, if models are not appropriately updated, these assumptions and judgements can become less appropriate, leading to an overall reduction in solvency standards. We therefore continue to develop early warning indicators to ensure that the Solvency Capital Requirement (SCR) will meet the Solvency II calibration on an ongoing basis. To achieve this objective, we believe that early warning indicators: a. should be based on metrics that are independent from the internal model calculations, i.e. not based on the firm’s modelled SCR; b. should be simple in their construction, calibration and application, avoiding complexity; and
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c. will, if breached, trigger an immediate supervisory response; a capital add-on is, in all but exceptional cases, likely to be the most effective way to restore compliance with the Solvency II calibration requirement (i.e. 99.5% over a one-year period). We consider that the use of early warning indicators is consistent with the supervisory powers set out in the Solvency II Directive and as such will form part of the supervisory review process for internal model firms. The early warning indicators would supplement information collected from firms during the supervisory review process, including in particular the results of model validation as well as any approval of changes to the model. Further, the calibration of the indicators will aim to identify significant deviations in firm risk profile with respect to the assumptions underlying the calculation of the SCR.

Industry responses
We received ten responses to our June 2012 letter. Overall, they focussed on how we will monitor the ongoing appropriateness of an internal model at the individual firm level. These are useful suggestions which we will take into account as part of our supervisory review process. We also received some suggestions of an alternative indicator to the proposed ratio between the pre-corridor Minimum Capital Requirement (pMCR) and modelled SCR and we are investigating credible alternatives. We did not receive any comments on the proposed industry sub-sector segmentation set out in the letter.

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Some respondents noted that the construction should also allow for the capture of the underwriting cycle, and be mindful of the potential for pro-cyclicality and we will take this feedback into consideration in further work. A number of respondents expressed support for a European approach and we have shared our thinking with EIOPA. I would like to confirm that we do not intend to use a multiple of the pMCR indicator, or any other early warning indicator, as a condition to the approval of a firm’s use of an internal model. Our work with firms in the run up to implementation will inform the calibration for the indicators at day one. As I said in my letter in June, we expect that, in the vast majority of cases, firms submitting a model that properly reflects the firm’s risk profile to the standard required by the Solvency II Directive, and which is approved by us, will fall within the ratio or range of the indicator. So this should not be an issue for approved models on day one. Fundamentally, the purpose of the indicator is to limit subsequent downward SCR drift relative to risk profile. We have set out our intention to review the indicators periodically, both from our experience of their use and their calibration. In response to comments received that the early warning indicators would not allow for the reflection of the nature of and risks run by individual insurers - we will not be providing calibration for indicators at an individual firm level as this runs counter to the policy approach to have a simple, easy-to-apply indicator.

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Next steps
There is still an opportunity for further engagement from the industry by cob Friday 26 October on early warning indicators that deliver the policy approach set out above. We also welcome suggestions for the segmentation set out in the June letter. You can send your response to your usual supervisory contact or to me directly. In the meantime we will be using data from firms to inform the development and calibration of early warning indicators. Yours sincerely

Julian Adams Director, Insurance

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18 June 2012

Solvency II: monitoring the ongoing appropriateness of internal models
As part of our commitment to share developments in our approach to the implementation of the Solvency II Directive, we wanted to set out our thinking on the way in which we would monitor the ongoing appropriateness of internal models after approval.

Model approval and beyond
As required by the Solvency II Directive, we will only approve an internal model for the calculation of the Solvency Capital Requirement (SCR) if we are satisfied that the systems for identifying, measuring, monitoring, managing and reporting risks are adequate and in particular if the model fulfils the tests and standards set out in the Solvency II framework. While our focus is on the work we need to do to be able to give firms a decision on their internal model application in time for the first day of the regime, we are also looking ahead to how we use our knowledge and learning to monitor the ongoing appropriateness of a firm’s internal model in the new regime. Following approval, firms are responsible for ensuring the ongoing appropriateness of the internal model, by ensuring that the internal model meets the tests and standards and reflects the firm’s risk profile. Firms should also ensure that the SCR is calibrated and corresponds to the value at risk of their basic own funds of the firm, subject to a confidence level of 99.5% over a one-year period. This means that we need to be assured that firms have put in place systems which ensure that the internal model operates properly on a continuous basis.

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We also need to be confident that the controls put in place are adequate and effective at all times, including stressed market conditions or crises. At a market level, we will monitor the movement of insurance sector capital over time. Our experience of internal models to date tells us that significant effort is put into an approval process, without adequate attention given to ongoing appropriateness. This leads to a risk that standards of solvency deteriorate over time. Based on the requirements of the Solvency II Directive, it is our expectation that models will be monitored and updated regularly to reflect the firm’s risk profile and to ensure compliance with model requirements.

Early warning indicators
To this end, we are developing a number of early warning indicators aimed at helping us and firms ensure that, after approval, internal models and the SCR calculation remain appropriate on an ongoing basis, at both firm and system level and that firms’ internal models continue to deliver outputs that are consistent with the requirements of Solvency II. We will use the information provided by firms in their Solvency II regulatory reporting to assess their position relative to these indicators (which may take the form of ratios or ranges) and so, the development of these indicators will not in itself create an additional reporting requirement. However, firms will be required to notify us immediately in the event their position falls outside these pre-determined ranges. In all but exceptional cases, we will take immediate supervisory action.
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This could include seeking a revision of the parameters and/or imposing a capital add-on. The aim of this action will be to increase the SCR so as to bring it once again above the indicator level with a view to ensuring that it complies with the Solvency II calibration requirement (i.e. 99.5% over a one-year period). In the meantime (and in any event), the firm and the FSA will work together to understand the issues better, which may result in improvements to the firm’s model. We propose to use a number of early warning indicators to assist us with our monitoring of capital on a firm-specific and industry-wide basis. The indicators will be tailored to specific sectors of the insurance market. We will periodically review the indicators, both from our experience of their use and their calibration.

Ratio between the pMCR and modelled SCR
One of the indicators that we are currently developing is a ratio between the pre-corridor minimum capital requirement (pMCR) and the modelled SCR. Separate pMCR indicators would be set at the level of an industry sub-sector to give us a high degree of assurance that the model is delivering a calibration at 99.5% over a one-year period. We intend to have indicators for firms which undertake: • life business, excluding with-profits business; • with-profits business;
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• general insurance business, excluding London market business; and • London market business. Our preliminary analysis indicates that the pMCR indicator could range between: • 175-200% for life business; and • 175-200% for general insurance business. We have used data from the fifth quantitative impact study, and applied it to the latest version of the MCR specification set out in the November 2011 draft Level 2 text to derive these preliminary ranges. However, to refine the calibration we will need information from UK firms and we will issue a template and instructions in September 2012. Our intention is to calibrate the indicator so that, in the vast majority of cases, firms submitting a model which properly reflects the firm’s risk profile to the standard required by the Solvency II Directive and which is approved by us will fall within the ratio or range of the indicator and so this should not be an issue for approved models on day one. Fundamentally, the purpose of the indicator is to limit subsequent downward SCR drift relative to risk profile. Since there is no MCR for groups, the ratio set out in this letter would apply to the UK solo entities.

Next steps
In addition to the request for data to refine the calibrations in September 2012, we will also provide an update on the other early warning indicators we are considering to prompt supervisory intervention, including the use
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of stress tests and scenarios for economy-wide variables for with-profits business and groups. Yours sincerely

Julian Adams Director, Insurance

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Final Basel III Rules in Australia
Australian Prudential Regulation Authority (APRA) To: All locally incorporated authorised deposit-taking institutions Basel III capital: interim arrangements for Additional Tier 1 and Tier 2 capital instruments APRA has released final prudential standards implementing the Basel III measures to raise the quality, consistency and transparency of the capital base, including Prudential Standard APS 111 Capital Adequacy: Measurement of Capital (APS 111). This letter sets out APRA’s treatment of new Additional Tier 1 and Tier 2 capital instruments issued before the new standard comes into effect on + To be eligible for inclusion in regulatory capital, all capital instruments that have not been submitted to APRA for review before close of business today must comply with the final version of APS 111 issued today. Instruments that have been submitted to APRA up to and including today’s date and that were intended to be issued under the current transitional arrangements (including APRA’s letters to industry dated 27 May 2011 and 30 March 2012), will be assessed against these criteria. To be counted as eligible regulatory capital, instruments approved by APRA under these criteria must be issued before close of business on 31 December 2012. Any questions in relation to this letter should in the first instance be directed to your Responsible Supervisor. Yours sincerely Charles Littrell Executive General Manager

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Notes
In December 2010, the Basel Committee on Banking Supervision (Basel Committee) released a package of reforms to raise the level and quality of regulatory capital in the global banking system (Basel III). APRA is a member of the Basel Committee and fully supports the implementation of these reforms. In September 2011, APRA released a discussion paper outlining its proposals to implement these Basel III capital reforms in Australia. APRA subsequently released, in March and June 2012, draft prudential and reporting standards on which submissions were invited. In June 2012, APRA also invited submissions on its proposal that certain capital instruments be subject to Australian law and on its proposed regulatory capital treatment of joint arrangements. Fifteen submissions were received on the March and June 2012 consultation packages.

APRA’s capital adequacy prudential and reporting standards
Submissions were broadly supportive of the content of the draft prudential and reporting standards and mostly sought clarification of particular provisions. In response, APRA has: • clarified its expectations for an ADI’s Internal Capital Adequacy Assessment Process (ICAAP), which are included in the draft Prudential Practice Guide CPG 110 Internal Capital Adequacy Assessment Process and supervisory review (CPG 110) recently released for public consultation;
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• revised its proposed treatment of an ADI’s funding of purchases of its own capital instruments, including margin loans; • removed the ‘profits test’ from Additional Tier 1 and Tier 2 Capital instruments; • clarified the operation of the countercyclical capital buffer; • simplified transitional arrangements for capital issued by consolidated subsidiaries and held by third parties; and • made minor changes to the prudential and reporting standards to improve ease of use. Submissions raised concerns about APRA’s proposal that certain capital instruments should be subject to Australian law. APRA acknowledges these concerns. In response, it has clarified areas of uncertainty about the loss absorption and non-viability requirements and has refined its approach to the question of governing law for capital instruments, such that only those provisions of capital instrument documentation dealing with loss absorption and non-viability must be governed by Australian law. In June 2012, the Basel Committee finalised its proposals to improve consistency and ease of use of disclosures on capital positions and capital composition. These measures, which are to come into effect for reporting periods ending on or after 30 June 2013, include a common template and disclosure provisions that, if implemented, would facilitate comparison between the capital position of banking institutions across jurisdictions. APRA will consult in early 2013 on these requirements.

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Consultation with industry and other interested stakeholders
The Basel III reforms also implement measures relating to external credit assessment institutions (ECAIs) and to minimise cliff effects arising from guarantees and derivatives.

Objectives and key requirements of this Prudential Standard
This Prudential Standard requires an authorised deposit-taking institution (ADI) to maintain adequate capital, on both a Level 1 and Level 2 basis, to act as a buffer against the risk associated with its activities. The ultimate responsibility for the prudent management of capital of an ADI rests with its Board of directors. The Board must ensure the ADI maintains an appropriate level and quality of capital commensurate with the type, amount and concentration of risks to which the ADI is exposed. The key requirements of this Prudential Standard are that an ADI and any Level 2 group must: - have an Internal Capital Adequacy Assessment Process; - maintain required levels of regulatory capital; - operate a capital conservation buffer and, if required, a countercyclical capital buffer; - inform APRA of any adverse change in actual or anticipated capital adequacy; and
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seek APRA’s approval for any planned capital reductions.

Interesting:
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An ADI that is part of a group may rely on the ICAAP of the group provided that the Board of the ADI is satisfied that the group ICAAP meets the criteria in respect of the ADI.

Group risk management
8. Paragraphs 9 to 13 of this Prudential Standard apply to an ADI that heads a conglomerate group. Where an ADI is part of a conglomerate group headed by an authorised non-operating holding company (authorised NOHC), the requirements set out in paragraphs 9 to 13 of this Prudential Standard apply to the ADI and its subsidiaries. 9. For conglomerate groups headed by an ADI, the Board of the ADI is responsible for ensuring that comprehensive policies and procedures are in place to measure, manage, monitor and report overall risk at a group level. To ensure that existing Board-approved policies and the relevant controls remain adequate and appropriate for managing and monitoring overall group risk, the Board or a board committee must review them regularly (at least annually) to take account of changing risk profiles of group entities. Any material changes to group risk management policies must be approved by the Board. 10. The Board of an ADI must ensure that the ADI establishes appropriate policies, systems and procedures to monitor compliance with APRA’s prudential requirements on a group basis. To facilitate conglomerate group supervision by APRA, an ADI must: (a) provide APRA with the following group information:
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(i) details of group members (e.g. name, place of incorporation, board composition, nature of business and any other additional information required by APRA for a better understanding of the risk profiles of individual group members); (ii) management structure of the group (including key risk management reporting lines); (iii) intra-group support arrangements (e.g. a specific guarantee of the obligations of an entity in the group); (iv) intra-group exposures; and (v) other information as required by APRA from time to time for the effective supervision of the group; (b) notify APRA in accordance with section 62A of the Banking Act of any breach of a requirement in a prudential standard or a condition of a banking authority (whether by an ADI in the group or by the group) and of any circumstances that might reasonably be seen as having a material impact and potentially adverse consequences for an ADI in the group or for the overall group; (c) advise APRA in advance of any proposed changes to the composition or operations of the group with the potential to materially alter the group’s overall risk profile (this must include any proposed changes to the ADI’s stand-alone operations); and (d) obtain APRA’s prior written approval for the establishment or acquisition of a regulated presence domestically or overseas. 11. An ADI must provide APRA with descriptions of its group risk management policies and the procedures used to measure and control overall group risk (including any material changes thereto).

