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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, If you want only the presentations of the Certified Basel iii Professional (CBiiiPro) program, you can have them at $97 (instead of $297, the cost of the full program). To learn more: www.basel-ii-association.com/Distance_Learning_Online_Certification _CBiiiPro_Presentations.htm _____________________________________________________________ We had such an interesting month… and the most interesting days were just after the first week of the month, when we could read the amended liquidity standards…

Basel III - Group of Governors and Heads of Supervision endorses revised liquidity standard for banks
6 January 2013 The Group of Governors and Heads of Supervision (GHOS), the oversight body of the Basel Committee on Banking Supervision, met today to consider the Basel Committee's amendments to the Liquidity Coverage Ratio (LCR) as a minimum standard. It unanimously endorsed them.
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Today's agreement is a clear commitment to ensure that banks hold sufficient liquid assets to prevent central banks becoming the "lender of first resort". The GHOS also endorsed a new Charter for the Committee, and discussed the Committee's medium-term work agenda. The GHOS reaffirmed the LCR as an essential component of the Basel III reforms. It endorsed a package of amendments to the formulation of the LCR announced in 2010. The package has four elements: 1. Revisions to the definition of high quality liquid assets (HQLA) and net cash outflows 2. A timetable for phase-in of the standard 3. A reaffirmation of the usability of the stock of liquid assets in periods of stress, including during the transition period 4. An agreement for the Basel Committee to conduct further work on the interaction between the LCR and the provision of central bank facilities. A summary description of the agreed LCR is in Annex 1. The changes to the definition of the LCR, developed and agreed by the Basel Committee over the past two years, include an expansion in the range of assets eligible as HQLA and some refinements to the assumed inflow and outflow rates to better reflect actual experience in times of stress. These changes are set out in Annex 2.

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The GHOS agreed that the LCR should be subject to phase-in arrangements which align with those that apply to the Basel III capital adequacy requirements. Specifically, the LCR will be introduced as planned on 1 January 2015, but the minimum requirement will begin at 60%, rising in equal annual steps of 10 percentage points to reach 100% on 1 January 2019. This graduated approach is designed to ensure that the LCR can be introduced without disruption to the orderly strengthening of banking systems or the ongoing financing of economic activity. The GHOS agreed that, during periods of stress it would be entirely appropriate for banks to use their stock of HQLA, thereby falling below the minimum. Moreover, it is the responsibility of bank supervisors to give guidance on usability according to circumstances. The GHOS also agreed today that, since deposits with central banks are the most - indeed, in some cases, the only - reliable form of liquidity, the interaction between the LCR and the provision of central bank facilities is critically important. The Committee will therefore continue to work on this issue over the next year. GHOS members endorsed two other areas of further analysis. First, the Committee will continue to develop disclosure requirements for bank liquidity and funding profiles. Second, the Committee will continue to explore the use of market-based indicators of liquidity to supplement the existing measures based on asset classes and credit ratings.

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The GHOS discussed and endorsed the Basel Committee's medium-term work agenda. Following the successful agreement of the LCR, the Committee will now press ahead with the review of the Net Stable Funding Ratio. This is a crucial component in the new framework, extending the scope of international agreement to the structure of banks' debt liabilities. This will be a priority for the Basel Committee over the next two years. Over the next few years, the Basel Committee will also: 1. Complete the overhaul of the policy framework currently under way 2. Continue to strengthen the peer review programme established in 2012 to monitor the implementation of reforms in individual jurisdictions 3. Monitor the impact of, and industry response to, recent and proposed regulatory reforms. During 2012 the Committee has been examining the comparability of model-based internal risk weightings and considering the appropriate balance between the simplicity, comparability and risk sensitivity of the regulatory framework. The GHOS encouraged continuation of this work in 2013 as a matter of priority. Furthermore, the GHOS supported the Committee's intention to promote effective macro- and microprudential supervision. The GHOS also endorsed a new Charter for the Basel Committee.

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The new Charter sets out the Committee's objectives and key operating modalities, and is designed to improve understanding of the Committee's activities and decision-making processes. Finally, the GHOS reiterated the importance of full, timely and consistent implementation of Basel III standards. Mervyn King, Chairman of the GHOS and Governor of the Bank of England, said, "The Liquidity Coverage Ratio is a key component of the Basel III framework. The agreement reached today is a very significant achievement. For the first time in regulatory history, we have a truly global minimum standard for bank liquidity. Importantly, introducing a phased timetable for the introduction of the LCR, and reaffirming that a bank's stock of liquid assets are usable in times of stress, will ensure that the new liquidity standard will in no way hinder the ability of the global banking system to finance a recovery." Stefan Ingves, Chairman of the Basel Committee and Governor of the Sveriges Riksbank, noted: "The amendments to the LCR are designed to ensure that it provides a sound minimum standard for bank liquidity - a standard that reflects actual experience during times of stress. The completion of this work will allow the Basel Committee to turn its attention to refining the other component of the new global liquidity standards, the Net Stable Funding Ratio, which remains subject to an observation period ahead of its implementation in 2018."

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Annex 1 Summary description of the LCR
To promote short-term resilience of a bank’s liquidity risk profile, the Basel Committee developed the Liquidity Coverage Ratio (LCR). This standard aims to ensure that a bank has an adequate stock of unencumbered high quality liquid assets (HQLA) which consists of cash or assets that can be converted into cash at little or no loss of value in private markets to meet its liquidity needs for a 30 calendar day liquidity stress scenario. The LCR has two components: (a) The value of the stock of HQLA (b) Total net cash outflows and is expressed as:

High Quality Liquid Assets
The numerator of the LCR is the stock of HQLA. Under the standard, banks must hold a stock of unencumbered HQLA to cover the total net cash outflows over a 30-day period under the prescribed stress scenario.
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In order to qualify as HQLA, assets should be liquid in markets during a time of stress and, in most cases, be eligible for use in central bank operations. Certain types of assets within HQLA are subject to a range of haircuts. HQLA are comprised of Level 1 and Level 2 assets. Level 1 assets generally include cash, central bank reserves, and certain marketable securities backed by sovereigns and central banks, among others. These assets are typically of the highest quality and the most liquid, and there is no limit on the extent to which a bank can hold these assets to meet the LCR. Level 2 assets are comprised of Level 2A and Level 2B assets and include certain marketable government securities as well as corporate debt securities, residential mortgage backed securities and equities that meet certain conditions. Level 2 assets (comprising Level 2A and Level 2B assets) are typically of slightly lesser quality and may not in aggregate account for more than 40% of a bank’s stock of HQLA. Level 2B assets may not account for more than 15% of a bank’s total stock of HQLA.

Total net cash outflows
The denominator of the LCR is the total net cash outflows. It is defined as total expected cash outflows, minus total expected cash inflows, in the specified stress scenario for the subsequent 30 calendar days.
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Total expected cash outflows are calculated by multiplying the outstanding balances of various categories or types of liabilities and off-balance sheet commitments by the rates at which they are expected to run off or be drawn down. Total expected cash inflows are calculated by multiplying the outstanding balances of various categories of contractual receivables by the rates at which they are expected to flow in. Total cash inflows are subject to an aggregate cap of 75% of total expected cash outflows, thereby ensuring a minimum level of HQLA holdings at all times.

Liquidity Coverage Ratio
The standard requires that, absent a situation of financial stress, the value of the ratio be no lower than 100% (ie the stock of HQLA should at least equal total net cash outflows). Banks are expected to meet this requirement continuously and hold a stock of unencumbered HQLA as a defence against the potential onset of liquidity stress. During a period of financial stress, however, banks may use their stock of HQLA, thereby falling below 100%. Important - The 100% threshold is the minimum requirement absent a period of financial stress, and after the phase-in arrangements are complete. References to 100% may be adjusted for any phase-in arrangements in force at a particular time.

Annex 2

Complete set of agreed changes to the Liquidity Coverage Ratio

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HIGH QUALITY LIQUID ASSETS (HQLA)
Expand the definition of HQLA subject to a higher haircut and limit
- Corporate debt securities rated A+ to BBB– with a 50% haircut - Certain unencumbered equities subject to a 50% haircut - Certain residential mortgage-backed securities rated AA or higher with a 25% haircut Aggregate of additional assets, after haircuts, subject to a 15% limit of the HQLA

Rating requirement on qualifying Level 2 assets
- Use of local rating scales and inclusion of qualifying commercial paper

Usability of the liquidity pool
- Incorporate language related to the expectation that banks will use their pool of HQLA during periods of stress

Operational requirements
- Refine and clarify the operational requirements for HQLA

Operation of the cap on Level 2 HQLA
- Revise and improve the operation of the cap

Alternative liquid asset (ALA) framework
- Develop the alternative treatments and include a fourth option for sharia-compliant banks
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Central bank reserves
- Clarify language to confirm that supervisors have national discretion to include or exclude required central bank reserves (as well as overnight and certain term deposits) as HQLA as they consider appropriate

INFLOWS AND OUTFLOWS
Insured deposits
- Reduce outflow on certain fully insured retail deposits from 5% to 3% - Reduce outflow on fully insured non-operational deposits from non-financial corporates, sovereigns, central banks and public sector entities (PSEs) from 40% to 20%

Non-financial corporate deposits
- Reduce the outflow rate for “non-operational” deposits provided by non-financial corporates, sovereigns, central banks and PSEs from 75% to 40%

Committed liquidity facilities to non-financial corporates
- Clarify the definition of liquidity facilities and reduce the drawdown rate on the unused portion of committed liquidity facilities to non-financial corporates, sovereigns, central banks and PSEs from 100% to 30%

Committed but unfunded inter-financial liquidity and credit facilities
- Distinguish between interbank and inter-financial credit and liquidity facilities and reduce the outflow rate on the former from 100% to 40%

Derivatives

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- Additional derivatives risks included in the LCR with a 100% outflow (relates to collateral substitution, and excess collateral that the bank is contractually obligated to return/provide if required by a counterparty) - Introduce a standardised approach for liquidity risk related to market value changes in derivatives positions - Assume net outflow of 0% for derivatives (and commitments) that are contractually secured/collateralised by HQLA

Trade finance
- Include guidance to indicate that a low outflow rate (0–5%) is expected to apply

Equivalence of central bank operations
- Reduce the outflow rate on maturing secured funding transactions with central banks from 25% to 0%

Client servicing brokerage
- Clarify the treatment of activities related to client servicing brokerage (which generally lead to an increase in net outflows)

OTHER
Rules text clarifications
- Clearer guidance on the usability of HQLA, and the appropriate supervisory response, has been developed to ensure that the stock of liquid assets is available to be used when needed - A number of clarifications to the rules text to promote consistent application and reduce arbitrage opportunities (eg operational deposits
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from wholesale clients, derivatives cash flows, open maturity loans). Also incorporation of previously agreed FAQ

Internationally agreed phase-in of the LCR
- The minimum LCR in 2015 would be 60% and increase by 10 percentage points per year to reach 100% in 2019

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Commissioner Michel Barnier

The impact of the latest Basel Committee liquidity developments for Capital Requirements (CRD 4) in the EU
In the light of the Group of Governors and Heads of Supervision meeting and the Basel Committee on Banking Supervision press release dated 6 January 2013. "I welcome the unanimous agreement reached by the Basel Committee on the revised liquidity coverage ratio and the gradual approach for its phasing-in by clearly defined dates. This is significant progress which addresses issues already raised by the European Commission. We now need to make full use of the observation period, and learn from the reports that the European Banking Authority will prepare on the results of the observation period, before formally implementing in 2015 the liquidity coverage ratio under EU law in line with the Basel standards. The treatment of liquidity is fundamental, both for the stability of banks as well as for their role in supporting wider economic recovery. I now call upon the Parliament and the Council to successfully conclude the CRD 4 trilogue negotiations in the coming weeks."

Context
The Basel Committee on Banking Supervision (BCBS) has agreed a package of LCR (liquidity coverage ratio) revisions unanimously as well as its 2013 work plan. The LCR revisions include an expansion of eligible assets, a less severe calibration for certain cash flows and a phasing-in arrangement from January 2015 to 2019.
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The current Commission approach to liquidity in the CRD4 negotiations, namely first a reporting period followed by comprehensive European Banking Authority (EBA) Reports and subsequently a delegated act by the Commission to define the detailed ratio remains fully valid.

Background information
The Commission's approach to liquidity in CRD 4 still remains valid in the light of the latest Basel Committee approval of the revision of a number of parameters and calibrations on liquidity (GHOS meeting of 6 January). In the Basel Committee, the European Central Bank, the European Commission and various countries including from the EU had argued for such a revision. At the level of the Basel Committee, the final package of LCR revisions will now be subject to an observation period with a Quantitative Impact Study (QIS) that will take place in 2013 together with some other important work that still needs to be completed in the coming year. The EU needs to take full benefit of this observation period and learn from it, as this is the first time in history that regulators are defining globally harmonized, quantitative liquidity standards. The EBA will make reports on the results of the observation period for EU banks before the end of 2013. Based on the evaluation of this work, the Commission will propose defining the detailed LCR through a delegated act (i.e. legislation adopted by the Commission provided no objections are raised by the EP and the Council). Nevertheless, important work still remains to be completed at the global and European levels. This includes the determination of alternative, market-based indicators for the definition of High Quality Liquid Assets (HQLA); the treatment of Central Bank facilities which could impact upon the definition of HQLA and related cash flows; and the treatment of market valuation changes on derivative cash flows.
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In this light, the best course continues to be rapid adoption of the CRD 4 package while leaving the necessary flexibility to implement the final detailed LCR standard through a delegated act, taking into account the on-going work by Basel and the comprehensive EBA reports. Subject to this approach, the texts on the table now of the European Parliament and Council should be adopted shortly, hopefully in the coming weeks.

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Basel III: The Liquidity Coverage Ratio and liquidity risk monitoring tools, January 2013 Introduction
1. This document presents one of the Basel Committee’s key reforms to develop a more resilient banking sector: the Liquidity Coverage Ratio (LCR). The objective of the LCR is to promote the short-term resilience of the liquidity risk profile of banks. It does this by ensuring that banks have an adequate stock of unencumbered high-quality liquid assets (HQLA) that can be converted easily and immediately in private markets into cash to meet their liquidity needs for a 30 calendar day liquidity stress scenario. The LCR will improve the banking sector’s ability to absorb shocks arising from financial and economic stress, whatever the source, thus reducing the risk of spillover from the financial sector to the real economy. This document sets out the LCR standard and timelines for its implementation. 2. During the early “liquidity phase” of the financial crisis that began in 2007, many banks – despite adequate capital levels – still experienced difficulties because they did not manage their liquidity in a prudent manner. The crisis drove home the importance of liquidity to the proper functioning of financial markets and the banking sector.
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Prior to the crisis, asset markets were buoyant and funding was readily available at low cost. The rapid reversal in market conditions illustrated how quickly liquidity can evaporate, and that illiquidity can last for an extended period of time. The banking system came under severe stress, which necessitated central bank action to support both the functioning of money markets and, in some cases, individual institutions. 3. The difficulties experienced by some banks were due to lapses in basic principles of liquidity risk management. In response, as the foundation of its liquidity framework, the Committee in 2008 published Principles for Sound Liquidity Risk Management and Supervision (“Sound Principles”). The Sound Principles provide detailed guidance on the risk management and supervision of funding liquidity risk and should help promote better risk management in this critical area, but only if there is full implementation by banks and supervisors. As such, the Committee will continue to monitor the implementation by supervisors to ensure that banks adhere to these fundamental principles. 4. To complement these principles, the Committee has further strengthened its liquidity framework by developing two minimum standards for funding liquidity. These standards have been developed to achieve two separate but complementary objectives. The first objective is to promote short-term resilience of a bank’s liquidity risk profile by ensuring that it has sufficient HQLA to survive a significant stress scenario lasting for one month.
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The Committee developed the LCR to achieve this objective. The second objective is to promote resilience over a longer time horizon by creating additional incentives for banks to fund their activities with more stable sources of funding on an ongoing basis. The Net Stable Funding Ratio (NSFR), which is not covered by this document, supplements the LCR and has a time horizon of one year. It has been developed to provide a sustainable maturity structure of assets and liabilities. 5. These two standards are comprised mainly of specific parameters which are internationally “harmonised” with prescribed values. Certain parameters, however, contain elements of national discretion to reflect jurisdiction-specific conditions. In these cases, the parameters should be transparent and clearly outlined in the regulations of each jurisdiction to provide clarity both within the jurisdiction and internationally. 6. It should be stressed that the LCR standard establishes a minimum level of liquidity for internationally active banks. Banks are expected to meet this standard as well as adhere to the Sound Principles. Consistent with the Committee’s capital adequacy standards, national authorities may require higher minimum levels of liquidity. In particular, supervisors should be mindful that the assumptions within the LCR may not capture all market conditions or all periods of stress.

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Supervisors are therefore free to require additional levels of liquidity to be held, if they deem the LCR does not adequately reflect the liquidity risks that their banks face. 7. Given that the LCR is, on its own, insufficient to measure all dimensions of a bank’s liquidity profile, the Committee has also developed a set of monitoring tools to further strengthen and promote global consistency in liquidity risk supervision. These tools are supplementary to the LCR and are to be used for ongoing monitoring of the liquidity risk exposures of banks, and in communicating these exposures among home and host supervisors. 8. The Committee is introducing phase-in arrangements to implement the LCR to help ensure that the banking sector can meet the standard through reasonable measures, while still supporting lending to the economy. 9. The Committee remains firmly of the view that the LCR is an essential component of the set of reforms introduced by Basel III and, when implemented, will help deliver a more robust and resilient banking system. However, the Committee has also been mindful of the implications of the standard for financial markets, credit extension and economic growth, and of introducing the LCR at a time of ongoing strains in some banking systems. It has therefore decided to provide for a phased introduction of the LCR, in a manner similar to that of the Basel III capital adequacy requirements. 10. Specifically, the LCR will be introduced as planned on 1 January 2015, but the minimum requirement will be set at 60% and rise in equal annual steps to reach 100% on 1 January 2019. This graduated approach, coupled with the revisions made to the 2010
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publication of the liquidity standards, are designed to ensure that the LCR can be introduced without material disruption to the orderly strengthening of banking systems or the ongoing financing of economic activity.

11. The Committee also reaffirms its view that, during periods of stress, it would be entirely appropriate for banks to use their stock of HQLA, thereby falling below the minimum. Supervisors will subsequently assess this situation and will give guidance on usability according to circumstances. Furthermore, individual countries that are receiving financial support for macroeconomic and structural reform purposes may choose a different implementation schedule for their national banking systems, consistent with the design of their broader economic restructuring programme. 12. The Committee is currently reviewing the NSFR, which continues to be subject to an observation period and remains subject to review to address any unintended consequences. It remains the Committee’s intention that the NSFR, including any revisions, will become a minimum standard by 1 January 2018. 13. This document is organised as follows: - Part 1 defines the LCR for internationally active banks and deals with application issues. - Part 2 presents a set of monitoring tools to be used by banks and supervisors in their monitoring of liquidity risks.
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Part 1: The Liquidity Coverage Ratio
14. The Committee has developed the LCR to promote the short-term resilience of the liquidity risk profile of banks by ensuring that they have sufficient HQLA to survive a significant stress scenario lasting 30 calendar days. 15. The LCR should be a key component of the supervisory approach to liquidity risk, but must be supplemented by detailed supervisory assessments of other aspects of the bank’s liquidity risk management framework in line with the Sound Principles, the use of the monitoring tools included in Part 2, and, in due course, the NSFR. In addition, supervisors may require an individual bank to adopt more stringent standards or parameters to reflect its liquidity risk profile and the supervisor’s assessment of its compliance with the Sound Principles.