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The ADI should, as best practice, disclose in the group’s full published annual report each year an outline of its group risk management policies, including the policies governing dealings between the ADI and other group members. 12. An ADI must submit a declaration signed by its chief executive officer, approved by the Board, covering the Level 2 group's risk management systems within three months of the ADI's annual balance date in accordance with the declaration requirements in Prudential Standard APS 310 Audit and Related Matters (APS 310). 13. If an ADI qualifies the declaration in paragraph 12, the ADI must explain the reasons for the qualifications in accordance with the requirements in APS 310 and provide plans for corrective action.

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Five Questions about the Federal Reserve and Monetary Policy
Chairman Ben S. Bernanke, at the Economic Club of Indiana, Indianapolis, Indiana Good afternoon. I am pleased to be able to join the Economic Club of Indiana for lunch today. I note that the mission of the club is "to promote an interest in, and enlighten its membership on, important governmental, economic and social issues." I hope my remarks today will meet that standard. Before diving in, I'd like to thank my former colleague at the White House, Al Hubbard, for helping to make this event possible. As the head of the National Economic Council under President Bush, Al had the difficult task of making sure that diverse perspectives on economic policy issues were given a fair hearing before recommendations went to the President. Al had to be a combination of economist, political guru, diplomat, and traffic cop, and he handled it with great skill. My topic today is "Five Questions about the Federal Reserve and Monetary Policy." I have used a question-and-answer format in talks before, and I know from much experience that people are eager to know more about the Federal Reserve, what we do, and why we do it. And that interest is even broader than one might think. I'm a baseball fan, and I was excited to be invited to a recent batting practice of the playoff-bound Washington Nationals. I was introduced to one of the team's star players, but before I could press my questions on some fine points of baseball strategy, he asked, "So, what's the scoop on quantitative easing?"

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So, for that player, for club members and guests here today, and for anyone else curious about the Federal Reserve and monetary policy, I will ask and answer these five questions: What are the Fed's objectives, and how is it trying to meet them? What's the relationship between the Fed's monetary policy and the fiscal decisions of the Administration and the Congress? What is the risk that the Fed's accommodative monetary policy will lead to inflation? How does the Fed's monetary policy affect savers and investors? How is the Federal Reserve held accountable in our democratic society?

What Are the Fed's Objectives, and How Is It Trying to Meet Them?
The first question on my list concerns the Federal Reserve's objectives and the tools it has to try to meet them. As the nation's central bank, the Federal Reserve is charged with promoting a healthy economy--broadly speaking, an economy with low unemployment, low and stable inflation, and a financial system that meets the economy's needs for credit and other services and that is not itself a source of instability. We pursue these goals through a variety of means. Together with other federal supervisory agencies, we oversee banks and other financial institutions. We monitor the financial system as a whole for possible risks to its stability. We encourage financial and economic literacy, promote equal access to credit, and advance local economic development by working with communities, nonprofit organizations, and others around the country.

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We also provide some basic services to the financial sector--for example, by processing payments and distributing currency and coin to banks. But today I want to focus on a role that is particularly identified with the Federal Reserve--the making of monetary policy. The goals of monetary policy--maximum employment and price stability--are given to us by the Congress. These goals mean, basically, that we would like to see as many Americans as possible who want jobs to have jobs, and that we aim to keep the rate of increase in consumer prices low and stable. In normal circumstances, the Federal Reserve implements monetary policy through its influence on short-term interest rates, which in turn affect other interest rates and asset prices. Generally, if economic weakness is the primary concern, the Fed acts to reduce interest rates, which supports the economy by inducing businesses to invest more in new capital goods and by leading households to spend more on houses, autos, and other goods and services. Likewise, if the economy is overheating, the Fed can raise interest rates to help cool total demand and constrain inflationary pressures. Following this standard approach, the Fed cut short-term interest rates rapidly during the financial crisis, reducing them to nearly zero by the end of 2008--a time when the economy was contracting sharply. At that point, however, we faced a real challenge: Once at zero, the short-term interest rate could not be cut further, so our traditional policy tool for dealing with economic weakness was no longer available. Yet, with unemployment soaring, the economy and job market clearly needed more support. Central banks around the world found themselves in a similar predicament.
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We asked ourselves, "What do we do now?" To answer this question, we could draw on the experience of Japan, where short-term interest rates have been near zero for many years, as well as a good deal of academic work. Unable to reduce short-term interest rates further, we looked instead for ways to influence longer-term interest rates, which remained well above zero. We reasoned that, as with traditional monetary policy, bringing down longer-term rates should support economic growth and employment by lowering the cost of borrowing to buy homes and cars or to finance capital investments. Since 2008, we've used two types of less-traditional monetary policy tools to bring down longer-term rates. The first of these less-traditional tools involves the Fed purchasing longer-term securities on the open market--principally Treasury securities and mortgage-backed securities guaranteed by government-sponsored enterprises such as Fannie Mae and Freddie Mac. The Fed's purchases reduce the amount of longer-term securities held by investors and put downward pressure on the interest rates on those securities. That downward pressure transmits to a wide range of interest rates that individuals and businesses pay. For example, when the Fed first announced purchases of mortgage-backed securities in late 2008, 30-year mortgage interest rates averaged a little above 6percent; today they average about 3-1/2 percent. Lower mortgage rates are one reason for the improvement we have been seeing in the housing market, which in turn is benefiting the economy more broadly. Other important interest rates, such as corporate bond rates and rates on auto loans, have also come down.
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Lower interest rates also put upward pressure on the prices of assets, such as stocks and homes, providing further impetus to household and business spending. The second monetary policy tool we have been using involves communicating our expectations for how long the short-term interest rate will remain exceptionally low. Because the yield on, say, a five-year security embeds market expectations for the course of short-term rates over the next five years, convincing investors that we will keep the short-term rate low for a longer time can help to pull down market-determined longer-term rates. In sum, the Fed's basic strategy for strengthening the economy--reducing interest rates and easing financial conditions more generally--is the same as it has always been. The difference is that, with the short-term interest rate nearly at zero, we have shifted to tools aimed at reducing longer-term interest rates more directly. Last month, my colleagues and I used both tools--securities purchases and communications about our future actions--in a coordinated way to further support the recovery and the job market. Why did we act? Though the economy has been growing since mid-2009 and we expect it to continue to expand, it simply has not been growing fast enough recently to make significant progress in bringing down unemployment. At 8.1 percent, the unemployment rate is nearly unchanged since the beginning of the year and is well above normal levels. While unemployment has been stubbornly high, our economy has enjoyed broad price stability for some time, and we expect inflation to remain low for the foreseeable future.

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So the case seemed clear to most of my colleagues that we could do more to assist economic growth and the job market without compromising our goal of price stability. Specifically, what did we do? On securities purchases, we announced that we would buy mortgage-backed securities guaranteed by the government-sponsored enterprises at a rate of $40 billion per month. Those purchases, along with the continuation of a previous program involving Treasury securities, mean we are buying $85 billion of longer-term securities per month through the end of the year. We expect these purchases to put further downward pressure on longer-term interest rates, including mortgage rates. To underline the Federal Reserve's commitment to fostering a sustainable economic recovery, we said that we would continue securities purchases and employ other policy tools until the outlook for the job market improves substantially in a context of price stability. In the category of communications policy, we also extended our estimate of how long we expect to keep the short-term interest rate at exceptionally low levels to at least mid-2015. That doesn't mean that we expect the economy to be weak through 2015. Rather, our message was that, so long as price stability is preserved, we will take care not to raise rates prematurely. Specifically, we expect that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economy strengthens. We hope that, by clarifying our expectations about future policy, we can provide individuals, families, businesses, and financial markets greater confidence about the Federal Reserve's commitment to promoting a sustainable recovery and that, as a result, they will become more willing to invest, hire and spend. Now, as I have said many times, monetary policy is no panacea.
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It can be used to support stronger economic growth in situations in which, as today, the economy is not making full use of its resources, and it can foster a healthier economy in the longer term by maintaining low and stable inflation. However, many other steps could be taken to strengthen our economy over time, such as putting the federal budget on a sustainable path, reforming the tax code, improving our educational system, supporting technological innovation, and expanding international trade. Although monetary policy cannot cure the economy's ills, particularly in today's challenging circumstances, we do think it can provide meaningful help. So we at the Federal Reserve are going to do what we can do and trust that others, in both the public and private sectors, will do what they can as well.

What's the Relationship between Monetary Policy and Fiscal Policy?
That brings me to the second question: What's the relationship between monetary policy and fiscal policy? To answer this question, it may help to begin with the more basic question of how monetary and fiscal policy differ. In short, monetary policy and fiscal policy involve quite different sets of actors, decisions, and tools. Fiscal policy involves decisions about how much the government should spend, how much it should tax, and how much it should borrow. At the federal level, those decisions are made by the Administration and the Congress. Fiscal policy determines the size of the federal budget deficit, which is the difference between federal spending and revenues in a year.

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Borrowing to finance budget deficits increases the government's total outstanding debt. As I have discussed, monetary policy is the responsibility of the Federal Reserve--or, more specifically, the Federal Open Market Committee, which includes members of the Federal Reserve's Board of Governors and presidents of Federal Reserve Banks. Unlike fiscal policy, monetary policy does not involve any taxation, transfer payments, or purchases of goods and services. Instead, as I mentioned, monetary policy mainly involves the purchase and sale of securities. The securities that the Fed purchases in the conduct of monetary policy are held in our portfolio and earn interest. The great bulk of these interest earnings is sent to the Treasury, thereby helping reduce the government deficit. In the past three years, the Fed remitted $200 billion to the federal government. Ultimately, the securities held by the Fed will mature or will be sold back into the market. So the odds are high that the purchase programs that the Fed has undertaken in support of the recovery will end up reducing, not increasing, the federal debt, both through the interest earnings we send the Treasury and because a stronger economy tends to lead to higher tax revenues and reduced government spending (on unemployment benefits, for example). Even though our activities are likely to result in a lower national debt over the long term, I sometimes hear the complaint that the Federal Reserve is enabling bad fiscal policy by keeping interest rates very low and thereby making it cheaper for the federal government to borrow. I find this argument unpersuasive. The responsibility for fiscal policy lies squarely with the Administration and the Congress.
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At the Federal Reserve, we implement policy to promote maximum employment and price stability, as the law under which we operate requires. Using monetary policy to try to influence the political debate on the budget would be highly inappropriate. For what it's worth, I think the strategy would also likely be ineffective: Suppose, notwithstanding our legal mandate, the Federal Reserve were to raise interest rates for the purpose of making it more expensive for the government to borrow. Such an action would substantially increase the deficit, not only because of higher interest rates, but also because the weaker recovery that would result from premature monetary tightening would further widen the gap between spending and revenues. Would such a step lead to better fiscal outcomes? It seems likely that a significant widening of the deficit--which would make the needed fiscal actions even more difficult and painful--would worsen rather than improve the prospects for a comprehensive fiscal solution. I certainly don't underestimate the challenges that fiscal policymakers face. They must find ways to put the federal budget on a sustainable path, but not so abruptly as to endanger the economic recovery in the near term. In particular, the Congress and the Administration will soon have to address the so-called fiscal cliff, a combination of sharply higher taxes and reduced spending that is set to happen at the beginning of the year. According to the Congressional Budget Office and virtually all other experts, if that were allowed to occur, it would likely throw the economy back into recession. The Congress and the Administration will also have to raise the debt ceiling to prevent the Treasury from defaulting on its obligations, an

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outcome that would have extremely negative consequences for the country for years to come. Achieving these fiscal goals would be even more difficult if monetary policy were not helping support the economic recovery.

What Is the Risk that the Federal Reserve's Monetary Policy Will Lead to Inflation?
A third question, and an important one, is whether the Federal Reserve's monetary policy will lead to higher inflation down the road. In response, I will start by pointing out that the Federal Reserve's price stability record is excellent, and we are fully committed to maintaining it. Inflation has averaged close to 2 percent per year for several decades, and that's about where it is today. In particular, the low interest rate policies the Fed has been following for about five years now have not led to increased inflation. Moreover, according to a variety of measures, the public's expectations of inflation over the long run remain quite stable within the range that they have been for many years. With monetary policy being so accommodative now, though, it is not unreasonable to ask whether we are sowing the seeds of future inflation. A related question I sometimes hear--which bears also on the relationship between monetary and fiscal policy, is this: By buying securities, are you "monetizing the debt"--printing money for the government to use--and will that inevitably lead to higher inflation? No, that's not what is happening, and that will not happen. Monetizing the debt means using money creation as a permanent source of financing for government spending. In contrast, we are acquiring Treasury securities on the open market and only on a temporary basis, with the goal of supporting the economic recovery through lower interest rates.
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At the appropriate time, the Federal Reserve will gradually sell these securities or let them mature, as needed, to return its balance sheet to a more normal size. Moreover, the way the Fed finances its securities purchases is by creating reserves in the banking system. Increased bank reserves held at the Fed don't necessarily translate into more money or cash in circulation, and, indeed, broad measures of the supply of money have not grown especially quickly, on balance, over the past few years. For controlling inflation, the key question is whether the Federal Reserve has the policy tools to tighten monetary conditions at the appropriate time so as to prevent the emergence of inflationary pressures down the road. I'm confident that we have the necessary tools to withdraw policy accommodation when needed, and that we can do so in a way that allows us to shrink our balance sheet in a deliberate and orderly way. For example, the Fed can tighten policy, even if our balance sheet remains large, by increasing the interest rate we pay banks on reserve balances they deposit at the Fed. Because banks will not lend at rates lower than what they can earn at the Fed, such an action should serve to raise rates and tighten credit conditions more generally, preventing any tendency toward overheating in the economy. Of course, having effective tools is one thing; using them in a timely way, neither too early nor too late, is another. Determining precisely the right time to "take away the punch bowl" is always a challenge for central bankers, but that is true whether they are using traditional or nontraditional policy tools.

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I can assure you that my colleagues and I will carefully consider how best to foster both of our mandated objectives, maximum employment and price stability, when the time comes to make these decisions.

How Does the Fed's Monetary Policy Affect Savers and Investors?
The concern about possible inflation is a concern about the future. One concern in the here and now is about the effect of low interest rates on savers and investors. My colleagues and I know that people who rely on investments that pay a fixed interest rate, such as certificates of deposit, are receiving very low returns, a situation that has involved significant hardship for some. However, I would encourage you to remember that the current low levels of interest rates, while in the first instance a reflection of the Federal Reserve's monetary policy, are in a larger sense the result of the recent financial crisis, the worst shock to this nation's financial system since the 1930s. Interest rates are low throughout the developed world, except in countries experiencing fiscal crises, as central banks and other policymakers try to cope with continuing financial strains and weak economic conditions. A second observation is that savers often wear many economic hats. Many savers are also homeowners; indeed, a family's home may be its most important financial asset. Many savers are working, or would like to be. Some savers own businesses, and--through pension funds and 401(k) accounts--they often own stocks and other assets. The crisis and recession have led to very low interest rates, it is true, but these events have also destroyed jobs, hamstrung economic growth, and led to sharp declines in the values of many homes and businesses. What can be done to address all of these concerns simultaneously?
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The best and most comprehensive solution is to find ways to a stronger economy. Only a strong economy can create higher asset values and sustainably good returns for savers. And only a strong economy will allow people who need jobs to find them. Without a job, it is difficult to save for retirement or to buy a home or to pay for an education, irrespective of the current level of interest rates. The way for the Fed to support a return to a strong economy is by maintaining monetary accommodation, which requires low interest rates for a time. If, in contrast, the Fed were to raise rates now, before the economic recovery is fully entrenched, house prices might resume declines, the values of businesses large and small would drop, and, critically, unemployment would likely start to rise again. Such outcomes would ultimately not be good for savers or anyone else.

How Is the Federal Reserve Held Accountable in a Democratic Society?
I will turn, finally, to the question of how the Federal Reserve is held accountable in a democratic society.

The Federal Reserve was created by the Congress, now almost a century ago. In the Federal Reserve Act and subsequent legislation, the Congress laid out the central bank's goals and powers, and the Fed is responsible to the Congress for meeting its mandated objectives, including fostering maximum employment and price stability. At the same time, the Congress wisely designed the Federal Reserve to be insulated from short-term political pressures.
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For example, members of the Federal Reserve Board are appointed to staggered, 14-year terms, with the result that some members may serve through several Administrations. Research and practical experience have established that freeing the central bank from short-term political pressures leads to better monetary policy because it allows policymakers to focus on what is best for the economy in the longer run, independently of near-term electoral or partisan concerns. All of the members of the Federal Open Market Committee take this principle very seriously and strive always to make monetary policy decisions based solely on factual evidence and careful analysis. It is important to keep politics out of monetary policy decisions, but it is equally important, in a democracy, for those decisions--and, indeed, all of the Federal Reserve's decisions and actions--to be undertaken in a strong framework of accountability and transparency. The American people have a right to know how the Federal Reserve is carrying out its responsibilities and how we are using taxpayer resources. One of my principal objectives as Chairman has been to make monetary policy at the Federal Reserve as transparent as possible. We promote policy transparency in many ways. For example, the Federal Open Market Committee explains the reasons for its policy decisions in a statement released after each regularly scheduled meeting, and three weeks later we publish minutes with a detailed summary of the meeting discussion. The Committee also publishes quarterly economic projections with information about where we anticipate both policy and the economy will be headed over the next several years. I hold news conferences four times a year and testify often before congressional committees, including twice-yearly appearances that are

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specifically designated for the purpose of my presenting a comprehensive monetary policy report to the Congress. My colleagues and I frequently deliver speeches, such as this one, in towns and cities across the country. The Federal Reserve is also very open about its finances and operations. The Federal Reserve Act requires the Federal Reserve to report annually on its operations and to publish its balance sheet weekly. Similarly, under the financial reform law enacted after the financial crisis, we publicly report in detail on our lending programs and securities purchases, including the identities of borrowers and counterparties, amounts lent or purchased, and other information, such as collateral accepted. In late 2010, we posted detailed information on our public website about more than 21,000 individual credit and other transactions conducted to stabilize markets during the financial crisis. And, just last Friday, we posted the first in an ongoing series of quarterly reports providing a great deal of information on individual discount window loans and securities transactions. The Federal Reserve's financial statement is audited by an independent, outside accounting firm, and an independent Inspector General has wide powers to review actions taken by the Board. Importantly, the Government Accountability Office (GAO) has the ability to--and does--oversee the efficiency and integrity of all of our operations, including our financial controls and governance. While the GAO has access to all aspects of the Fed's operations and is free to criticize or make recommendations, there is one important exception: monetary policymaking. In the 1970s, the Congress deliberately excluded monetary policy deliberations, decisions, and actions from the scope of GAO reviews.
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In doing so, the Congress carefully balanced the need for democratic accountability with the benefits that flow from keeping monetary policy free from short-term political pressures. However, there have been recent proposals to expand the authority of the GAO over the Federal Reserve to include reviews of monetary policy decisions. Because the GAO is the investigative arm of the Congress and GAO reviews may be initiated at the request of members of the Congress, these reviews (or the prospect of reviews) of individual policy decisions could be seen, with good reason, as efforts to bring political pressure to bear on monetary policymakers. A perceived politicization of monetary policy would reduce public confidence in the ability of the Federal Reserve to make its policy decisions based strictly on what is good for the economy in the longer term. Balancing the need for accountability against the goal of insulating monetary policy from short-term political pressure is very important, and I believe that the Congress had it right in the 1970s when it explicitly chose to protect monetary policy decisionmaking from the possibility of politically motivated reviews.

Conclusion
In conclusion, I will simply note that these past few years have been a difficult time for the nation and the economy. For its part, the Federal Reserve has also been tested by unprecedented challenges. As we approach next year's 100th anniversary of the signing of the Federal Reserve Act, however, I have great confidence in the institution. In particular, I would like to recognize the skill, professionalism, and dedication of the employees of the Federal Reserve System.

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They work tirelessly to serve the public interest and to promote prosperity for people and businesses across America. The Fed's policy choices can always be debated, but the quality and commitment of the Federal Reserve as a public institution is second to none, and I am proud to lead it. Now that I've answered questions that I've posed to myself, I'd be happy to respond to yours.

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BIS, Results of the Basel III monitoring exercise as of 31 December 2011 Important parts
This report presents the results of the Basel Committee's Basel III monitoring exercise. The study is based on rigorous reporting processes set up by the Committee to periodically review the implications of the Basel III standards for financial markets; the first results of the exercise based on June 2011 data had been published in April 2012. A total of 209 banks participated in the study, including 102 Group 1 banks (ie those that have Tier 1 capital in excess of €3 billion and are internationally active) and 107 Group 2 banks (ie all other banks). While the Basel III framework sets out transitional arrangements to implement the new standards, the monitoring exercise results assume full implementation of the final Basel III package based on data as of 31 December 2011 (ie they do not take account of the transitional arrangements such as the phase in of deductions). No assumptions were made about bank profitability or behavioural responses, such as changes in bank capital or balance sheet composition. For that reason the results of the study are not comparable to industry estimates. The study finds that based on data as of 31 December 2011 and applying the changes to the definition of capital and risk-weighted assets, the average common equity Tier 1 capital ratio (CET1) of Group 1 banks was 7.7%, as compared with the Basel III minimum requirement of 4.5%.

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In order for all Group 1 banks to reach the 4.5% minimum, an increase of €11.9 billion CET1 would be required. The overall shortfall increases to €374.1 billion to achieve a CET1 target level of 7.0% (ie including the capital conservation buffer); this amount includes the surcharge for global systemically important banks where applicable. As a point of reference, the sum of profits after tax and prior to distributions across the same sample of Group 1 banks in 2011 was €356 billion. Compared to the June 2011 exercise, the aggregate CET1 shortfall with respect to the 4.5% minimum for Group 1 banks has reduced by €26.9 billion. At the CET1 target level of 7.0%, the aggregate CET1 shortfall for Group 1 banks has reduced by €111.5 billion. For Group 2 banks, the average CET1 ratio stood at 8.8%. In order for all Group 2 banks in the sample to meet the new 4.5% CET1 ratio, the additional capital needed is estimated to be €7.6 billion. They would have required an additional €21.7 billion to reach a CET1 target 7.0%; the sum of these banks' profits after tax and prior to distributions in 2011 was €24 billion.

Executive summary
In 2010, the Basel Committee on Banking Supervision1 conducted a comprehensive quantitative impact study (C-QIS) using data as of 31 December 2009 to ascertain the impact on banks of the Basel III framework that was published in December 2010 and revised in June 2011.
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The Committee intends to continue monitoring the impact of the Basel III framework in order to gather full evidence on its dynamics. For this purpose, a semi-annual monitoring framework has been set up on the risk-based capital ratio, the leverage ratio, and the liquidity metrics using data collected by national supervisors on a representative sample of institutions in each jurisdiction. This report is the second publication of results of the Basel III monitoring exercise and summarises the aggregate results using data as of 31 December 2011. The Committee believes that the information contained in the report will provide the relevant stakeholders with a useful benchmark for analysis. Information considered for this report was obtained by data submissions of individual banks to their national supervisors on a voluntary and confidential basis. A total of 209 banks participated in the study, including 102 Group 1 banks and 107 Group 2 banks. Members’ coverage of their banking sector is very high for Group 1 banks, reaching 100% coverage for some jurisdictions, while coverage is comparatively lower for Group 2 banks and varied across jurisdictions. The Committee appreciates the significant efforts contributed by both banks and national supervisors to this ongoing data collection exercise. The report focuses on the following items: - Changes to bank capital ratios under the new requirements, and estimates of any capital deficiencies relative to fully phased-in minimum and target capital requirements (to include capital charges for global systemically important banks – G-SIBs);

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- Changes to the definition of capital that result from the new capital standard, referred to as common equity Tier 1 (CET1), including a reallocation of deductions to CET1, and changes to the eligibility criteria for Additional Tier 1 and Tier 2 capital; - Increases in risk-weighted assets resulting from changes to the definition of capital, securitisation, trading book, and counterparty credit risk requirements; - The Basel III leverage ratio; and - Two Basel III liquidity standards – the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR). With the exception of the transitional arrangements for non-correlation trading securitization positions in the trading book, this report does not take into account any transitional arrangements such as phase-in of deductions and grandfathering arrangements. Rather, the estimates presented assume full implementation of the final Basel III requirements based on data as of 31 December 2011. No assumptions have been made about banks’ profitability or behavioural responses, such as changes in bank capital or balance sheet composition, since this date or in the future. For this reason, the results are not comparable to current industry estimates, which tend to be based on forecasts and consider management actions to mitigate the impact, and incorporate estimates where information is not publicly available. The results presented in this report are also not comparable to the C-QIS that was prepared using end-December 2009 data because that report evaluated the impact of policy questions that differ in certain key respects from the finalised Basel III framework.

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As one significant example, the C-QIS did not consider the impact of capital surcharges for global systemically important banks.

Key results Capital shortfalls
Assuming full implementation of the Basel III requirements as of 31 December 2011, including changes to the definition of capital and risk-weighted assets, and ignoring phase-in arrangements, Group 1 banks would have an overall shortfall of €11.9 billion for the CET1 minimum capital requirement of 4.5%, which rises to €374.1 billion for a CET1 target level of 7.0% (ie including the capital conservation buffer); the latter shortfall also includes the G-SIB surcharge where applicable. As a point of reference, the sum of profits after tax prior to distributions across the same sample of Group 1 banks in 2011 was €356 billion. Compared to the June 2011 exercise, the aggregate CET1 shortfall with respect to the 4.5% minimum for Group 1 banks has improved by €26.9 billion or 69.3%. At the CET1 target level of 7.0%, the aggregate CET1 shortfall for Group 1 banks has improved by €111.5 billion or 23.0%. Under the same assumptions, the capital shortfall for Group 2 banks included in the Basel III monitoring sample is estimated at €7.6 billion for the CET1 minimum of 4.5% and €21.7 billion for a CET1 target level of 7.0%. The sum of Group 2 bank profits after tax prior to distributions in 2011 was €24 billion. Further details on additional capital needs to meet the Basel III requirements are included in Section 2.

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Capital ratios
The average CET1 ratio under the Basel III framework would decline from 10.4% to 7.7% for Group 1 banks and from 10.4% to 8.8% for Group 2 banks. The Tier 1 capital ratios of Group 1 banks would decline, on average from 11.7% to 8.0% and total capital ratios would decline from 14.2% to 9.2%. As with the CET1 ratios, the decline in other capital ratios is comparatively less pronounced for Group 2 banks; Tier 1 capital ratios would decline on average from 11.0% to 9.2% and total capital ratios would decline on average from 14.3% to 11.0%.

Changes in risk-weighted assets
As compared to current risk-weighted assets, total risk-weighted assets increase on average by 18.1% for Group 1 banks under the Basel III framework. This increase is driven largely by charges against counterparty credit risk, trading book exposures, and securitization exposures (principally those risk-weighted at 1250% under the Basel III framework that were previously 50/50 deductions under Basel II). Banks that have significant exposures in these areas influence the average increase in risk-weighted assets heavily. As Group 2 banks are less affected by the revised counterparty credit risk and trading book rules, these banks experience a comparatively smaller increase in risk-weighted assets of only 7.5%. Even within this sample, higher risk-weighted assets are attributed largely to Group 2 banks with counterparty and securitisation exposures (ie those subject to a 1250% risk weighting).
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As discussed in Section 4.1, the increase in risk-weighted assets contains certain estimates pertaining to trading book exposures for banks that have already adopted the Basel 2.5 enhancements.