I. Objective of the LCR and use of HQLA
16. This standard aims to ensure that a bank has an adequate stock of unencumbered HQLA that consists of cash or assets that can be converted into cash at little or no loss of value in private markets, to meet its liquidity needs for a 30 calendar day liquidity stress scenario. At a minimum, the stock of unencumbered HQLA should enable the bank to survive until Day 30 of the stress scenario, by which time it is assumed that appropriate corrective actions can be taken by management and supervisors, or that the bank can be resolved in an orderly way. Furthermore, it gives the central bank additional time to take appropriate measures, should they be regarded as necessary. As noted in the Sound Principles, given the uncertain timing of outflows and inflows, banks are also expected to be aware of any potential mismatches within the 30-day period and ensure that sufficient HQLA are available to meet any cash flow gaps throughout the period.
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17. The LCR builds on traditional liquidity “coverage ratio” methodologies used internally by banks to assess exposure to contingent liquidity events. The total net cash outflows for the scenario are to be calculated for 30 calendar days into the future. The standard requires that, absent a situation of financial stress, the value of the ratio be no lower than 100% (ie the stock of HQLA should at least equal total net cash outflows) on an ongoing basis because the stock of unencumbered HQLA is intended to serve as a defence against the potential onset of liquidity stress. During a period of financial stress, however, banks may use their stock of HQLA, thereby falling below 100%, as maintaining the LCR at 100% under such circumstances could produce undue negative effects on the bank and other market participants. Supervisors will subsequently assess this situation and will adjust their response flexibly according to the circumstances. 18. In particular, supervisory decisions regarding a bank’s use of its HQLA should be guided by consideration of the core objective and definition of the LCR. Supervisors should exercise judgement in their assessment and account not only for prevailing macrofinancial conditions, but also consider forward-looking assessments of macroeconomic and financial conditions. In determining a response, supervisors should be aware that some actions could be procyclical if applied in circumstances of market-wide stress. Supervisors should seek to take these considerations into account on a consistent basis across jurisdictions.

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(a) Supervisors should assess conditions at an early stage, and take actions if deemed necessary, to address potential liquidity risk. (b) Supervisors should allow for differentiated responses to a reported LCR below 100%. Any potential supervisory response should be proportionate with the drivers, magnitude, duration and frequency of the reported shortfall. (c) Supervisors should assess a number of firm- and market-specific factors in determining the appropriate response as well as other considerations related to both domestic and global frameworks and conditions. Potential considerations include, but are not limited to: (i) The reason(s) that the LCR fell below 100%. This includes use of the stock of HQLA, an inability to roll over funding or large unexpected draws on contingent obligations. In addition, the reasons may relate to overall credit, funding and market conditions, including liquidity in credit, asset and funding markets, affecting individual banks or all institutions, regardless of their own condition; (ii) The extent to which the reported decline in the LCR is due to a firm-specific or market-wide shock; (iii) A bank’s overall health and risk profile, including activities, positions with respect to other supervisory requirements, internal risk systems, controls and other management processes, among others; (iv) The magnitude, duration and frequency of the reported decline of HQLA;

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(v) The potential for contagion to the financial system and additional restricted flow of credit or reduced market liquidity due to actions to maintain an LCR of 100%; (vi) The availability of other sources of contingent funding such as central bank funding, or other actions by prudential authorities. (d) Supervisors should have a range of tools at their disposal to address a reported LCR below 100%. Banks may use their stock of HQLA in both idiosyncratic and systemic stress events, although the supervisory response may differ between the two. (i) At a minimum, a bank should present an assessment of its liquidity position, including the factors that contributed to its LCR falling below 100%, the measures that have been and will be taken and the expectations on the potential length of the situation. Enhanced reporting to supervisors should be commensurate with the duration of the shortfall. (ii) If appropriate, supervisors could also require actions by a bank to reduce its exposure to liquidity risk, strengthen its overall liquidity risk management, or improve its contingency funding plan. (iii) However, in a situation of sufficiently severe system-wide stress, effects on the entire financial system should be considered. Potential measures to restore liquidity levels should be discussed, and should be executed over a period of time considered appropriate to prevent additional stress on the bank and on the financial system as a whole. (e) Supervisors’ responses should be consistent with the overall approach to the prudential framework.
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II. Definition of the LCR
19. The scenario for this standard entails a combined idiosyncratic and market-wide shock that would result in: (a) The run-off of a proportion of retail deposits; (b) A partial loss of unsecured wholesale funding capacity; (c) A partial loss of secured, short-term financing with certain collateral and counterparties; (d) Additional contractual outflows that would arise from a downgrade in the bank’s public credit rating by up to and including three notches, including collateral posting requirements; (e) Increases in market volatilities that impact the quality of collateral or potential future exposure of derivative positions and thus require larger collateral haircuts or additional collateral, or lead to other liquidity needs; (f) Unscheduled draws on committed but unused credit and liquidity facilities that the bank has provided to its clients; and (g) The potential need for the bank to buy back debt or honour non-contractual obligations in the interest of mitigating reputational risk. 20. In summary, the stress scenario specified incorporates many of the shocks experienced during the crisis that started in 2007 into one significant stress scenario for which a bank would need sufficient liquidity on hand to survive for up to 30 calendar days. 21. This stress test should be viewed as a minimum supervisory requirement for banks.

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Banks are expected to conduct their own stress tests to assess the level of liquidity they should hold beyond this minimum, and construct their own scenarios that could cause difficulties for their specific business activities. Such internal stress tests should incorporate longer time horizons than the one mandated by this standard. Banks are expected to share the results of these additional stress tests with supervisors. 22. The LCR has two components: (a) Value of the stock of HQLA in stressed conditions; and (b) Total net cash outflows, calculated according to the scenario parameters outlined below.

A. Stock of HQLA
23. The numerator of the LCR is the “stock of HQLA”. Under the standard, banks must hold a stock of unencumbered HQLA to cover the total net cash outflows (as defined below) over a 30-day period under the prescribed stress scenario. In order to qualify as “HQLA”, assets should be liquid in markets during a time of stress and, ideally, be central bank eligible.

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The following sets out the characteristics that such assets should generally possess and the operational requirements that they should satisfy.

1. Characteristics of HQLA
24. Assets are considered to be HQLA if they can be easily and immediately converted into cash at little or no loss of value. The liquidity of an asset depends on the underlying stress scenario, the volume to be monetised and the timeframe considered. Nevertheless, there are certain assets that are more likely to generate funds without incurring large discounts in sale or repurchase agreement (repo) markets due to fire-sales even in times of stress. This section outlines the factors that influence whether or not the market for an asset can be relied upon to raise liquidity when considered in the context of possible stresses. These factors should assist supervisors in determining which assets, despite meeting the criteria from paragraphs 49 to 54, are not sufficiently liquid in private markets to be included in the stock of HQLA.

(i) Fundamental characteristics
- Low risk: assets that are less risky tend to have higher liquidity. High credit standing of the issuer and a low degree of subordination increase an asset’s liquidity. Low duration, low legal risk, low inflation risk and denomination in a convertible currency with low foreign exchange risk all enhance an asset’s liquidity.

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- Ease and certainty of valuation: an asset’s liquidity increases if market participants are more likely to agree on its valuation. Assets with more standardised, homogenous and simple structures tend to be more fungible, promoting liquidity. The pricing formula of a high-quality liquid asset must be easy to calculate and not depend on strong assumptions. The inputs into the pricing formula must also be publicly available. In practice, this should rule out the inclusion of most structured or exotic products. - Low correlation with risky assets: the stock of HQLA should not be subject to wrong-way (highly correlated) risk. For example, assets issued by financial institutions are more likely to be illiquid in times of liquidity stress in the banking sector. - Listed on a developed and recognised exchange: being listed increases an asset’s transparency.

(ii) Market-related characteristics
- Active and sizable market: the asset should have active outright sale or repo markets at all times. This means that: - There should be historical evidence of market breadth and market depth. This could be demonstrated by low bid-ask spreads, high trading volumes, and a large and diverse number of market participants.

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Diversity of market participants reduces market concentration and increases the reliability of the liquidity in the market. - There should be robust market infrastructure in place. - The presence of multiple committed market makers increases liquidity as quotes will most likely be available for buying or selling HQLA. - Low volatility: Assets whose prices remain relatively stable and are less prone to sharp price declines over time will have a lower probability of triggering forced sales to meet liquidity requirements. Volatility of traded prices and spreads are simple proxy measures of market volatility. There should be historical evidence of relative stability of market terms (eg prices and haircuts) and volumes during stressed periods. - Flight to quality: historically, the market has shown tendencies to move into these types of assets in a systemic crisis. The correlation between proxies of market liquidity and banking system stress is one simple measure that could be used. 25. As outlined by these characteristics, the test of whether liquid assets are of “high quality” is that, by way of sale or repo, their liquidity generating capacity is assumed to remain intact even in periods of severe idiosyncratic and market stress. Lower quality assets typically fail to meet that test. An attempt by a bank to raise liquidity from lower quality assets under conditions of severe market stress would entail acceptance of a large fire-sale discount or haircut to compensate for high market risk.