Leverage ratio
The average Basel III Tier 1 leverage ratio for all banks is 3.6%. The Basel III average for Group 1 banks is 3.5%, and the average for Group 2 banks is 4.2%.

Liquidity standards
Both liquidity standards are currently subject to an observation period which includes a review clause to address any unintended consequences prior to their respective implementation dates of 1 January 2015 for the LCR and 1 January 2018 for the NSFR. Basel III monitoring results for the end-December 2011 reporting period give an indication of the impact of the calibration of the standards based on the December 2010 rules text and highlight several key observations: - A total of 102 Group 1 and 107 Group 2 banks participated in the liquidity monitoring exercise for the end-December 2011 reference period. - The weighted average LCR for Group 1 banks is 91%, compared to 90% for 30 June 2011, while the weighted average LCR for Group 2 banks is 98%. The aggregate LCR shortfall is €1.8 trillion which represents approximately 3% of the €61.4 trillion total assets of the aggregate sample.

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- The weighted average NSFR is 98% for Group 1 banks and 95% for Group 2 banks, compared to 94% for each of the Group 1 and Group 2 samples as at 30 June 2011. The aggregate shortfall of required stable funding is €2.5 trillion.

Sample of participating banks
A total of 209 banks participated in the study, including 102 Group 1 banks and 107 Group 2 banks. Group 1 banks are those that have Tier 1 capital in excess of €3 billion and are internationally active. All other banks are considered Group 2 banks. Banks were asked to provide data as of 31 December 2011 at the consolidated level. Subsidiaries are not included in the analyses to avoid double counting. Table 1 shows the distribution of participation by jurisdiction. For Group 1 banks members’ coverage of their banking sector was very high reaching 100% coverage for some jurisdictions. Coverage for Group 2 banks was comparatively lower and varied across jurisdictions. Not all banks provided data relating to all parts of the Basel III framework. Accordingly, a small number of banks are excluded from individual sections of the Basel III monitoring analysis due to incomplete data.

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In certain sections, data are based on a consistent sample of banks. This consistent sample represents only those banks that reported necessary data at both the June 2011 and December 2011 reporting dates, in order to make more meaningful period-to-period comparisons.

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Capital shortfalls
Chart 5 and Table 2 provide estimates of the amount of capital that Group 1 and Group 2 banks would need based on data as of 31 December 2011 in addition to capital already held at the reporting date, in order to meet the target CET1, Tier 1, and total capital ratios under Basel III assuming fully phased-in target requirements and deductions. Under these assumptions, the CET1 capital shortfall for Group 1 banks with respect to the 4.5% CET1 minimum requirement is €11.9 billion. The CET1 shortfall with respect to the 4.5% requirement for Group 2 banks, where coverage of the sector is considerably smaller, is estimated at €7.6 billion. For a CET1 target of 7.0% (ie the 4.5% CET1 minimum plus the 2.5% capital conservation buffer, plus any capital surcharge for Group 1 G-SIBs as applicable), Group 1 banks’ shortfall is €374.1 billion and Group 2 banks’ shortfall is €21.7 billion.

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The surcharges for G-SIBs are a binding constraint on 21 of the 27 G-SIBs included in this Basel III monitoring exercise. As a point of reference, the aggregate sum of after-tax profits prior to distributions for Group 1 and Group 2 banks in the same sample was €356 billion and €24 billion, respectively in 2011. Compared to the June 2011 exercise, the aggregate CET1 shortfall with respect to the 4.5% minimum for Group 1 banks has improved by €26.9 billion or 69.3% (see Chart 5). At the CET1 target level of 7.0%, the aggregate CET1 shortfall for Group 1 banks has improved by €111.5 billion or 23.0%. Assuming the 4.5% CET1 minimum capital requirements were fully met (ie, there were no CET1 shortfalls), Group 1 banks would need an additional €32.5 billion of additional Tier 1 or CET1 capital to meet the minimum Tier 1 capital ratio requirement of 6.0%. Assuming banks already hold 7.0% CET1 capital, Group 1 banks would need an additional €219.3 billion of additional Tier 1 or CET1 capital to meet the Tier 1 capital target ratio of 8.5% (ie the 6.0% Tier 1 minimum plus the 2.5% CET1 capital conservation buffer), respectively. Group 2 banks would need an additional €2.1 billion and an additional €11.9 billion to meet these respective Tier 1 capital minimum and target ratio requirements. Assuming CET1 and Tier 1 capital requirements were fully met (ie, there were no shortfalls in either CET1 or Tier 1 capital), Group 1 banks would need an additional €100.2 billion of Tier 2 or higher quality capital to meet the minimum total capital ratio requirement of 8.0% and an additional €224.3 billion of Tier 2 or higher quality capital to meet the total capital target ratio of 10.5% (ie the 8.0% Tier 1 minimum plus the 2.5% CET1 capital conservation buffer).

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Group 2 banks would need an additional €4.1 billion and an additional €8.6 billion to meet these respective total capital minimum and target ratio requirements. As indicated above, no assumptions have been made about bank profits or behavioural responses, such as changes balance sheet composition, that will serve to ameliorate the impact of capital shortfalls over time.

Impact of the definition of capital on Common Equity Tier 1 capital
As noted above, reductions in capital ratios under the Basel III framework are attributed in part to capital deductions not previously applied at the common equity level of Tier 1 capital in most jurisdictions. Table 3 shows the impact of various regulatory adjustment categories

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on the gross CET1 capital (ie, CET1 before adjustments) of Group 1 and Group 2 banks. In the aggregate, regulatory adjustments reduce the gross CET1 of Group 1 banks under the Basel III framework by 29.0%. The largest driver of Group 1 bank deductions is goodwill, followed by combined deferred tax assets (DTAs) deductions, and intangibles other than mortgage servicing rights. These deductions reduce Group 1 bank gross CET1 by 14.0%, 4.3%, and 3.5%, respectively. The category described as other adjustments reduces Group 1 bank gross CET1 by 3.8% and pertain mainly to deductions for provision shortfalls relative to expected credit losses and deductions related to defined benefit pension fund schemes. Holdings of capital of other financial companies reduce the CET1 of Group 1 banks by 1.9%. The category “Excess above 15%” refers to the deduction of the amount by which the aggregate of the three items subject to the 10% limit for inclusion in CET1 capital exceeds 15% of a bank’s CET1, calculated after all deductions from CET1. These 15% threshold bucket deductions reduce Group 1 bank gross CET1 by 1.6%. Deductions for MSRs exceeding the 10% limit have no impact on Group 1 CET1 in the aggregate. Table 3 also compares regulatory adjustments for Group 1 banks with the results of the previous period for those banks which participated in both exercises.

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Overall, deductions have been reduced by 2.6 percentage points, mainly driven by lower deductions for goodwill and financials. Regulatory adjustments reduce the CET1 of Group 2 banks by 20.4%. Goodwill is the largest driver of deductions for Group 2 banks, followed by holdings of the capital of other financial companies, deductions for intangibles other than mortgage servicing rights, and combined DTAs deductions. These deductions reduce Group 2 bank CET1 by 7.5%, 2.3%, 2.3% and 1.9%, respectively. Other adjustments, which are driven significantly by deductions for provision shortfalls relative to expected credit losses, result in a 3.1% reduction in Group 2 bank gross CET1. Deductions for items in excess of the aggregate 15% threshold basket reduce Group 2 bank gross CET1 by 1.2%. Deductions for mortgage servicing rights above the 10% limit have no impact on Group 2 banks.

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Changes in risk-weighted assets 4.1 Overall results
Reductions in capital ratios under the Basel III framework are also attributed to increases in risk-weighted assets. Table 4 provides additional detail on the contributors to these increases, to include the following categories:

Definition of capital:
These columns measure the change in risk-weighted assets as a result of proposed changes to the definition of capital. The column heading “other” includes the effects of lower risk-weighted assets for exposures that are currently included in risk-weighted assets but receive a deduction treatment under Basel III. The column heading “50/50” measures the increase in risk-weighted assets applied to securitisation exposures currently deducted under the Basel II framework that are risk-weighted at 1250% under Basel III. The column heading “threshold” measures the increase in risk-weighted assets for exposures that fall below the 10% and 15% limits for CET1 deduction;

Counterparty credit risk (CCR):
This column measures the new capital charge for credit valuation adjustments (CVA risk) and the higher capital charge that results from applying a higher asset value correlation parameter against exposures to financial institutions under the IRB approaches to credit risk. Banks have not been asked to provide data on the risk-weighted asset effects of capital charges for exposures to central counterparties (CCPs)
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or on any impact of incorporating stressed parameters for effective expected positive exposure (EEPE);

Trading book:
As data from most countries already include the RWA impact of the Basel 2.5 market risk rules, the incremental impact for changes in market RWA shown in these tables has been estimated using the sum of the following elements relative to elements in place under Basel II: the proportion of internally modeled general and specific risk that is attributable to stress value-at-risk, the incremental risk capital charge (IRC), capital charges for the correlation trading portfolio, and capital charges under the standardised measurement method (SMM) for other securitisation exposures and nth-to-default credit derivatives. The effect of higher capital charges for re-securitisation exposures in the banking book and increased conversion factors for short-term liquidity facilities to off-balance sheet conduits are not considered in these tables given the data are no longer available for all countries. However, prior reports have shown the impact of these charges to be generally small for both Group 1 and Group 2 banks. Risk-weighted assets for Group 1 banks increase overall by 18.1% for Group 1 banks. This increase is to a large extent attributed to higher risk-weighted assets for counterparty credit risk exposures, which result in an overall increase in total Group 1 bank risk-weighted assets of 7.9%. The predominant drivers behind this figure are capital charges for CVA risk and the higher asset value correlation parameter, which is included in the column labelled “CCR”.

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Trading book exposures and securitisation exposures currently subject to deduction under Basel II, also contribute significantly to higher risk-weighted assets at Group 1 banks at 4.9% and 4.2%, respectively.

Risk-weighted assets of Group 2 banks increase overall by 7.5%. Banks in this group tend to have smaller counterparty credit risk and trading book exposures, which explains the lower increase risk-weighted assets for Group 2 banks as compared to Group 1 banks. Securitisation exposures currently subject to deduction, CCR exposures, and exposures that fall below the 10% and 15% CET1 eligibility limits are significant contributors to changes in risk-weighted assets for Group 2 banks. Changes in risk-weighted assets show significant variation across banks as shown in Chart 6. Again, these differences are explained in large part by the extent of banks’ counterparty credit risk and trading book exposures, which attract significantly higher capital charges under Basel III as compared to current rules.

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Liquidity 6.1 Liquidity coverage ratio
One of the two standards introduced by the Committee is a 30-day liquidity coverage ratio (LCR) which is intended to promote short-term resilience to potential liquidity disruptions. The LCR has been designed to require global banks to have sufficient high-quality liquid assets to withstand a stressed 30-day funding scenario specified by supervisors.
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The LCR numerator consists of a stock of unencumbered, high-quality liquid assets that must be available to cover any net outflow, while the denominator is comprised of cash outflows less cash inflows (subject to a cap at 75% of outflows) that are expected to occur in a severe stress scenario. 102 Group 1 and 107 Group 2 banks provided sufficient data in the 31 December 2011 Basel III monitoring exercise to calculate the LCR according to the Basel III liquidity framework. The weighted average LCR was 91% for Group 1 banks, compared to 90% for 30 June 2011, and 98% for Group 2 banks. These aggregate numbers do not speak to the range of results across the banks. Chart 8 below gives an indication of the distribution of bank results; the thick red line indicates the 100% minimum requirement, the thin red horizontal lines indicate the median for the respective bank group. 47% of the banks in the Basel III monitoring sample already meet or exceed the minimum LCR requirement, an increase from 45% at the end of June 2011, and 62% have LCRs that are at or above 75%.

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For the banks in the sample, Basel III monitoring results show a shortfall (ie the difference between high-quality liquid assets and net cash outflows) of €1.8 trillion (which represents approximately 3% of the €61.4 trillion total assets of the aggregate sample) as of 31 December 2011, if banks were to make no changes whatsoever to their liquidity risk profile.

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This number is only reflective of the aggregate shortfall for banks that are below the 100% requirement and does not reflect surplus liquid assets at banks above the 100% requirement. Banks that are below the 100% required minimum have until 2015 to meet the standard by scaling back business activities which are most vulnerable to a significant short term liquidity shock or by lengthening the term of their funding beyond 30 days. Banks may also increase their holdings of liquid assets. The key components of outflows and inflows are shown in Table 7. Group 1 banks show a notably larger percentage of total outflows, when compared to balance sheet liabilities, than Group 2 banks. This can be explained by the relatively greater contribution of wholesale funding activities and commitments within the Group 1 sample, whereas Group 2 banks, as a whole, are less reliant on these types of activities.

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75% cap on total inflows
As at 31 December 2011, no Group 1 and 16 Group 2 banks reported inflows that exceeded the cap, compared to 19 Group 2 banks as at 30 June 2011. Of the 16 Group 2 banks, three fail to meet the LCR, so the cap is binding on them. Of the banks impacted by the cap on inflows, 12 have inflows from other financial institutions that are in excess of the excluded portion of inflows.
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Composition of high-quality liquid assets
The composition of high-quality liquid assets currently held at banks is depicted in Chart 9. The majority of Group 1 and Group 2 banks’ holdings, in aggregate, are comprised of Level 1 assets; however the sample, on whole, shows diversity in their holdings of eligible liquid assets. Within Level 1 assets, 0% risk-weighted securities issued or guaranteed by sovereigns, central banks and PSEs, and cash and central bank reserves comprise the most significant portions of the qualifying pool, with the latter increasing its contribution to the overall composition to 31.4% as at the end of December 2011 from 27.6% as at the end of June 2011. Comparatively, within the Level 2 asset class, the majority of holdings are comprised of 20% risk-weighted securities issued or guaranteed by sovereigns, central banks or PSEs, and qualifying covered bonds.

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Cap on Level 2 assets
€117 billion of Level 2 liquid assets were excluded because reported Level 2 assets were in excess of the 40% cap as currently operationalised. 23 banks currently reported assets excluded, of which 16 (8% of the total sample) had LCRs below 100%. These results compare to €121 billion of Level 2 liquid assets excluded by 34 banks as at 30 June 2011, of which 24% (11% of the sample) had LCRs below 100%. Chart 10 combines the above LCR components by comparing liquidity resources (buffer assets and inflows) to outflows. Note that the €710 billion difference between the amount of liquid assets and inflows and the amount of outflows and impact of the cap displayed in the chart is smaller than the €1.8 trillion gross shortfall noted above as it is assumed here that surpluses at one bank can offset shortfalls at other banks. In practice the aggregate shortfall in the industry is likely to lie somewhere between these two numbers depending on how efficiently banks redistribute liquidity around the system.

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Net stable funding ratio
The second standard is the net stable funding ratio (NSFR), a longer-term structural ratio to address liquidity mismatches and provide incentives for banks to use stable sources to fund their activities. 102 Group 1 and 107 Group 2 banks provided sufficient data in the 31 December 2011 Basel III monitoring exercise to calculate the NSFR according to the Basel III liquidity framework. 51% of these banks already meet or exceed the minimum NSFR requirement, compared to 46% at the end of June 2011, with 92% at an NSFR of 75% or higher as at 31 December 2011.
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The weighted average NSFR for the Group 1 bank sample is 98% while it is 95% for the Group 2 sample, compared to 94% for each of the Group 1 and Group 2 samples as at 30 June 2011. Chart 11 shows the distribution of results for Group 1 and Group 2 banks; the thick red line indicates the 100% minimum requirement, the thin red horizontal lines indicate the median for the respective bank group.

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The results show that banks in the sample had a shortfall of stable funding of €2.5 trillion at the end of December 2011, a decrease from €2.8 trillion at the end of June 2011, if banks were to make no changes whatsoever to their funding structure. This number is only reflective of the aggregate shortfall for banks that are below the 100% NSFR requirement and does not reflect any surplus stable funding at banks above the 100% requirement. Banks that are below the 100% required minimum have until 2018 to meet the standard and can take a number of measures to do so, including by lengthening the term of their funding or reducing maturity mismatch. It should be noted that the shortfalls in the LCR and the NSFR are not necessarily additive, as decreasing the shortfall in one standard may result in a similar decrease in the shortfall of the other standard, depending on the steps taken to decrease the shortfall.

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Benoît Coeuré: Challenges to the single monetary policy and the European Central Bank’s response
Speech by Mr Benoît Coeuré, Member of the Executive Board of the European Central Bank, at the Institut d’études politiques, Paris, 20 September 2012. Ladies and gentlemen, It is a great pleasure for me to speak here today at Sciences Po Paris. 9 August this year was the fifth anniversary of the start of the financial crisis. The past few years have been times of hardship, financial turbulence and risks. At the same time, the crisis has exposed weaknesses in the framework of the economic and monetary union and provided an impetus to strengthen its foundations and to begin the process of bringing all euro area countries back to a more sustainable fiscal and macroeconomic path. The crisis has also brought challenges and opportunities for monetary policy, which is going to be the focus of my remarks today. Let me elaborate on two of them. The first challenge I will describe is that after Lehman’s collapse central banks had to combat exceptional threats to price stability arising from financial instability and recessionary forces. At that time their standard tool of monetary policy – changes to the short-term interest rate – was losing traction due to the dislocation in the financial system.
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Central banks had to quickly learn that this situation required switching from normal operating mode, based simply on setting short-term interest rates, to crisis mode, aimed at sidestepping the obstacles to the standard channels of monetary policy transmission. This experience has given us an opportunity to deepen our understanding of monetary policy and, in particular, to reject the textbook dichotomy that either the central bank is able to rely on the “interest rate channel” for the transmission of its intentions, or else the economy is condemned to lasting instability. It is now clear that additional channels and conduits are available. The second challenge I want to discuss is the sovereign debt crisis and the associated fragmentation of credit markets across national borders. Starting in 2010, the financial crisis began to unfold in the euro area by turning into a debt crisis for some sovereign issuers. This quickly spilled across markets and countries. And more recently, it was exacerbated by investors’ fears of the reversibility of the euro. The challenge faced by monetary policy in this environment is enormous and is testing the ability of the ECB to act as the central bank of a single monetary area with 17 fiscal jurisdictions. It has been increasingly challenging to preserve the singleness of the monetary policy and to ensure the proper transmission of the policy stance to the real economy throughout the currency area. To address this situation, the ECB has taken a number of non-standard measures, and two weeks ago it announced the modalities for undertaking Outright Monetary Transactions in secondary markets for sovereign bonds in the euro area.
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I will describe the rationale for this decision and argue that it is a key element to ensure a lasting “monetary dominance” in the euro area, compliant with the Treaties.

Channels of monetary policy in normal times and crisis times
In normal times, monetary policy works primarily through inter-temporal financial arbitrage. In the Eurosystem, this arbitrage covers two different time dimensions. There is the weekly arbitrage cycle, through which the volume of central bank liquidity is reallocated across banks trading in the money market in the period between two consecutive weekly Eurosystem main refinancing operations (MROs). The reason for this reallocation is that – as a matter of routine, at least – the Eurosystem provides reserves at weekly intervals. While the banking sector’s need for reserves in the aggregate may not change significantly within a week, the cash needs of individual banks do fluctuate at higher frequencies, probably daily. So banks with liquidity deficits in the infra-weekly period need to borrow from banks with liquidity surpluses. The price at which these trades of liquid reserves between banks occur, i.e. the overnight interest rate (of which a euro area average, the EONIA, is computed and published every day by the ECB), is influenced by expectations of the cost of Eurosystem credit – the so-called MRO rate – at the next weekly monetary policy operation. A short-term inter-temporal arbitrage calculus anchors the overnight interest rate applied on the credit transaction between banks that need liquidity and banks that have a liquidity surplus.
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The second dimension of the inter-temporal calculus has a longer horizon and a wider scope of application across asset classes. Banks can borrow short in the money market or from the Eurosystem and decide to engage in term lending to other banks or to their customers. Bank customers, in turn, can use bank liquidity to finance consumption or the acquisition of capital. It is important to note that all of these money transactions in the broader economy involve traders weighing the costs of their borrowing against the return opportunities on their asset acquisition at different points in time, where the horizon is typically longer than a week. But, again, as banks borrowing from the Eurosystem are the source of this liquidity propagation pattern, and banks’ financial calculus is based on their anticipations of the interest rate settings by the Eurosystem in the future, such anticipations anchor the pricing of credit in the broader economy. We call this “the interest rate channel” of monetary policy decisions. In normal times, when risk factors are contained and can be diversified away, the interest rate channel, working through inter-temporal arbitrage, is the prime conduit of monetary policy (see slide 2). It sets the floor for term borrowing costs. Parsing longer-term yields into two components – the average level of the short-term policy interest rate expected over the term to maturity of the asset, and the risk premia – expectations of monetary policy pin down the first component. The mechanism through which this occurs is the inter-temporal financial arbitrage I just described.

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Term and liquidity premia are the additional returns that investors demand as a compensation for their reluctance to bear interest rate risk over long-duration assets, and for their decision to forgo liquidity services – I am abstracting here from credit risk, to which I will return later. When markets are properly functioning, non-depository institutions – dealers, hedge funds, investment banks – provide immediacy by offering lenders and borrowers their capacity to take positions on both sides of the market. Their ready availability to take positions as lenders and borrowers supports market liquidity, namely the ease with which a lender can liquidate a position before maturity. When market liquidity is secure, lenders are willing to engage in finance, trades in long-duration assets are active and the liquidity premia are contained. And, most importantly, they are steady. With a steady premium, the expectations of the short-term rates become the driving factor in the pricing of long-dated securities, and monetary policy acquires a potent handle on the economy. In August 2007, a sudden re-pricing in the US sub-prime mortgage market changed this world. The close and predictable relationship between the expected path of policy rates and market rates broke down because the liquidity premia widened and became volatile. The elevation of market premia was especially pronounced in the spread between the three-month EURIBOR and the expected three-month path of the overnight rate (see slide 3). Banks recognised a substantial counterparty risk in lending to each other, given that interbank lending was generally unsecured.

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But, even if collateral was taken, the ability to liquidate it at a reasonable price was severely impaired in an environment of widespread fear and uncertainty. Bank positions in the interbank market can be highly persistent. Large diversified banks tend to be borrowers and smaller, regional banks lenders. When the financial turmoil erupted, persistent borrowers endured a sharp and sustained jump in their funding costs and many of them had no access to markets at all. When Lehman Brothers finally filed for bankruptcy in mid-September 2008, widespread financial panic broke out. The paralysis of transactions spread beyond the money markets, where it had been more or less confined for a year. Outside the money market, dealers play a critical role guaranteeing market liquidity. But in order to be able to take positions on both sides of the market, they need to finance their securities positions via collateralised funding. For that, they need their own capital, which they can use to pay for the margins required by those who lend them securities. When confidence evaporates, margins increase and dealers’ capital is eroded, so that their ability to trade as buyers is restricted. Markets lose a critical actor, assets become less liquid, and the value of assets declines further. Having tasted the forbidden fruit of excess risk-taking, financial institutions were cast out of the paradise of seamless financial markets.
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In a financial crisis of these proportions, “outside money” – an asset that is not a liability for anybody else than a central bank – becomes the sole trustworthy store of value. Only a central bank, the monopoly provider of outside money, can respond to the scrambles for liquidity. The ECB injected its funding capacity into a market vacuum left wide open by bank retrenchment, dealer defaults and investor panic. In these conditions, inter-temporal financial arbitrage – of the type I described above – becomes impaired. The power of banks and dealers to engage in or finance inter-temporal trades of liquidity balances is degraded. So the main conduit of monetary policy – which depends on those trades – is lost. The ECB had to open a new channel, the “liquidity channel”, to get round the roadblocks facing the interest rate channel (see slide 4). More precisely, the ECB acted in two dimensions. It sought to alleviate the difficulties experienced by banks in getting liquidity from the interbank market, which was putting pressure on the assets side of banks’ balance sheets and increasing the risks of hindering credit supply. At the same time, it sought to restore the normal pass-through from short-term money market (lending) rates to other market and bank interest rates. As far as impairments to banks’ funding are concerned, the ECB addressed banks’ funding uncertainty by fully accommodating liquidity

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needs at a fixed interest rate (the ECB main refinancing rate), while simultaneously lengthening the maturity of refinancing operations: from three to six months and twelve months, and more recently two operations with a three-year maturity. This has allowed an alleviation of the funding constraints of the banking system. In this way, a substantial change in the term structure of liquidity has taken place. While before the crisis about three-quarters of outstanding liquidity had a maturity of one week and the rest three months (i.e. an average maturity of 15–20 days), the current average maturity is 28 months (see slide 5). The expansion of the ECB collateralised monetary policy operations, together with the more widespread collateralisation of financial transactions, has raised the fear of encumbrance of bank assets. This risk has not materialised as the list of eligible collateral has been expanded to enable banks to take full advantage of the ECB full-allotment policy, while rigorously applying risk control measures to mitigate liquidity, market and credit risk. But as higher haircuts erode the refinancing power of encumbered assets, there must be an asymptotic limit to the ability of the central bank to provide outside money without endangering its creditworthiness, on which confidence in the currency rests. The notion that central banks have an unlimited capacity to create money is an illusion and thus cannot be used as an excuse not to reform the economy. Overall, the policy measures taken on several fronts were able to stem the risk of a credit flow fallout with related adverse implications for price stability.

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In particular, the role of bank credit in financing the private sector has been preserved, supported by an increased recourse to debt markets especially by large firms (see slide 6).

The sovereign debt crisis and fragmentation of credit markets across national borders
My discussion so far has focused on term and liquidity premia, which have taken centre stage since the very beginning of the financial crisis. Starting in May 2010, the crisis was marked by a new phenomenon, until then little known in euro area: the emergence of large and variable credit risk premia in the pricing of supposedly risk-free securities issued by euro area governments. This has led to questions about the creditworthiness of some sovereign issuers and to a fully-fledged sovereign debt crisis. This new phase of the crisis has taken on several dimensions. The first and most noticeable one has been the large sell-off of government debt issued by sovereigns in precarious fiscal positions (see slide 7). Markets have increased their scrutiny of the fiscal and structural conditions of Member States (the “fundamentals”) and assessed them with an increasing degree of risk aversion. At times, markets have also overreacted to national news and to the political debate at euro area level, with yields subsequently displaying little mean reversion.