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That may not only erode the market’s confidence in the bank, but would also generate mark-to-market losses for banks holding similar instruments and add to the pressure on their liquidity position, thus encouraging further fire sales and declines in prices and market liquidity. In these circumstances, private market liquidity for such instruments is likely to disappear quickly. 26. HQLA (except Level 2B assets as defined below) should ideally be eligible at central banks for intraday liquidity needs and overnight liquidity facilities. In the past, central banks have provided a further backstop to the supply of banking system liquidity under conditions of severe stress. Central bank eligibility should thus provide additional confidence that banks are holding assets that could be used in events of severe stress without damaging the broader financial system. That in turn would raise confidence in the safety and soundness of liquidity risk management in the banking system. 27. It should be noted however, that central bank eligibility does not by itself constitute the basis for the categorisation of an asset as HQLA.

2. Operational requirements
28. All assets in the stock of HQLA are subject to the following operational requirements. The purpose of the operational requirements is to recognise that not all assets outlined in paragraphs 49-54 that meet the asset class, risk-weighting and credit-rating criteria should be eligible for the stock as there are other operational restrictions on the availability of HQLA that can prevent timely monetisation during a stress period.
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29. These operational requirements are designed to ensure that the stock of HQLA is managed in such a way that the bank can, and is able to demonstrate that it can, immediately use the stock of assets as a source of contingent funds that is available for the bank to convert into cash through outright sale or repo, to fill funding gaps between cash inflows and outflows at any time during the 30-day stress period, with no restriction on the use of the liquidity generated. 30. A bank should periodically monetise a representative proportion of the assets in the stock through repo or outright sale, in order to test its access to the market, the effectiveness of its processes for monetisation, the availability of the assets, and to minimise the risk of negative signalling during a period of actual stress. 31. All assets in the stock should be unencumbered. “Unencumbered” means free of legal, regulatory, contractual or other restrictions on the ability of the bank to liquidate, sell, transfer, or assign the asset. An asset in the stock should not be pledged (either explicitly or implicitly) to secure, collateralise or credit-enhance any transaction, nor be designated to cover operational costs (such as rents and salaries). Assets received in reverse repo and securities financing transactions that are held at the bank, have not been rehypothecated, and are legally and contractually available for the bank's use can be considered as part of the stock of HQLA. In addition, assets which qualify for the stock of HQLA that have been pre-positioned or deposited with, or pledged to, the central bank or a public sector entity (PSE) but have not been used to generate liquidity may be included in the stock. 32. A bank should exclude from the stock those assets that, although meeting the definition of “unencumbered” specified in paragraph 31, the
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bank would not have the operational capability to monetise to meet outflows during the stress period. Operational capability to monetise assets requires having procedures and appropriate systems in place, including providing the function identified in paragraph 33 with access to all necessary information to execute monetisation of any asset at any time. Monetisation of the asset must be executable, from an operational perspective, in the standard settlement period for the asset class in the relevant jurisdiction. 33. The stock should be under the control of the function charged with managing the liquidity of the bank (eg the treasurer), meaning the function has the continuous authority, and legal and operational capability, to monetise any asset in the stock. Control must be evidenced either by maintaining assets in a separate pool managed by the function with the sole intent for use as a source of contingent funds, or by demonstrating that the function can monetise the asset at any point in the 30-day stress period and that the proceeds of doing so are available to the function throughout the 30-day stress period without directly conflicting with a stated business or risk management strategy. For example, an asset should not be included in the stock if the sale of that asset, without replacement throughout the 30-day period, would remove a hedge that would create an open risk position in excess of internal limits. 34. A bank is permitted to hedge the market risk associated with ownership of the stock of HQLA and still include the assets in the stock. If it chooses to hedge the market risk, the bank should take into account (in the market value applied to each asset) the cash outflow that would

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arise if the hedge were to be closed out early (in the event of the asset being sold). 35. In accordance with Principle 9 of the Sound Principles a bank “should monitor the legal entity and physical location where collateral is held and how it may be mobilised in a timely manner”. Specifically, it should have a policy in place that identifies legal entities, geographical locations, currencies and specific custodial or bank accounts where HQLA are held. In addition, the bank should determine whether any such assets should be excluded for operational reasons and therefore, have the ability to determine the composition of its stock on a daily basis. 36. As noted in paragraphs 171 and 172, qualifying HQLA that are held to meet statutory liquidity requirements at the legal entity or sub consolidated level (where applicable) may only be included in the stock at the consolidated level to the extent that the related risks (as measured by the legal entity’s or sub-consolidated group’s net cash outflows in the LCR) are also reflected in the consolidated LCR. Any surplus of HQLA held at the legal entity can only be included in the consolidated stock if those assets would also be freely available to the consolidated (parent) entity in times of stress. 37. In assessing whether assets are freely transferable for regulatory purposes, banks should be aware that assets may not be freely available to the consolidated entity due to regulatory, legal, tax, accounting or other impediments. Assets held in legal entities without market access should only be included to the extent that they can be freely transferred to other entities that could monetise the assets.

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38. In certain jurisdictions, large, deep and active repo markets do not exist for eligible asset classes, and therefore such assets are likely to be monetised through outright sale. In these circumstances, a bank should exclude from the stock of HQLA those assets where there are impediments to sale, such as large fire-sale discounts which would cause it to breach minimum solvency equirements, or requirements to hold such assets, including, but not limited to, statutory minimum inventory requirements for market making. 39. Banks should not include in the stock of HQLA any assets, or liquidity generated from assets, they have received under right of rehypothecation, if the beneficial owner has the contractual right to withdraw those assets during the 30-day stress period. 40. Assets received as collateral for derivatives transactions that are not segregated and are legally able to be rehypothecated may be included in the stock of HQLA provided that the bank records an appropriate outflow for the associated risks as set out in paragraph 116. 41. As stated in Principle 8 of the Sound Principles, a bank should actively manage its intraday liquidity positions and risks to meet payment and settlement obligations on a timely basis under both normal and stressed conditions and thus contribute to the smooth functioning of payment and settlement systems. Banks and regulators should be aware that the LCR stress scenario does not cover expected or unexpected intraday liquidity needs. 42. While the LCR is expected to be met and reported in a single currency, banks are expected to be able to meet their liquidity needs in each currency and maintain HQLA consistent with the distribution of their liquidity needs by currency.

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The bank should be able to use the stock to generate liquidity in the currency and jurisdiction in which the net cash outflows arise. As such, the LCR by currency is expected to be monitored and reported to allow the bank and its supervisor to track any potential currency mismatch issues that could arise, as outlined in Part 2. In managing foreign exchange liquidity risk, the bank should take into account the risk that its ability to swap currencies and access the relevant foreign exchange markets may erode rapidly under stressed conditions. It should be aware that sudden, adverse exchange rate movements could sharply widen existing mismatched positions and alter the effectiveness of any foreign exchange hedges in place. 43. In order to mitigate cliff effects that could arise, if an eligible liquid asset became ineligible (eg due to rating downgrade), a bank is permitted to keep such assets in its stock of liquid assets for an additional 30 calendar days. This would allow the bank additional time to adjust its stock as needed or replace the asset.

3. Diversification of the stock of HQLA
44. The stock of HQLA should be well diversified within the asset classes themselves (except for sovereign debt of the bank’s home jurisdiction or from the jurisdiction in which the bank operates; central bank reserves; central bank debt securities; and cash). Although some asset classes are more likely to remain liquid irrespective of circumstances, ex-ante it is not possible to know with certainty which specific assets within each asset class might be subject to shocks ex-post. Banks should therefore have policies and limits in place in order to
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avoid concentration with respect to asset types, issue and issuer types, and currency (consistent with the distribution of net cash outflows by currency) within asset classes.

4. Definition of HQLA
45. The stock of HQLA should comprise assets with the characteristics outlined in paragraphs 24-27. This section describes the type of assets that meet these characteristics and can therefore be included in the stock. 46. There are two categories of assets that can be included in the stock. Assets to be included in each category are those that the bank is holding on the first day of the stress period, irrespective of their residual maturity. “Level 1” assets can be included without limit, while “Level 2” assets can only comprise up to 40% of the stock. 47. Supervisors may also choose to include within Level 2 an additional class of assets (Level 2B assets - see paragraph 53 below). If included, these assets should comprise no more than 15% of the total stock of HQLA. They must also be included within the overall 40% cap on Level 2 assets. 48. The 40% cap on Level 2 assets and the 15% cap on Level 2B assets should be determined after the application of required haircuts, and after taking into account the unwind of short-term securities financing transactions and collateral swap transactions maturing within 30 calendar days that involve the exchange of HQLA. In this context, short term transactions are transactions with a maturity date up to and including 30 calendar days.
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The details of the calculation methodology are provided in Annex 1.

(i) Level 1 assets
49. Level 1 assets can comprise an unlimited share of the pool and are not subject to a haircut under the LCR. However, national supervisors may wish to require haircuts for Level 1 securities based on, among other things, their duration, credit and liquidity risk, and typical repo haircuts. 50. Level 1 assets are limited to: (a) Coins and banknotes; (b) Central bank reserves (including required reserves), to the extent that the central bank policies allow them to be drawn down in times of stress; (c) Marketable securities representing claims on or guaranteed by sovereigns, central banks, PSEs, the Bank for International Settlements, the International Monetary Fund, the European Central Bank and European Community, or multilateral development banks, and satisfying all of the following conditions: - assigned a 0% risk-weight under the Basel II Standardised Approach for credit risk; - traded in large, deep and active repo or cash markets characterised by a low level of concentration; - have a proven record as a reliable source of liquidity in the markets (repo or sale) even during stressed market conditions; and - not an obligation of a financial institution or any of its affiliated entities.