Fragmentation of credit market across national borders
The second dimension of the debt crisis has been a fragmentation of credit markets across national borders, affecting both banks and the
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private non-financial sector – in addition to the fragmentation experienced in government debt markets. The tight link between sovereign and bank creditworthiness is clearly visible in the high degree of correlation between sovereign CDS premia and bank CDS premia within the same jurisdiction (see slide 8). Causality runs both ways: banks’ rising funding costs reflect the risk associated with banks’ holdings of bonds issued by their own sovereign; and sovereign risk is exacerbated by the contingent liabilities coming from the perception that the government will have to intervene to rescue the domestic financial system. This creates a self-reinforcing loop between bank and sovereign risks, with doubts about the solvency of the sovereigns feeding doubts about the solvency of the banks, and vice versa. Such dynamics are much weaker in euro area countries considered by markets as financially solid. In the US – an example of a well-integrated fiscal and financial union, with a shock-absorbing capacity at the federal level, credible discipline at state level and a centralised mechanism to supervise and resolve banks – there is no correlation between bank and sovereign CDS premia. With hindsight, the “original sins” of Economic and Monetary Union, an otherwise carefully thought-through and consistent project, were weak fiscal institutions, tolerance of economic imbalances and the lack of an integrated mechanism to supervise and resolve banks. As a matter of fact, financial fragmentation has led to a “two-gear” monetary union, in which the marginal cost of borrowing for banks varies according to the jurisdiction. 1. Banks belonging to jurisdictions considered by markets as financially sound can generally access the interbank money market and get

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overnight financing at the EONIA rate, which is currently as low as 0.10%. 2. Banks in jurisdictions where risks and uncertainty are elevated generally have limited access to the interbank money market and rely to a large extent on central bank liquidity, charged at the MRO rate, currently 0.75%. The distressed funding conditions faced by banks in some parts of the euro area, compounded by expectations of a worsening macroeconomic outlook, have in turn resulted in fragmented credit conditions for households and firms, again along national borders. For one thing, credit supply standards applied by banks in their lending to the real economy have diverged across euro area countries. A similar message comes from the cross-country comparison of bank lending rates. The 75 basis point cut in the ECB main policy rate implemented in late 2011 has been accompanied by little reaction or even an increase of lending rates in countries under stress, whereas there has been a complete pass-through in euro area countries considered by the markets as financially solid (see slide 9).

Self-fulfilling equilibria driven by break-up fears
The third, and most recent, dimension of the debt crisis has taken the form of investor fears of a break-up of the currency union. Whereas exchange rate risk across euro area countries should have disappeared permanently with the creation of the single currency in 1999, there have been signs, especially over the summer, that investors have started pricing in redenomination risk. Investors require a compensation for the risk that the euro might not
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remain the irreversible currency of the euro area – at least in its current composition. Although it is difficult to disentangle redenomination premia from other sources of risks – and it requires econometric analysis – the inversion of the slope of the term structure of sovereign bond spreads observed in early summer 2012, for instance, for Spain and Italy was consistent with expectations of imminent break-up risks. Market fears of a high probability of not paying back in full, or of equivalently to repaying in a different, lower-valued currency, command high spreads. If the probability of this event concentrates over the short horizon, then the cumulative default probability for longer horizons (bounded overall by 100%) cannot rise much further, and inversion of the spread curve necessarily follows. Redenomination premia share some similarities with exchange rate premia that were driven out of control in the early 1990s by speculative attacks against the legacy currencies. The early symptoms – inverted sovereign yield curves, at least for some contries – were the same. And the potential of such attacks is known to generate self-fulfilling prophecies. In early summer 2012 this situation had two main implications. One was for fiscal policy: it needs to deliver sound fundamentals as the only way to lastingly overcome the crisis; but, at the same time, there can be no viable fiscal adjustment that can ensure sustainability if the interest rate faced by the fiscal authority keeps rising and there are severe distortions in government bond markets.

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The second implication was for monetary policy: the central bank cannot fulfil its mandate to maintain price stability if its policy intentions are not transmitted correctly to the real economy through the chain which forms the basis for monetary policy transmission; but, at the same time, the central bank cannot fulfil its mandate to maintain price stability if the fiscal authority does not fully honour its obligation to pay back its liabilities under all circumstances. How to make these apparently conflicting instances compatible? And how to overcome the deadlock?

The ECB policy response: Outright Monetary Transactions
Guidance to answer these questions can be derived from the Maastricht Treaty and the conceptual apparatus developed in the context of the economic literature on monetary vs. fiscal dominance. These insights have made clear that, from an institutional design perspective, central bank independence and a clear focus on price stability are necessary but not sufficient to ensure that the central bank can provide a regime of low and stable inflation under all circumstances – in the economic jargon, ensuring “monetary dominance”. Maintaining price stability also requires appropriate fiscal policy. To borrow from Leeper’s terminology, this means that an “active” monetary policy – namely a monetary policy that actively engages in the setting of its policy interest rate instrument independently and in the exclusive pursuit of its objective of price stability – must be accompanied by “passive” fiscal policy. A passive fiscal policy means that the fiscal authority must be ready and willing to adjust its policy stance (revenues and primary spending) in such a way as to stabilise its debt at any level of the interest rate that the central bank may choose.
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Or, to put it another way, borrowing from Woodford’s terminology, fiscal policy needs to be “Ricardian”. Although the Treaty shows an awareness of the need for consistency between monetary and fiscal policy, in the sense described above, to ensure lasting stability, it did not foresee that fiscal policy could go off track to an extent that requires dedicated institutions and policies able to provide financial assistance, against conditionality, in order to restore sustainability and preserve financial stability in the euro area. The creation of the EFSF/ESM in charge of providing support to euro area Member States in difficulties and enforcing appropriate conditionality has filled this gap. It provides the euro area with a means to restore “Ricardianess”, thereby minimising the risk of “fiscal dominance”. Against this background, it is easy to understand the ECB’s decision on 6 September to undertake Outright Monetary Transactions (OMTs) in secondary markets for sovereign bonds in the euro area, and to understand the specific framework within which they will be implemented. The aim of OMTs is to preserve the singleness of monetary policy and to ensure the proper transmission of the monetary policy stance to the real economy throughout the euro area. OMTs are intended to provide the ECB with a tool to address severe distortions in government bond markets which originate from, in particular, unfounded fears on the part of investors of the reversibility of the euro. Effectively, OMTs represent a means to rule out destructive self-fulfilling prophecies that would force the economy into a sub-optimal equilibrium (with elevated interest rates, adjustments made impossible, ultimately leading to default and currency redenomination).

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Meanwhile, OMTs preserve the incentives for governments to enforce the economic and fiscal adjustments which will prove necessary to steer the economy towards the “good” equilibrium. As a consequence, OMTs can succeed only if action is taken by governments, at national and at euro area level, to restore long-term growth and bridge fiscal and economic imbalances. The framework for OMTs is based on six main elements (see slide 10). First, strict and effective conditionality. A necessary condition for initiating OMTs is that a Member State activates an appropriate EFSF/ESM programme, which envisages strict and effective conditionality spanning the fiscal, macroeconomic, structural and financial spheres. And the design of conditionality and the monitoring of such a programme can largely benefit from the involvement of the IMF. This is however not sufficient. The country also needs to maintain (at least some) market access. And this is signalled by the reference the ECB has made to the need for the EFSF/ESM programme to include the possibility of primary market purchases. In addition, and most importantly, the Governing Council maintains full discretion to initiate OMTs, focusing its assessment exclusively on monetary policy considerations. The second main element on which the framework for OMTs is based is a built-in exit strategy.

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OMTs will be terminated when one of the following conditions materialises. OMTs are no longer warranted due to threats to price stability; the aim of OMTs has been achieved; there is non-compliance with the conditionality established in the EFSF/ESM programme. This announced rules-based approach represents a way to address time inconsistency. Third, OMTs will focus on the shorter part of the yield curve, and in particular on sovereign bonds with a maturity of between one and three years. This underscores the monetary policy nature of such outright transactions, the principle of which was foreseen in the ECB Statute. And it buttresses the OMTs’ aim to address reversibility premia which, as I argued above, have tended to manifest themselves at the short end of the term structure, while addressing the fact that credit risk embedded in longer-term yields should reflect the credibility of countries’ economic and financial adjustment programmes. Fourth, there are no ex ante quantitative limits on the size of OMTs. This makes clear that the ECB is committed to do whatever it takes, within its mandate, to preserve the solidity and irreversibility of the currency. Fifth, the ECB accepts the same (pari passu) treatment as private or other creditors with respect to bonds purchased in the context of OMTs. Finally, the liquidity created through OMTs will be fully sterilised. This reflects the role of OMTs in counteracting destructive self-fulfilling equilibria rather than altering the aggregate liquidity stance.
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The main features of the framework for OMTs outlined here address by design also three concerns or questions sometimes voiced in relation to outright purchases of government bonds by a central bank. The first concern can be summed up in two questions: Are OMTs a form of monetary financing of governments and will inflation be unleashed? The answer to both questions is: No. In fact, quite the opposite. OMTs will be conducive to the monetary authority restoring its power to control credit conditions in the euro area and, through that channel, inflation in the medium term. It thus creates the conditions for a transition from a regime of undisciplined fiscal policies – from a “non-Ricardian” or “active” fiscal policy, using the terminology of the economic literature referred to above – to a regime where fiscal policy respects its inter-temporal obligations – it becomes “Ricardian”, or “passive”. This means that monetary policy has regained its pre-eminence in determining credit conditions and inflation. This renewed assignment of tasks pushes back fiscal dominance and affirms monetary dominance. The second concern can be formulated in terms of the question: will OMTs bring large risks to the central bank’s balance sheet? The answer again is: no. OMTs establish a second type of interaction: between the central bank, real money investors and households and firms, which save and borrow to finance real economic activity.

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To the extent that break-up and reversibility premia are squeezed out of bond pricing, real money investors will return to the euro area securities market, and the prices of securities will again better reflect the fundamentals. Households and firms will benefit from restored credit conditions. And the associated widespread reassessment of risks will make market portfolios and the central bank portfolios grow in value. Ultimately, strict and effective conditionality could be seen as acting as a credit enhancement of all euro area portfolios. The third question is whether OMTs are a form of quantitative easing (QE). The answer is: no. First of all, QE is meant to ease the general credit conditions which are considered by the central bank to have become tight in a situation in which the short-term interest rate cannot be reduced further. OMTs are meant instead to restore homogeneous credit conditions throughout the euro area, but not necessarily to ease credit conditions in the aggregate. In the euro area as a region, there are currently no clear signs of deflation fears (see slide 11) that would justify QE. In addition, the channels of transmission are different. QE is expected to act on risk premia (primarily term premia) by subtracting long-duration securities from the market and replacing them with base money, which has a very short duration. This would reduce term premia and bid up the price of long-dated securities.
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The aim of OMTs however is not to create an excess demand for duration in the market, but to counteract redenomination risk and squeeze redenomination premia out of bond prices. In fact, OMTs focus on relatively short maturities, where premia associated with break-up risk are most evident. Finally, QE would need to be tailored to the specificities of the euro area, where two-thirds of the external financing of non-financial corporations is extended by banks and which does not have access to actively traded credit markets.

Conclusions
Let me conclude. The effectiveness of monetary policy relies on the control of monetary and credit conditions. This ability has been severely tested by the crisis. Some of the challenges faced by the ECB have been common to other central banks. The threat to the viability of the interest rate channel, and the consequent need to devise alternative (“non-standard”) measures exploiting other channels of transmission, is a prominent example. The crisis has taught us that the liquidity channel exploited by monetary policy in the euro area can be very powerful. It has allowed the ECB to maintain the flow of credit to the real economy and ensure price stability even in face of the soaring liquidity and funding risks experienced by banks during the crisis.

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Other challenges faced by the ECB have taken a specific form in the euro area and thus been somewhat different from those experienced by central banks elsewhere. The most obvious one is the sovereign debt crisis, with the associated fragmentation of credit markets across national borders and more recently the break-up fears. The destructive potential of these developments is enormous. This has led the ECB to recently announce its Outright Monetary Transactions in secondary markets for sovereign bonds as a means to safeguard the monetary policy transmission mechanism in all countries of the euro area and to counteract self-fulfilling prophecies. The design of OMTs has been inspired by the desire to affirm in a lasting manner “monetary dominance”, in compliance with the principles enshrined in the Maastricht Treaty. Going forward, the ECB remains committed to do whatever it takes to comply with its mandate of maintaining price stability in the euro area.

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Joint Forum, Principles for the supervision of financial conglomerates Corporate Governance
Broadly, corporate governance describes the processes, policies and laws that govern how a company or group is directed, administered or controlled. It defines the set of relationships between a company’s management, its board, its shareholders, and other recognised stakeholders. Corporate governance also provides the structure through which the objectives of the company are set, and the means of attaining those objectives and monitoring performance are determined. Good corporate governance should provide proper incentives for the board and management to pursue objectives that are in the interests of the company and its shareholders and should facilitate effective monitoring. The presence of an effective corporate governance system, within an individual company or group and across an economy as a whole, helps to provide a degree of confidence that is necessary for the proper functioning of a market economy. Financial conglomerates are often complex groups with multiple regulated and unregulated financial and other entities. Given this inherent complexity, corporate governance must carefully consider and balance the combination of interests of recognised stakeholders of the ultimate parent, and the regulated financial and other entities of the group.

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Ensuring that a common strategy supports the desired balance and that regulated entities are compliant with regulation on an individual and on an aggregate basis should be a goal of the governance system. This governance system is the fiduciary responsibility of the board of directors. When assessing corporate governance across a financial conglomerate, supervisors should apply these principles in a manner that is appropriate to the relevant sectors and the supervisory objectives of those sectors. This section describes the elements of the governance system most relevant to financial conglomerates, and how they should be assessed by supervisors.

Corporate governance in financial conglomerates
10. Supervisors should seek to ensure that the financial conglomerate establishes a comprehensive and consistent governance framework across the group that addresses the sound governance of the financial conglomerate, including unregulated entities, without prejudice to the governance of individual entities in the group.

Implementation criteria
10(a) Supervisors should require that the corporate governance framework of the financial conglomerate has minimum requirements for good governance of the entities of the financial conglomerate which allow for the prudential and legal obligations of its constituent entities to be effectively met. The ultimate responsibility for the sound and prudent management of a financial conglomerate rests with the board of the head of the financial conglomerate.