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(d) where the sovereign has a non-0% risk weight, sovereign or central bank debt securities issued in domestic currencies by the sovereign or central bank in the country in which the liquidity risk is being taken or in the bank’s home country; and (e) where the sovereign has a non-0% risk weight, domestic sovereign or central bank debt securities issued in foreign currencies are eligible up to the amount of the bank’s stressed net cash outflows in that specific foreign currency stemming from the bank’s operations in the jurisdiction where the bank’s liquidity risk is being taken.

(ii) Level 2 assets
51. Level 2 assets (comprising Level 2A assets and any Level 2B assets permitted by the supervisor) can be included in the stock of HQLA, subject to the requirement that they comprise no more than 40% of the overall stock after haircuts have been applied. 52. A 15% haircut is applied to the current market value of each Level 2A asset held in the stock of HQLA.

Level 2A assets are limited to the following:
(a) Marketable securities representing claims on or guaranteed by sovereigns, central banks, PSEs or multilateral development banks that satisfy all of the following conditions: - assigned a 20% risk weight under the Basel II Standardised Approach for credit risk; - traded in large, deep and active repo or cash markets characterised by a low level of concentration; - have a proven record as a reliable source of liquidity in the markets (repo or sale) even during stressed market conditions (ie maximum
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decline of price not exceeding 10% or increase in haircut not exceeding 10 percentage points over a 30-day period during a relevant period of significant liquidity stress); and - not an obligation of a financial institution or any of its affiliated entities. (b) Corporate debt securities (including commercial paper) and covered bonds that satisfy all of the following conditions: - in the case of corporate debt securities: not issued by a financial institution or any of its affiliated entities; - in the case of covered bonds: not issued by the bank itself or any of its affiliated entities; - either (i) have a long-term credit rating from a recognised external credit assessment institution (ECAI) of at least AA-21 or in the absence of a long term rating, a short-term rating equivalent in quality to the long-term rating; or (ii) do not have a credit assessment by a recognised ECAI but are internally rated as having a probability of default (PD) corresponding to a credit rating of at least AA-; - traded in large, deep and active repo or cash markets characterised by a low level of concentration; and - have a proven record as a reliable source of liquidity in the markets (repo or sale) even during stressed market conditions: ie maximum decline of price or increase in haircut over a 30-day period during a relevant period of significant liquidity stress not exceeding 10%.

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(iii) Level 2B assets
53. Certain additional assets (Level 2B assets) may be included in Level 2 at the discretion of national authorities. In choosing to include these assets in Level 2 for the purpose of the LCR, supervisors are expected to ensure that such assets fully comply with the qualifying criteria. Supervisors are also expected to ensure that banks have appropriate systems and measures to monitor and control the potential risks (eg credit and market risks) that banks could be exposed to in holding these assets. 54. A larger haircut is applied to the current market value of each Level 2B asset held in the stock of HQLA. Level 2B assets are limited to the following: (a) Residential mortgage backed securities (RMBS) that satisfy all of the following conditions may be included in Level 2B, subject to a 25% haircut: - not issued by, and the underlying assets have not been originated by the bank itself or any of its affiliated entities; - have a long-term credit rating from a recognised ECAI of AA or higher, or in the absence of a long term rating, a short-term rating equivalent in quality to the long-term rating; - traded in large, deep and active repo or cash markets characterised by a low level of concentration; - have a proven record as a reliable source of liquidity in the markets (repo or sale) even during stressed market conditions, ie a maximum decline of price not exceeding 20% or increase in haircut over a 30-day
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period not exceeding 20 percentage points during a relevant period of significant liquidity stress; - the underlying asset pool is restricted to residential mortgages and cannot contain structured products; - the underlying mortgages are “full recourse’’ loans (ie in the case of foreclosure the mortgage owner remains liable for any shortfall in sales proceeds from the property) and have a maximum loan-to-value ratio (LTV) of 80% on average at issuance; and - the securitisations are subject to “risk retention” regulations which require issuers to retain an interest in the assets they securitise. (b) Corporate debt securities (including commercial paper) that satisfy all of the following conditions may be included in Level 2B, subject to a 50% haircut: - not issued by a financial institution or any of its affiliated entities; - either - (i) have a long-term credit rating from a recognised ECAI between A+ and BBB- or in the absence of a long term rating, a short-term rating equivalent in quality to the long-term rating; or - (ii) do not have a credit assessment by a recognised ECAI and are internally rated as having a PD corresponding to a credit rating of between A+ and BBB-; - traded in large, deep and active repo or cash markets characterised by a low level of concentration; and - have a proven record as a reliable source of liquidity in the markets (repo or sale) even during stressed market conditions, ie a maximum decline of price not exceeding 20% or increase in haircut over a 30-day
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period not exceeding 20 percentage points during a relevant period of significant liquidity stress. (c) Common equity shares that satisfy all of the following conditions may be included in Level 2B, subject to a 50% haircut: - not issued by a financial institution or any of its affiliated entities; - exchange traded and centrally cleared; - a constituent of the major stock index in the home jurisdiction or where the liquidity risk is taken, as decided by the supervisor in the jurisdiction where the index is located; - denominated in the domestic currency of a bank’s home jurisdiction or in the currency of the jurisdiction where a bank’s liquidity risk is taken; - traded in large, deep and active repo or cash markets characterised by a low level of concentration; and - have a proven record as a reliable source of liquidity in the markets (repo or sale) even during stressed market conditions, ie a maximum decline of share price not exceeding 40% or increase in haircut not exceeding 40 percentage points over a 30-day period during a relevant period of significant liquidity.

(iv) Treatment for jurisdictions with insufficient HQLA (a) Assessment of eligibility for alternative liquidity approaches (ALA)
55. Some jurisdictions may have an insufficient supply of Level 1 assets (or both Level 1 and Level 2 assets) in their domestic currency to meet the aggregate demand of banks with significant exposures in this currency.
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To address this situation, the Committee has developed alternative treatments for holdings in the stock of HQLA, which are expected to apply to a limited number of currencies and jurisdictions. Eligibility for such alternative treatment will be judged on the basis of the qualifying criteria set out in Annex 2 and will be determined through an independent peer review process overseen by the Committee. The purpose of this process is to ensure that the alternative treatments are only used when there is a true shortfall in HQLA in the domestic currency relative to the needs in that currency. 56. To qualify for the alternative treatment, a jurisdiction should be able to demonstrate that: - there is an insufficient supply of HQLA in its domestic currency, taking into account all relevant factors affecting the supply of, and demand for, such HQLA; - the insufficiency is caused by long-term structural constraints that cannot be resolved within the medium term; - it has the capacity, through any mechanism or control in place, to limit or mitigate the risk that the alternative treatment cannot work as expected; and - it is committed to observing the obligations relating to supervisory monitoring, disclosure, and periodic self-assessment and independent peer review of its eligibility for alternative treatment. All of the above criteria have to be met to qualify for the alternative treatment. 57. Irrespective of whether a jurisdiction seeking ALA treatment will adopt the phase-in arrangement set out in paragraph 10 for implementing

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the LCR, the eligibility for that jurisdiction to adopt ALA treatment will be based on a fully implemented LCR standard (ie 100% requirement).

(b) Potential options for alternative treatment
58. Option 1 – Contractual committed liquidity facilities from the relevant central bank, with a fee: For currencies that do not have sufficient HQLA, as determined by reference to the qualifying principles and criteria, Option 1 would allow banks to access contractual committed liquidity facilities provided by the relevant central bank (ie relevant given the currency in question) for a fee. These facilities should not be confused with regular central bank standing arrangements. In particular, these facilities are contractual arrangements between the central bank and the commercial bank with a maturity date which, at a minimum, falls outside the 30-day LCR window. Further, the contract must be irrevocable prior to maturity and involve no ex-post credit decision by the central bank. Such facilities are only permissible if there is also a fee for the facility which is charged regardless of the amount, if any, drawn down against that facility and the fee is set so that banks which claim the facility line to meet the LCR, and banks which do not, have similar financial incentives to reduce their exposure to liquidity risk. That is, the fee should be set so that the net yield on the assets used to secure the facility should not be higher than the net yield on a representative portfolio of Level 1 and Level 2 assets, after adjusting for any material differences in credit risk. A jurisdiction seeking to adopt Option 1 should justify in the independent peer review that the fee is suitably set in a manner as prescribed in this
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paragraph. 59. Option 2 – Foreign currency HQLA to cover domestic currency liquidity needs: For currencies that do not have sufficient HQLA, as determined by reference to the qualifying principles and criteria, Option 2 would allow supervisors to permit banks that evidence a shortfall of HQLA in the domestic currency (which would match the currency of the underlying risks) to hold HQLA in a currency that does not match the currency of the associated liquidity risk, provided that the resulting currency mismatch positions are justifiable and controlled within limits agreed by their supervisors. Supervisors should restrict such positions within levels consistent with the bank’s foreign exchange risk management capacity and needs, and ensure that such positions relate to currencies that are freely and reliably convertible, are effectively managed by the bank, and would not pose undue risk to its financial strength. In managing those positions, the bank should take into account the risks that its ability to swap currencies, and its access to the relevant foreign exchange markets, may erode rapidly under stressed conditions. It should also take into account that sudden, adverse exchange rate movements could sharply widen existing mismatch positions and alter the effectiveness of any foreign exchange hedges in place. 60. To account for foreign exchange risk associated with foreign currency HQLA used to cover liquidity needs in the domestic currency, such liquid assets should be subject to a minimum haircut of 8% for major currencies that are active in global foreign exchange markets. For other currencies, jurisdictions should increase the haircut to an appropriate level on the basis of historical (monthly) exchange rate volatilities between the currency pair over an extended period of time.
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If the domestic currency is formally pegged to another currency under an effective mechanism, the haircut for the pegged currency can be lowered to a level that reflects the limited exchange rate risk under the peg arrangement. To qualify for this treatment, the jurisdiction concerned should demonstrate in the independent peer review the effectiveness of its currency peg mechanism and assess the long-term prospect of keeping the peg. 61. Haircuts for foreign currency HQLA used under Option 2 would apply only to HQLA in excess of a threshold specified by supervisors which is not greater than 25%. This is to accommodate a certain level of currency mismatch that may commonly exist among banks in their ordinary course of business. 62. Option 3 – Additional use of Level 2 assets with a higher haircut: This option addresses currencies for which there are insufficient Level 1 assets, as determined by reference to the qualifying principles and criteria, but where there are sufficient Level 2A assets. In this case, supervisors may choose to allow banks that evidence a shortfall of HQLA in the domestic currency (to match the currency of the liquidity risk incurred) to hold additional Level 2A assets in the stock. These additional Level 2A assets would be subject to a minimum haircut of 20%, ie 5% higher than the 15% haircut applicable to Level 2A assets that are included in the 40% cap. The higher haircut is used to cover any additional price and market liquidity risks arising from increased holdings of Level 2A assets beyond the 40% cap, and to provide a disincentive for banks to use this option based on yield considerations.