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10(b) Supervisors should require that the financial conglomerate emphasises a high degree of integrity in the conduct of its affairs. 10(c) Supervisors should seek to ensure that the corporate governance framework appropriately balances the diverging interests of constituent entities and the financial conglomerate as a whole. 10(d) Supervisors should require that the governance framework respects the interests of policy holders and depositors (where relevant), and should seek to ensure that it respects the interests of other recognised stakeholders of the financial conglomerate and the financial soundness of entities in the financial conglomerate. 10(e) Supervisors should require that the governance framework includes adequate policies and processes that enable potential intra-group conflicts of interest to be avoided, and actual conflicts of interest to be identified and managed.

Explanatory comments
10.1 The corporate governance framework should address where appropriate: • Alignment to the structure of the financial conglomerate; • Financial soundness of the significant owners; • Suitability of board members, senior management and key persons in control functions including their ability to make reasonable and impartial business judgments; • Fiduciary responsibilities of the boards of directors and senior management of the head company and material subsidiaries;

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• Management of conflicts of interest, in particular at the intra-group level and remuneration policies and practices within the financial conglomerate; and • Internal control and risk management systems and internal audit and compliance functions for the financial conglomerate. 10.2 The group’s corporate governance framework should notably include a strong risk management framework (refer to the Risk Management section), a robust internal control system, effective internal audit and compliance functions, and ensure that the group conducts its affairs with appropriate independence and a high degree of integrity. 10.3 Group-wide governance not only involves the governance of the head of the financial conglomerate, but also applies group-wide to all material activities and entities of the financial conglomerate. 10.4 In the event the local corporate governance requirements applicable to any particular material entity in the financial conglomerate are below the group standards, the more stringent group corporate governance standards should apply, except where this would lead to a violation of local law. 10.5 Supervisors should require that the corporate governance framework of the financial conglomerate includes a code of ethical conduct. 10.6 Supervisors should require that the financial conglomerate have in place policies focused on identifying and managing potential intra-group conflicts of interest, including those that may result from intra-group transactions, charges, up streaming dividends, and risk-shifting. The policies should be approved by the board of the head of the financial conglomerate and be effectively implemented throughout the group. The policies should recognise the long-term interest of the financial conglomerate as a whole, the long term interest of the significant entities
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of the financial conglomerate, the stakeholders within the financial conglomerate, and all applicable laws and regulations.

Structure of the financial conglomerate
11. Supervisors should seek to ensure that the financial conglomerate has a transparent organisational and managerial structure, which is consistent with its overall strategy and risk profile and is well understood by the board and senior management of the head company.

Implementation criteria
11(a) Supervisors should understand the financial conglomerate’s group structure and the impact of any proposed changes to this structure. 11(b) Supervisors should assess the ownership structure of the financial conglomerate, including the financial soundness and integrity of its significant owners. 11(c) Supervisors should seek to ensure that the structure of the financial conglomerate does not impede effective supervision. Supervisors may seek restructuring under appropriate circumstances to achieve this, if necessary. 11(d) Supervisors should seek to ensure that the board and senior management of the head of the financial conglomerate are capable of describing and understanding the purpose, structure, strategy, material operations, and material risks of the financial conglomerate, including those of unregulated entities that are part of the financial conglomerate structure. 11(e) Supervisors should assess and monitor the financial conglomerate's process for approving and controlling structural changes, including the creation of new legal entities. 11(f) Where the financial conglomerate is part of a wider group, supervisors should require that the board and senior management of the
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head of the financial conglomerate have governance arrangements that enable material risks stemming from the wider group structure to be identified and appropriately assessed by relevant supervisory authorities. 11(g) Supervisors should seek to ensure that there is a framework governing information flows within the financial conglomerate and between the financial conglomerate and entities of the wider group (eg reporting procedures).

Explanatory comments
11.1 A financial conglomerate may freely set its functional, hierarchical, business and/or regional organisation, provided all entities within the financial conglomerate comply with their relevant sectoral and legal frameworks. 11.2 Elements to be considered for assessing the significant ownership structure of the financial conglomerate may include the identification of significant owners, including the ultimate beneficial owners, the transparency of their ownership structure, their financial information, and the sources of their initial capital and all other requirements of national authorities. At a minimum, the necessary qualities of significant owners relate to the integrity demonstrated in personal behaviour and business conduct, as well as to the ability to provide additional support when needed. 11.3 Supervisors should seek to ensure that a financial conglomerate has an organisational and managerial structure that promotes and enables prudent management, and if necessary, orderly resolution aligned with corresponding sectoral requirements. Reporting lines within the financial conglomerate should be clear and should facilitate information flows within the financial conglomerate, both bottom-up and top-down.
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11.4 Supervisors should be satisfied that the board and senior management of the head of the financial conglomerate understand and influence the evolution of an appropriate group legal structure in alignment with the approved business strategy and risk profile of the financial conglomerate, and understand how the various elements of the structure relate to one another. Where a financial conglomerate creates many legal entities, their number and, particularly, the interconnections and transactions between them, may pose challenges for the design of effective corporate governance arrangements. This risk should be recognised and managed. This is particularly the case where the organisational and managerial structure of the financial conglomerate deviates from the legal entity structure of the financial conglomerate. 11.5 Supervisors should assess changes to the group structure and how these changes impact its soundness, especially where such changes cause the financial conglomerate to engage in activities and/or operate in jurisdictions that impede transparency or do not meet international standards stemming from sectoral regulation.

Suitability of board members, senior managers and key persons in control functions
12. Supervisors should seek to ensure that the board members, senior managers and key persons in control functions in the various entities in a financial conglomerate possess integrity, competence, experience and qualifications to fulfil their role and exercise sound objective judgment.

Implementation criteria
12(a) Supervisors should be satisfied of the suitability of board members, senior managers and key persons in control functions.
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12(b) Supervisors should require financial conglomerates to have satisfactory processes for periodically assessing suitability. 12(c) Supervisors should require that the members of the boards of the head of the financial conglomerate and of its significant subsidiaries act independently of parties and interests external to the wider group; and that the board of the head of the financial conglomerate include a number of members acting independently of the wider group (including owners, board members, executives, and staff of the wider group). 12(d) Supervisors should communicate with the supervisors of other regulated entities within the conglomerate when board members, senior management and key persons in control functions are deemed not to meet their suitability tests.

Explanatory comments
12.1 Board members, senior managers and key persons in control functions need to have appropriate skills, experience and knowledge, and act with care, honesty and integrity, in order to to make reasonable and impartial business judgments and strengthen the protection afforded to recognised stakeholders. To this end, institutions need to prudently manage the risk that persons in positions of responsibility may not be suitable. Suitability criteria may vary depending on the degree of influence on or the responsibilities for the financial conglomerate. 12.2 Supervisors of regulated entities of the financial conglomerate are subject to statutory and other requirements in applying suitability tests to these entities in their jurisdiction. The organisational and managerial structure of financial conglomerates adds elements of complexity for supervisors seeking to ensure the suitability of persons.
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For instance, the management of regulated entities within the financial conglomerate can be extensively influenced by persons who are not directly responsible for such functions. A group-wide perspective regarding suitability of persons is intended to close any loopholes in this respect. Supervisors may rely on assessments made by other relevant supervisors in this area regarding suitability. Alternatively they may decide on concerted supervisory actions regarding suitability if required. 12.3 In order to meet suitability requirements, board members, senior managers and key persons in control functions, both individually and collectively, should have and demonstrate the ability to perform the duties or to carry out the responsibilities required in their position. Competence can generally be judged from the level of professionalism (eg pertinent experience within financial industries or other businesses) and/or formal qualifications. 12.4 Serving as a board member or senior manager of a company (from the wider group) that competes or does business with the regulated entities in the financial conglomerate can compromise independent judgment and create conflicts of interest, as can cross-membership on boards. A board’s ability to exercise objective judgment independent of the views of executives and of inappropriate political or personal interests can be enhanced by recruiting members from a sufficiently broad population of candidates. The key characteristic of independence is the ability to exercise objective, independent judgment after fair consideration of all relevant information and views without undue influence from executives or from inappropriate
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external parties and interests and while taking into account the requirements of applicable law.

Responsibility of the board of the head of the financial conglomerate
13. Supervisors should require that the board of the head of the financial conglomerate appropriately defines the strategy and risk appetite of the financial conglomerate, and ensures this strategy is implemented and executed in the various entities, both regulated and unregulated.

Implementation criteria
13(a) Supervisors should require that the board of the head of the financial conglomerate has in place a framework for monitoring compliance with the strategy and risk appetite across the financial conglomerate. 13(b) Supervisors should require that the board of the head of the financial conglomerate regularly assesses the strategy and risk appetite of the financial conglomerate to ensure it remains appropriate as the conglomerate evolved. 13(c) Where the financial conglomerate is part of a wider group, supervisors should assess whether the head is managing its relationship with the wider group and ultimate parent in a manner that is consistent with the governance framework of the financial conglomerate. 13(d) Supervisors should require that a framework is in place which seeks to ensure resources are available across the financial conglomerate for constituent entities to meet both the group and their own entity’s governance standards.

Explanatory comments

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13.1 Supervisors should assess if the board of directors exercises adequate oversight over the management of the head of the financial conglomerate. This includes assessing the actions taken by the board of the head to define the strategy for the financial conglomerate and ensure the consistency of the operations of the various entities in the financial conglomerate with such strategy. To this end, the head company should set up an adequate corporate governance framework in line with the structure, business and risks of the financial conglomerate and its entities and applicable laws. This framework should ensure that the strategy is implemented and monitored throughout the financial conglomerate and reviewed on a regular basis and following material change including due to growth, increased complexity, geographic expansion, etc. 13.2 The head company should exercise adequate oversight of subsidiaries, both regulated and unregulated, while respecting independent legal and governance responsibilities. Supervisors should satisfy themselves that entities within a financial conglomerate adhere to the same group-wide corporate governance principles or at least apply policies that remain consistent with these principles. The board of a regulated subsidiary of a financial conglomerate will retain and set its own corporate governance responsibilities and practices in line with its own legal requirements or in proportion to its size or business. These should not, however, conflict with the broader financial conglomerate corporate governance framework. Appropriate governance arrangements will address arrangements such that legal or regulatory provisions or prudential rules of regulated subsidiaries will be known and taken into account by the head company.
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13.3 Where the financial conglomerate is part of a wider group structure, the head of the financial conglomerate is responsible for managing the relationship with its wider group. This includes ensuring there are appropriate arrangements for capital and liquidity management, assessing any material risk impact that may come from decisions made at its ownership level, service level agreements, reporting lines and regular top-level consultations with related companies in the wider group and the ultimate parent. 13.4 For smaller institutions within a larger conglomerate, it may be unnecessary to duplicate systems and controls. Such smaller institutions can rely on the systems and controls of the head if they have assessed that this is suitable to address group risks. 13.5 Supervisors should be satisfied with the amount and quality of information they receive from the head company of the financial conglomerate on its strategy, risk appetite and corporate governance framework.

Remuneration in a financial conglomerate
14. Supervisors should require that the financial conglomerate has and implements an appropriate remuneration policy that is consistent with its risk profile. The policy should take into account the material risks that organisation is exposed to, including those from its employees’ activities.

Implementation criteria
14(a) Supervisors should require that an appropriate remuneration policy consistent with established international standards is in place and observed at all levels and across jurisdictions in the financial conglomerate.

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An appropriate policy aligns risk-takers’ variable remuneration with prudent risk taking, promotes sound and effective risk management, and takes into account any other appropriate factors. The overarching objective of the policy should be consistent across the group but can allow for reasonable differences based on the nature of the constituent entities/units and local legal requirements. 14 (b) Supervisors should require that ultimate oversight of the remuneration policy rest with the financial conglomerate’s head company. 14(c) Supervisors should require that the remuneration of board members, senior managers and key persons in control functions be determined in a manner that does not incentivise them to disregard the obligations they owe to the financial conglomerate or any of its entities, nor to otherwise act in a manner contrary to any legal or regulatory obligations. 14(d) Supervisors should require that the risks associated with remuneration are reflected in the financial conglomerate’s broader risk management framework. For example, staff engaged in financial and risk control at the group-wide level should be compensated in a manner that is consistent with their control role and should be involved in designing incentive arrangements, and assessing whether such arrangements encourage imprudent risk-taking. 14(e) Supervisors should require that the variable remuneration received by risk management and control personnel is not based substantially on the financial performance of the business units that they review but rather on the achievement of the objectives of their functions (eg adherence to internal controls).

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Explanatory comments
14.1 Remuneration is a key aspect of any governance framework and needs to be properly considered in order to mitigate the risks that may arise from poorly designed remuneration arrangements. The risks associated with remuneration should be reflected in the financial conglomerate’s broader risk management framework. 14.2 Remuneration may serve important objectives, including attracting skilled staff, promoting better organisation-wide and employee performance, promoting retention, providing retirement security and allowing personnel costs to vary with revenues. It is also clear, however, that ill-designed compensation arrangements can provide incentives to take risks that are not consistent with the long term health of the organisation. Such risks and misaligned incentives are of particular supervisory interest. 14.3 Ultimately a financial conglomerate’s remuneration policy should aim to ensure effective governance of remuneration, alignment of remuneration with prudent risk-taking, and engagement of recognised stakeholders. 14.4 Supervisors should ensure that the governance system identifies and closes loopholes that allow the circumvention of conglomerate, sectoral or entity-level remuneration requirements. 14.5 Board members, senior managers and key persons in control functions should be measured against performance criteria tied not only to the short-term, but also to the long-term interest of the financial conglomerate as a whole.

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V. Risk Management
Since financial conglomerates are in the business of risk-taking, good risk management is a crucial focus of supervision. This section provides principles for the sound and comprehensive supervision of risk management frameworks in financial conglomerates. It covers factors ranging from risk culture and tolerance, to the use of stress and scenario testing and the monitoring of risk concentrations.

Risk management framework
21. Supervisors should require that an independent, comprehensive and effective risk management framework, accompanied by a robust system of internal controls, effective internal audit and compliance functions, is in place for the financial conglomerate.