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Supervisors have the obligation to conduct an analysis to assess whether the additional haircut is sufficient for Level 2A assets in their markets, and should increase the haircut if this is warranted to achieve the purpose for which it is intended. Supervisors should explain and justify the outcome of the analysis (including the level of increase in the haircut, if applicable) during the independent peer review assessment process. Any Level 2B assets held by the bank would remain subject to the cap of 15%, regardless of the amount of other Level 2 assets held.

(c) Maximum level of usage of options for alternative treatment
63. The usage of any of the above options would be constrained by a limit specified by supervisors in jurisdictions whose currency is eligible for the alternative treatment. The limit should be expressed in terms of the maximum amount of HQLA associated with the use of the options (whether individually or in combination) that a bank is allowed to include in its LCR, as a percentage of the total amount of HQLA the bank is required to hold in the currency concerned. HQLA associated with the options refer to: (i) In the case of Option 1, the amount of committed liquidity facilities granted by the relevant central bank; (ii) In the case of Option 2, the amount of foreign currency HQLA used to cover the shortfall of HQLA in the domestic currency; and (iii) In the case of Option 3, the amount of Level 2 assets held (including those within the 40% cap). 64. If, for example, the maximum level of usage of the options is set at 80%, it means that a bank adopting the options, either individually or in
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combination, would only be allowed to include HQLA associated with the options (after applying any relevant haircut) up to 80% of the required amount of HQLA in the relevant currency. Thus, at least 20% of the HQLA requirement will have to be met by Level 1 assets in the relevant currency. The maximum usage of the options is of course further constrained by the bank’s actual shortfall of HQLA in the currency concerned. 65. The appropriateness of the maximum level of usage of the options allowed by a supervisor will be evaluated in the independent peer review process. The level set should be consistent with the projected size of the HQLA gap faced by banks subject to the LCR in the currency concerned, taking into account all relevant factors that may affect the size of the gap over time. The supervisor should explain how this level is derived, and justify why this is supported by the insufficiency of HQLA in the banking system. Where a relatively high level of usage of the options is allowed by the supervisor (eg over 80%), the suitability of this level will come under closer scrutiny in the independent peer review.

(d) Supervisory obligations and requirements
66. A jurisdiction with insufficient HQLA must, among other things, fulfil the following obligations (the detailed requirements are set out in Annex 2): - Supervisory monitoring: There should be a clearly documented supervisory framework for overseeing and controlling the usage of the options by its banks, and for monitoring their compliance with the relevant requirements applicable to their use of the options;
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- Disclosure framework: The jurisdiction should disclose its framework for applying the options to its banks (whether on its website or through other means). The disclosure should enable other national supervisors and stakeholders to gain a sufficient understanding of its compliance with the qualifying principles and criteria and the manner in which it supervises the use of the options by its banks; - Periodic self-assessment of eligibility for alternative treatment: The jurisdiction should perform a self-assessment of its eligibility for alternative treatment every five years after it has adopted the options, and disclose the results to other national supervisors and stakeholders. 67. Supervisors in jurisdictions with insufficient HQLA should devise rules and requirements governing the use of the options by their banks, having regard to the guiding principles set out below. - Principle 1: Supervisors should ensure that banks’ use of the options is not simply an economic choice that maximises the profits of the bank through the selection of alternative HQLA based primarily on yield considerations. The liquidity characteristics of an alternative HQLA portfolio must be considered to be more important than its net yield. - Principle 2: Supervisors should ensure that the use of the options is constrained, both for all banks with exposures in the relevant currency and on a bank-by-bank basis. - Principle 3: Supervisors should ensure that banks have, to the extent practicable, taken reasonable steps to use Level 1 and Level 2 assets and reduce their overall level of liquidity risk to improve the LCR, before the alternative treatment can be applied.

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- Principle 4: Supervisors should have a mechanism for restraining the usage of the options to mitigate risks of non-performance of the alternative HQLA.

(v) Treatment for Shari’ah compliant banks
68. Shari’ah compliant banks face a religious prohibition on holding certain types of assets, such as interest-bearing debt securities. Even in jurisdictions that have a sufficient supply of HQLA, an insurmountable impediment to the ability of Shari’ah compliant banks to meet the LCR requirement may still exist. In such cases, national supervisors in jurisdictions in which Shari’ah compliant banks operate have the discretion to define Shari’ah compliant financial products (such as Sukuk) as alternative HQLA applicable to such banks only, subject to such conditions or haircuts that the supervisors may require. It should be noted that the intention of this treatment is not to allow Shari’ah compliant banks to hold fewer HQLA. The minimum LCR standard, calculated based on alternative HQLA (post-haircut) recognised as HQLA for these banks, should not be lower than the minimum LCR standard applicable to other banks in the jurisdiction concerned. National supervisors applying such treatment for Shari’ah compliant banks should comply with supervisory monitoring and disclosure obligations similar to those set out in paragraph 66 above.

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B. Total net cash outflows
69. The term total net cash outflows is defined as the total expected cash outflows minus total expected cash inflows in the specified stress scenario for the subsequent 30 calendar days. Total expected cash outflows are calculated by multiplying the outstanding balances of various categories or types of liabilities and off-balance sheet commitments by the rates at which they are expected to run off or be drawn down. Total expected cash inflows are calculated by multiplying the outstanding balances of various categories of contractual receivables by the rates at which they are expected to flow in under the scenario up to an aggregate cap of 75% of total expected cash outflows.

70. While most roll-off rates, draw-down rates and similar factors are harmonised across jurisdictions as outlined in this standard, a few parameters are to be determined by supervisory authorities at the national level. Where this is the case, the parameters should be transparent and made publicly available. 71. Annex 4 provides a summary of the factors that are applied to each category. 72. Banks will not be permitted to double count items, ie if an asset is included as part of the “stock of HQLA” (ie the numerator), the associated cash inflows cannot also be counted as cash inflows (ie part of the denominator).
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Where there is potential that an item could be counted in multiple outflow categories, (eg committed liquidity facilities granted to cover debt maturing within the 30 calendar day period), a bank only has to assume up to the maximum contractual outflow for that product.

1. Cash outflows (i) Retail deposit run-off
73. Retail deposits are defined as deposits placed with a bank by a natural person. Deposits from legal entities, sole proprietorships or partnerships are captured in wholesale deposit categories. Retail deposits subject to the LCR include demand deposits and term deposits, unless otherwise excluded under the criteria set out in paragraphs 82 and 83. 74. These retail deposits are divided into “stable” and “less stable” portions of funds as described below, with minimum run-off rates listed for each category. The run-off rates for retail deposits are minimum floors, with higher run-off rates established by individual jurisdictions as appropriate to capture depositor behaviour in a period of stress in each jurisdiction.

(a) Stable deposits (run-off rate = 3% and higher)
75. Stable deposits, which usually receive a run-off factor of 5%, are the amount of the deposits that are fully insured by an effective deposit insurance scheme or by a public guarantee that provides equivalent protection and where:

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- the depositors have other established relationships with the bank that make deposit withdrawal highly unlikely; or - the deposits are in transactional accounts (eg accounts where salaries are automatically deposited). 76. For the purposes of this standard, an “effective deposit insurance scheme” refers to a scheme (i) That guarantees that it has the ability to make prompt payouts, (ii) For which the coverage is clearly defined and (iii) Of which public awareness is high. The deposit insurer in an effective deposit insurance scheme has formal legal powers to fulfil its mandate and is operationally independent, transparent and accountable. A jurisdiction with an explicit and legally binding sovereign deposit guarantee that effectively functions as deposit insurance can be regarded as having an effective deposit insurance scheme. 77. The presence of deposit insurance alone is not sufficient to consider a deposit “stable”. 78. Jurisdictions may choose to apply a run-off rate of 3% to stable deposits in their jurisdiction, if they meet the above stable deposit criteria and the following additional criteria for deposit insurance schemes: - the insurance scheme is based on a system of prefunding via the periodic collection of levies on banks with insured deposits; - the scheme has adequate means of ensuring ready access to additional funding in the event of a large call on its reserves, eg an

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explicit and legally binding guarantee from the government, or a standing authority to borrow from the government - access to insured deposits is available to depositors in a short period of time once the deposit insurance scheme is triggered. Jurisdictions applying the 3% run-off rate to stable deposits with deposit insurance arrangements that meet the above criteria should be able to provide evidence of run-off rates for stable deposits within the banking system below 3% during any periods of stress experienced that are consistent with the conditions within the LCR.