Implementation criteria
21(a) Supervisors should ensure that the risk management framework is comprehensive, consistent across entities supervised in all sectors and covers the risk management function, risk management processes and governance, and systems and controls.

Risk management function
21(b) Supervisors should require that the risk management function is independent from the business units and has a sufficient level of authority and adequately skilled resources to carry out its functions. 21(c) Supervisors should require that the risk management function generally has a direct reporting line to the board and senior management of the financial conglomerate. 21(d) Supervisors should, where they consider it appropriate, require that
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a separate risk management committee at the board of directors level is established by the financial conglomerate.

Risk management governance
21(e) Supervisors should require that the board of the head of the financial conglomerate has overall responsibility for the financial conglomerate’s group-wide risk management, internal control mechanism, internal audit and compliance functions to ensure that the group conducts its affairs with a high degree of integrity. 21(f) Supervisors should require that the financial conglomerate has an established enterprise-wide risk management process for, among others, periodically reviewing the effectiveness of the group-wide risk management framework and for ensuring appropriate aggregation of risks. 21(g) Supervisors should require that the risk management process cover identification, measurement, monitoring and controlling of risk types (eg credit risk, operational risk, strategic risk, liquidity risk) and these be linked where appropriate to specific capital requirements.

Systems and controls
21(h) Supervisors should require that financial conglomerates have in place adequate, sound and effective risk management processes and internal control mechanisms at the level of the financial conglomerate, including sound administrative and accounting procedures. 21(i) Supervisors should require that risk management processes and internal control mechanisms of a financial conglomerate are appropriately documented and, at a minimum, take into account the: • nature, scale and complexity of its business; • diversity of its operations, including geographical reach ;
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• volume, frequency and size of its transactions; • degree of risk associated with each area of its operation; • interconnectedness of the entities within the financial conglomerate (using intra-group transactions and exposures reporting as one measure); and • sophistication and functionality of information and reporting systems.

Explanatory comments
21.1 Financial conglomerates, irrespective of their particular mix of business lines or financial sectors, are in the business of risk taking. Therefore, strong risk management is of paramount importance. 21.2 The comprehensive risk management framework and process should include board and senior management oversight. 21.3 In identifying, evaluating, monitoring, controlling and mitigating material risks (from regulated and unregulated activities), financial conglomerates should consider the prospect for these to change over time and prepare themselves accordingly. 21.4 The risk management processes and internal control mechanisms of a financial conglomerate should include clear arrangements for delegating authority and responsibility; segregation of the functions that involve committing the financial conglomerate’s funds and accounting for assets and liabilities; reconciliation of these processes; safeguarding of the financial conglomerate’s assets; and appropriate independent internal audit and compliance functions to test adherence to these controls as well as applicable laws and regulations.

Risk tolerance levels and risk appetite policy
23. Supervisors should require that the financial conglomerate establishes
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appropriate board approved, group-wide risk tolerance levels and a risk appetite policy.

Implementation criteria
23(a) Supervisors should require that key staff, senior management and the board of the head of the financial conglomerate be aware of and understand the financial conglomerate’s risk tolerance levels and risk appetite policy. 23(b) Supervisors should require that the financial conglomerate identify and measure against risk tolerance limits (and in line with its risk appetite policy) the risk exposure of the financial conglomerate on an on-going basis in order to identify potential risks as early as possible. This may include looking at risks by territory, by line of business, or by financial sector.

Explanatory comments
23.1 Financial conglomerates should establish risk tolerance levels and a risk appetite policy which set the tone for acceptable and unacceptable risk taking. This should be aligned with the financial conglomerate’s business strategy, risk profile and capital plan. 23.2 A financial conglomerate’s risk tolerance should be kept under periodic review so as to ensure that it remains relevant and takes account of the changing dynamics of the financial conglomerate. The financial conglomerate’s risk appetite policy is re-assessed regularly with respect to new business opportunities, changes in risk capacity and tolerance, and operating environment.

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New business
24. Supervisors should require that the financial conglomerate carries out a robust risk assessment when entering into new business areas.

Implementation criteria
24(a) Supervisors should, where they consider it appropriate, review the risk assessment carried out by a financial conglomerate in the context of entering into new business. 24(b) Supervisors should require that financial conglomerates not expand into new products unless they have put in place adequate processes, controls and systems (such as IT) to manage them. 24(c) Supervisors should make sure that a financial conglomerate carries out the ongoing risk assessment after entering into new business areas.

Explanatory comments
24.1 At the time of assessing whether or not to enter into a new business area or product line, it is imperative that financial conglomerates undertake risk assessments and analyses to identify potential risks inherent in the new activity. 24.2 They should seek to understand the potential interaction between the risks of the new activity and the existing risk profile of the financial conglomerate. This should include a consideration of whether the new activity could adversely affect the risk appetite or risk tolerance of the financial conglomerate.

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Outsourcing
25. Supervisors should require that, when considering whether to outsource a particular function, the financial conglomerate carries out an assessment of the risks of outsourcing, including the appropriateness of outsourcing a particular function.

Implementation criteria
25(a) Supervisors should require that financial conglomerates have processes and criteria in place to review decisions to outsource a function in order to ensure that such outsourcing does not imply delegation of responsibility for that function. 25(b) Supervisors should be satisfied that the decision to outsource a function does not impede effective group-wide supervision of the financial conglomerate.

Explanatory comments
25.1 It is important that supervisors be satisfied that, when considering whether to outsource a particular function, financial conglomerates have considered the risks involved and the appropriateness of outsourcing a particular function. This includes considering the appropriateness of outsourcing to a particular provider and the cumulative risks of all outsourced functions. The supervisor should require the financial conglomerate to review the provider in advance to ensure it is in a position to provide the services, comply with the contractual terms, and observe all applicable laws and regulations.

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25.2 Supervisors should periodically assess the outsourced function with regard to policy compliance, risk management measures and control procedures. 25.3 Outsourcing should never result in a delegation of responsibility for a given function. There may be certain functions within financial conglomerates which should not be outsourced under any circumstances, while there may be some that may only be outsourced if certain safeguards are put in place.

Stress and scenario testing
26. Supervisors should require, where appropriate, that the financial conglomerate periodically carries out group-wide stress tests and scenario analyses for its major sources of risk.

Implementation criteria
26(a) Supervisors should require that stress tests are sufficiently severe, forward looking and flexible. They should cover an appropriate set of business activities and include a variety of different types of tests such as sensitivity analyses, scenario analyses and reverse stress testing. 26(b) Supervisors should require the financial conglomerate to document its stress and scenario tests, including reverse stress tests. Stress tests should be conducted under a robust governance framework that encompasses policies, procedures, and adequate documentation of procedures as well as validation of results. 26(c) Supervisors should require that the group-wide stress tests and scenario analyses conducted by the financial conglomerate are
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appropriate to the nature, scale and complexity of those major sources of risk and to the nature, scale and complexity of the financial conglomerate’s business. 26(d) Supervisors should require that group-wide stress tests and scenario analyses include a group-wide approach (which takes account of the interaction between different parts of the group and different risk types) and consider the results of sectoral stress tests. 26(e) Supervisors should require that, when carrying out reverse stress tests, a financial conglomerate identifies a range of adverse circumstances which would cause its business to fail and assess the likelihood of such events crystallising.

Explanatory comments
26.1 A financial conglomerate should have a good understanding of correlation between its respective sectors and the heterogeneity of such risks when conducting its stress tests. Stress tests should be robust and should consider sufficiently adverse circumstances. The group-wide stress test analysis should measure and evaluate the potential impact on individual entities. 26.2 Attention should be paid to covering all risks, including off-balance sheet items. For example, a financial conglomerate’s stress tests and scenario analyses should take into account the risk that the financial conglomerate may have to bring back on to its consolidated balance sheet the assets and liabilities of off-balance sheet entities as a result of reputational contagion, notwithstanding the appearance of legal risk transfer.

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26.3 Where reverse stress tests reveal a risk of business failure that is unacceptably high relative to the financial conglomerate’s risk appetite or risk tolerance, the financial conglomerate should evaluate and adopt, where appropriate, effective arrangements, processes, systems or other measures to prevent or mitigate that risk.

Risk aggregation
27. Supervisors should require that the financial conglomerate aggregate the risks to which it is exposed in a prudent manner.

Implementation criteria
27(a) Supervisors should require that financial conglomerates ***not make overly ambitious diversification assumptions*** or imprudent correlation claims, particularly for capital adequacy and solvency purposes. 27(b) Supervisors should require financial conglomerates to have adequate resources and systems (including IT) for the purpose of aggregating risks.

Explanatory comments
27.1 Risk aggregation should include a clear understanding of assumptions and be robust enough to support a comprehensive assessment of risk. 27.2 While it is possible that the spread of activities within a financial conglomerate may create diversification effects and reduce correlation, it is also true that membership of a financial conglomerate group may create “group risks” in the form of financial contagion, reputational contagion, ratings contagion (where a subsidiary accesses capital through a parent’s credit rating and then suffers stress following the utilisation of the capital), double/multiple-gearing (use of same capital
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more than once within a group), excessive leveraging (upgrade in the quality of capital as it moves through a group), and regulatory arbitrage (it is important that risks are assessed at the financial conglomerate level as well as at the level of its constituent parts).

Risk concentrations and intra-group transactions and exposures
28. Supervisors should require that the financial conglomerate has in place effective systems and processes to manage and report group-wide risk concentrations and intra-group transactions and exposures.

Implementation criteria
28(a) Supervisors should require that the financial conglomerate has in place effective systems and processes to identify, assess and report group-wide risk concentrations (including for the purposes of monitoring and controlling those concentrations). 28(b) Supervisors should require that the financial conglomerate has in place effective systems and processes to identify, assess and report significant intra-group transactions and exposures. 28(c) Supervisors should require the financial conglomerate to report significant risk concentrations and intra-group transactions and exposures at the level of the financial conglomerate on a regular basis. 28(d) Supervisors should consider setting quantitative limits and adequate reporting requirements.

Explanatory comments
28.1 Supervisors should ensure that financial conglomerates are managing their risk concentrations and intra-group transactions and exposures satisfactorily.

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28.2 Supervisors should encourage adequate public disclosure of risk concentrations and intra-group transactions and exposures. 28.3 Supervisors should liaise closely with one another to ascertain each other’s concerns and coordinate as deemed appropriate any supervisory action relative to risk concentrations and intra-group transactions and exposures within the financial conglomerate. 28.4 Supervisors should deal effectively with material risk concentrations and intra-group transactions and exposures that are considered to have a detrimental effect on the regulated entities or the financial conglomerate as a whole.

Off-balance sheet activities
29. Supervisors should require that off-balance sheet activities, including special purpose entities, are brought within the scope of group-wide supervision of the financial conglomerate, where appropriate.

Implementation criteria
29(a) Supervisors should require that there is a process for determining whether the nature of the relationship between the financial conglomerate and a special purpose entity (SPE) requires the SPE to be fully or proportionally consolidated into the financial conglomerate for regulatory purposes. 29(b) Supervisors should require that the financial conglomerate’s stress tests and scenario analyses take into account the risk associated with off balance sheet activities. 29(c) Supervisors should require that the overall nature of the relationship between the financial conglomerate and the SPE is considered including the risk of contagion from the SPE. This assessment should go beyond traditional control and influence relationships.

Explanatory comments
29.1 A financial conglomerate’s risk management framework and processes should cover the full spectrum of risks to the financial
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conglomerate. This includes risks from regulated and unregulated entities, including SPEs and off-balance sheet activities. 29.2 The fact that a financial conglomerate does not own or control the SPE in the traditional sense should not mean that it should not be consolidated. Other channels of contagion should be considered, such as the provision of (actual or contingent) liquidity support, reputational risk, and whether the assets of the SPE previously belonged to the financial conglomerate or were third-party assets. 29.3 It is important that financial conglomerates assess all economic risks and business purposes of an SPE throughout the life of a transaction, distinguishing between risk transfer and risk transformation. Financial conglomerates should be particularly aware that, over time, the nature of these risks can change. Supervisors should require such assessment to be ongoing and that management has sufficient understanding of the risks. 29.4 Financial conglomerates should have the capability to aggregate, assess and report all their SPE exposure risks in conjunction with all other firm-wide risks. 29.5 Supervisors should regularly oversee and monitor the use of all SPE activity and assess the implications for the financial conglomerate of the activities of SPEs, in order to identify developments that can lead to systemic weakness and contagion or that can exacerbate pro-cyclicality.

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The Basel iii Compliance Professionals Association (BiiiCPA) is the largest association of Basel iii Professionals in the world. It is a business unit of the Basel ii Compliance Professionals Association (BCPA), which is also the largest association of Basel ii Professionals in the world.

Basel III Speakers Bureau
The Basel iii Compliance Professionals Association (BiiiCPA) has established the Basel III Speakers Bureau for firms and organizations that want to access the Basel iii expertise of Certified Basel iii Professionals (CBiiiPros). The BiiiCPA will be the liaison between our certified professionals and these organizations, at no cost. We strongly believe that this can be a great opportunity for both, our certified professionals and the organizers. To learn more: www.basel-iii-association.com/Basel_iii_Speakers_Bureau.html

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Certified Basel iii Professional (CBiiiPro) Distance Learning and Online Certification Program
The all-inclusive cost is $297 What is included in this price:

A. The official presentations we use in our instructor-led classes (1426 slides)
You can find the course synopsis at: www.basel-iii-association.com/Course_Synopsis_Certified_Basel_III_Pr ofessional.html

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

C. Personalized Certificate printed in full color.
Processing, printing and posting to your office or home. To become a Certified Basel iii Professional (CBiiiPro) you must follow the steps described at: www.basel-iii-association.com/Basel_III_Distance_Learning_Online_C ertification.html
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