(b) Less stable deposits (run-off rates = 10% and higher)
79. Supervisory authorities are expected to develop additional buckets with higher runoff rates as necessary to apply to buckets of potentially less stable retail deposits in their jurisdictions, with a minimum run-off rate of 10%. These jurisdiction-specific run-off rates should be clearly outlined and publicly transparent. Buckets of less stable deposits could include deposits that are not fully covered by an effective deposit insurance scheme or sovereign deposit guarantee, high-value deposits, deposits from sophisticated or high net worth individuals, deposits that can be withdrawn quickly (eg internet deposits) and foreign currency deposits, as determined by each jurisdiction. 80. If a bank is not able to readily identify which retail deposits would qualify as “stable” according to the above definition (eg the bank cannot determine which deposits are covered by an effective deposit insurance scheme or a sovereign deposit guarantee), it should place the full amount in the “less stable” buckets as established by its supervisor.

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81. Foreign currency retail deposits are deposits denominated in any other currency than the domestic currency in a jurisdiction in which the bank operates. Supervisors will determine the run-off factor that banks in their jurisdiction should use for foreign currency deposits. Foreign currency deposits will be considered as “less stable” if there is a reason to believe that such deposits are more volatile than domestic currency deposits. Factors affecting the volatility of foreign currency deposits include the type and sophistication of the depositors, and the nature of such deposits (eg whether the deposits are linked to business needs in the same currency, or whether the deposits are placed in a search for yield). 82. Cash outflows related to retail term deposits with a residual maturity or withdrawal notice period of greater than 30 days will be excluded from total expected cash outflows if the depositor has no legal right to withdraw deposits within the 30-day horizon of the LCR, or if early withdrawal results in a significant penalty that is materially greater than the loss of interest. 83. If a bank allows a depositor to withdraw such deposits without applying the corresponding penalty, or despite a clause that says the depositor has no legal right to withdraw, the entire category of these funds would then have to be treated as demand deposits (ie regardless of the remaining term, the deposits would be subject to the deposit run-off rates as specified in paragraphs 74-81). Supervisors in each jurisdiction may choose to outline exceptional circumstances that would qualify as hardship, under which the exceptional term deposit could be withdrawn by the depositor without changing the treatment of the entire pool of deposits.

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Such reasons could include, but are not limited to, supervisory concerns that depositors would withdraw term deposits in a similar fashion as retail demand deposits during either normal or stress times, concern that banks may repay such deposits early in stressed times for reputational reasons, or the presence of unintended incentives on banks to impose material penalties on consumers if deposits are withdrawn early. In these cases supervisors would assess a higher run-off against all or some of such deposits.

(ii) Unsecured wholesale funding run-off
85. For the purposes of the LCR, "unsecured wholesale funding” is defined as those liabilities and general obligations that are raised from non-natural persons (ie legal entities, including sole proprietorships and partnerships) and are not collateralised by legal rights to specifically designated assets owned by the borrowing institution in the case of bankruptcy, insolvency, liquidation or resolution. Obligations related to derivative contracts are explicitly excluded from this definition. 86. The wholesale funding included in the LCR is defined as all funding that is callable within the LCR’s horizon of 30 days or that has its earliest possible contractual maturity date situated within this horizon (such as maturing term deposits and unsecured debt securities) as well as funding with an undetermined maturity. This should include all funding with options that are exercisable at the investor’s discretion within the 30 calendar day horizon. For funding with options exercisable at the bank’s discretion, supervisors should take into account reputational factors that may limit a bank's ability not to exercise the option.

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In particular, where the market expects certain liabilities to be redeemed before their legal final maturity date, banks and supervisors should assume such behaviour for the purpose of the LCR and include these liabilities as outflows. 87. Wholesale funding that is callable by the funds provider subject to a contractually defined and binding notice period surpassing the 30-day horizon is not included. 88. For the purposes of the LCR, unsecured wholesale funding is to be categorised as detailed below, based on the assumed sensitivity of the funds providers to the rate offered and the credit quality and solvency of the borrowing bank. This is determined by the type of funds providers and their level of sophistication, as well as their operational relationships with the bank. The run-off rates for the scenario are listed for each category.

(a) Unsecured wholesale funding provided by small business customers: 5%, 10% and Higher
89. Unsecured wholesale funding provided by small business customers is treated the same way as retail deposits for the purposes of this standard, effectively distinguishing between a "stable" portion of funding provided by small business customers and different buckets of less stable funding defined by each jurisdiction. The same bucket definitions and associated run-off factors apply as for retail deposits. 90. This category consists of deposits and other extensions of funds made by nonfinancial small business customers.

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“Small business customers” are defined in line with the definition of loans extended to small businesses in paragraph 231 of the Basel II framework that are managed as retail exposures and are generally considered as having similar liquidity risk characteristics to retail accounts provided the total aggregated funding raised from one small business customer is less than €1 million (on a consolidated basis where applicable). 91. Where a bank does not have any exposure to a small business customer that would enable it to use the definition under paragraph 231 of the Basel II Framework, the bank may include such a deposit in this category provided that the total aggregate funding raised from the customer is less than €1 million (on a consolidated basis where applicable) and the deposit is managed as a retail deposit. This means that the bank treats such deposits in its internal risk management systems consistently over time and in the same manner as other retail deposits, and that the deposits are not individually managed in a way comparable to larger corporate deposits. 92. Term deposits from small business customers should be treated in accordance with the treatment for term retail deposits as outlined in paragraph 82, 83, and 84.

(b) Operational deposits generated by clearing, custody and cash management activities: 25%
93. Certain activities lead to financial and non-financial customers needing to place, or leave, deposits with a bank in order to facilitate their access and ability to use payment and settlement systems and otherwise make payments. These funds may receive a 25% run-off factor only if the customer has a substantive dependency with the bank and the deposit is required for such activities.
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Supervisory approval would have to be given to ensure that banks utilising this treatment actually are conducting these operational activities at the level indicated. Supervisors may choose not to permit banks to utilise the operational deposit runoff rates in cases where, for example, a significant portion of operational deposits are provided by a small proportion of customers (ie concentration risk). 94. Qualifying activities in this context refer to clearing, custody or cash management activities that meet the following criteria: - The customer is reliant on the bank to perform these services as an independent third party intermediary in order to fulfil its normal banking activities over the next 30 days. For example, this condition would not be met if the bank is aware that the customer has adequate back-up arrangements. - These services must be provided under a legally binding agreement to institutional customers. - The termination of such agreements shall be subject either to a notice period of at least 30 days or significant switching costs (such as those related to transaction, information technology, early termination or legal costs) to be borne by the customer if the operational deposits are moved before 30 days. 95. Qualifying operational deposits generated by such an activity are ones where: - The deposits are by-products of the underlying services provided by the banking organisation and not sought out in the wholesale market in the sole interest of offering interest income.

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- The deposits are held in specifically designated accounts and priced without giving an economic incentive to the customer (not limited to paying market interest rates) to leave any excess funds on these accounts. In the case that interest rates in a jurisdiction are close to zero, it would be expected that such accounts are noninterest bearing. Banks should be particularly aware that during prolonged periods of low interest rates, excess balances (as defined below) could be significant. 96. Any excess balances that could be withdrawn and would still leave enough funds to fulfil these clearing, custody and cash management activities do not qualify for the 25% factor. In other words, only that part of the deposit balance with the service provider that is proven to serve a customer’s operational needs can qualify as stable. Excess balances should be treated in the appropriate category for non-operational deposits. If banks are unable to determine the amount of the excess balance, then the entire deposit should be assumed to be excess to requirements and, therefore, considered non-operational. 97. Banks must determine the methodology for identifying excess deposits that are excluded from this treatment. This assessment should be conducted at a sufficiently granular level to adequately assess the risk of withdrawal in an idiosyncratic stress. The methodology should take into account relevant factors such as the likelihood that wholesale customers have above average balances in

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advance of specific payment needs, and consider appropriate indicators (eg ratios of account balances to payment or settlement volumes or to assets under custody) to identify those customers that are not actively managing account balances efficiently. 98. Operational deposits would receive a 0% inflow assumption for the depositing bank given that these deposits are required for operational reasons, and are therefore not available to the depositing bank to repay other outflows. 99. Notwithstanding these operational categories, if the deposit under consideration arises out of correspondent banking or from the provision of prime brokerage services, it will be treated as if there were no operational activity for the purpose of determining run-off factors.42 100. The following paragraphs describe the types of activities that may generate operational deposits. A bank should assess whether the presence of such an activity does indeed generate an operational deposit as not all such activities qualify due to differences in customer dependency, activity and practices. 101. A clearing relationship, in this context, refers to a service arrangement that enables customers to transfer funds (or securities) indirectly through direct participants in domestic settlement systems to final recipients. Such services are limited to the following activities: transmission, reconciliation and confirmation of payment orders; daylight overdraft, overnight financing and maintenance of post-settlement balances; and determination of intra-day and final settlement positions. 102. A custody relationship, in this context, refers to the provision of safekeeping, reporting, processing of assets or the facilitation of the operational and administrative elements of related activities on behalf of customers in the process of their transacting and retaining financial assets.
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Such services are limited to the settlement of securities transactions, the transfer of contractual payments, the processing of collateral, and the provision of custody related cash management services. Also included are the receipt of dividends and other income, client subscriptions and redemptions. Custodial services can furthermore extend to asset and corporate trust servicing, treasury, escrow, funds transfer, stock transfer and agency services, including payment and settlement services (excluding correspondent banking), and depository receipts. 103. A cash management relationship, in this context, refers to the provision of cash management and related services to customers. Cash management services, in this context, refers to those products and services provided to a customer to manage its cash flows, assets and liabilities, and conduct financial transactions necessary to the customer’s ongoing operations. Such services are limited to payment remittance, collection and aggregation of funds, payroll administration, and control over the disbursement of funds. 104. The portion of the operational deposits generated by clearing, custody and cash management activities that is fully covered by deposit insurance can receive the same treatment as “stable” retail deposits

(c) Treatment of deposits in institutional networks of cooperative banks: 25% or 100%
105. An institutional network of cooperative (or otherwise named) banks is a group of legally autonomous banks with a statutory framework of cooperation with common strategic focus and brand where specific
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functions are performed by central institutions or specialized service providers. A 25% run-off rate can be given to the amount of deposits of member institutions with the central institution or specialised central service providers that are placed (a) due to statutory minimum deposit requirements, which are registered at regulators or (b) in the context of common task sharing and legal, statutory or contractual arrangements so long as both the bank that has received the monies and the bank that has deposited participate in the same institutional network’s mutual protection scheme against illiquidity and insolvency of its members. As with other operational deposits, these deposits would receive a 0% inflow assumption for the depositing bank, as these funds are considered to remain with the centralised institution. 106. Supervisory approval would have to be given to ensure that banks utilising this treatment actually are the central institution or a central service provider of such a cooperative (or otherwise named) network. Correspondent banking activities would not be included in this treatment and would receive a 100% outflow treatment, as would funds placed at the central institutions or specialised service providers for any other reason other than those outlined in (a) and (b) in the paragraph above, or for operational functions of clearing, custody, or cash management as outlined in paragraphs 101-103.

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(d) Unsecured wholesale funding provided by non-financial corporates and sovereigns, central banks, multilateral development banks, and PSEs: 20% or 40%
107. This category comprises all deposits and other extensions of unsecured funding from non-financial corporate customers (that are not categorised as small business customers) and (both domestic and foreign) sovereign, central bank, multilateral development bank, and PSE customers that are not specifically held for operational purposes (as defined above). The run-off factor for these funds is 40%, unless the criteria in paragraph 108 are met. 108. Unsecured wholesale funding provided by non-financial corporate customers, sovereigns, central banks, multilateral development banks, and PSEs without operational relationships can receive a 20% run-off factor if the entire amount of the deposit is fully covered by an effective deposit insurance scheme or by a public guarantee that provides equivalent protection.

(e) Unsecured wholesale funding provided by other legal entity customers: 100%
109. This category consists of all deposits and other funding from other institutions (including banks, securities firms, insurance companies, etc), fiduciaries, beneficiaries, conduits and special purpose vehicles, affiliated entities of the bank and other entities that are not specifically held for operational purposes (as defined above) and not included in the prior three categories. The run-off factor for these funds is 100%. 110. All notes, bonds and other debt securities issued by the bank are included in this category regardless of the holder, unless the bond is sold
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exclusively in the retail market and held in retail accounts (including small business customer accounts treated as retail per paragraphs 89-91), in which case the instruments can be treated in the appropriate retail or small business customer deposit category. To be treated in this manner, it is not sufficient that the debt instruments are specifically designed and marketed to retail or small business customers. Rather there should be limitations placed such that those instruments cannot be bought and held by parties other than retail or small business customers. 111. Customer cash balances arising from the provision of prime brokerage services, including but not limited to the cash arising from prime brokerage services as identified in paragraph 99, should be considered separate from any required segregated balances related to client protection regimes imposed by national regulations, and should not be netted against other customer exposures included in this standard. These offsetting balances held in segregated accounts are treated as inflows in paragraph 154 and should be excluded from the stock of HQLA.

(iii) Secured funding run-off
112. For the purposes of this standard, “secured funding” is defined as those liabilities and general obligations that are collateralised by legal rights to specifically designated assets owned by the borrowing institution in the case of bankruptcy, insolvency, liquidation or resolution. 113. Loss of secured funding on short-term financing transactions: In this scenario, the ability to continue to transact repurchase, reverse repurchase and other securities financing transactions is limited to transactions backed by HQLA or with the bank’s domestic
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sovereign, PSE or central bank. Collateral swaps should be treated as repurchase or reverse repurchase agreements, as should any other transaction with a similar form. Additionally, collateral lent to the bank’s customers to effect short positions should be treated as a form of secured funding. For the scenario, a bank should apply the following factors to all outstanding secured funding transactions with maturities within the 30 calendar day stress horizon, including customer short positions that do not have a specified contractual maturity. The amount of outflow is calculated based on the amount of funds raised through the transaction, and not the value of the underlying collateral. 114. Due to the high-quality of Level 1 assets, no reduction in funding availability against these assets is assumed to occur. Moreover, no reduction in funding availability is expected for any maturing secured funding transactions with the bank’s domestic central bank. A reduction in funding availability will be assigned to maturing transactions backed by Level 2 assets equivalent to the required haircuts. A 25% factor is applied for maturing secured funding transactions with the bank’s domestic sovereign, multilateral development banks, or domestic PSEs that have a 20% or lower risk weight, when the transactions are backed by assets other than Level 1 or Level 2A assets, in recognition that these entities are unlikely to withdraw secured funding from banks in a time of market-wide stress. This, however, gives credit only for outstanding secured funding transactions, and not for unused collateral or merely the capacity to borrow.
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115. For all other maturing transactions the run-off factor is 100%, including transactions where a bank has satisfied customers’ short positions with its own long inventory. The table below summarises the applicable standards:

(iv) Additional requirements
116. Derivatives cash outflows: the sum of all net cash outflows should receive a 100% factor. Banks should calculate, in accordance with their existing valuation methodologies, expected contractual derivative cash inflows and outflows. Cash flows may be calculated on a net basis (ie inflows can offset outflows) by counterparty, only where a valid master netting agreement exists. Banks should exclude from such calculations those liquidity requirements that would result from increased collateral needs due to market value movements or falls in value of collateral posted.
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Options should be assumed to be exercised when they are ‘in the money’ to the option buyer. 117. Where derivative payments are collateralised by HQLA, cash outflows should be calculated net of any corresponding cash or collateral inflows that would result, all other things being equal, from contractual obligations for cash or collateral to be provided to the bank, if the bank is legally entitled and operationally capable to re-use the collateral in new cash raising transactions once the collateral is received. This is in line with the principle that banks should not double count liquidity inflows and outflows. 118. Increased liquidity needs related to downgrade triggers embedded in financing transactions, derivatives and other contracts: (100% of the amount of collateral that would be posted for, or contractual cash outflows associated with, any downgrade up to and including a 3-notch downgrade). Often, contracts governing derivatives and other transactions have clauses that require the posting of additional collateral, drawdown of contingent facilities, or early repayment of existing liabilities upon the bank’s downgrade by a recognised credit rating organisation. The scenario therefore requires that for each contract in which “downgrade triggers” exist, the bank assumes that 100% of this additional collateral or cash outflow will have to be posted for any downgrade up to and including a 3-notch downgrade of the bank’s long-term credit rating. Triggers linked to a bank’s short-term rating should be assumed to be triggered at the corresponding long-term rating in accordance with published ratings criteria. The impact of the downgrade should consider impacts on all types of margin collateral and contractual triggers which change rehypothecation rights for non-segregated collateral.
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119. Increased liquidity needs related to the potential for valuation changes on posted collateral securing derivative and other transactions: (20% of the value of non- Level 1 posted collateral). Observation of market practices indicates that most counterparties to derivatives transactions typically are required to secure the mark-to-market valuation of their positions and that this is predominantly done using cash or sovereign, central bank, multilateral development banks, or PSE debt securities with a 0% risk weight under the Basel II standardised approach. When these Level 1 liquid asset securities are posted as collateral, the framework will not require that an additional stock of HQLA be maintained for potential valuation changes. If however, counterparties are securing mark-to-market exposures with other forms of collateral, to cover the potential loss of market value on those securities, 20% of the value of all such posted collateral, net of collateral received on a counterparty basis (provided that the collateral received is not subject to restrictions on reuse or rehypothecation) will be added to the stock of required HQLA by the bank posting such collateral. This 20% will be calculated based on the notional amount required to be posted as collateral after any other haircuts have been applied that may be applicable to the collateral category. Any collateral that is in a segregated margin account can only be used to offset outflows that are associated with payments that are eligible to be offset from that same account. 120. Increased liquidity needs related to excess non-segregated collateral held by the bank that could contractually be called at any time by the counterparty: 100% of the non-segregated collateral that could contractually be recalled by the counterparty because the collateral is in excess of the counterparty’s current collateral requirements.
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121. Increased liquidity needs related to contractually required collateral on transactions for which the counterparty has not yet demanded the collateral be posted: 100% of the collateral that is contractually due but where the counterparty has not yet demanded the posting of such collateral. 122. Increased liquidity needs related to contracts that allow collateral substitution to non-HQLA assets: 100% of the amount of HQLA collateral that can be substituted for non-HQLA assets without the bank’s consent that have been received to secure transactions that have not been segregated. 123. Increased liquidity needs related to market valuation changes on derivative or other transactions: As market practice requires collateralisation of mark-to-market exposures on derivative and other transactions, banks face potentially substantial liquidity risk exposures to these valuation changes. Inflows and outflows of transactions executed under the same master netting agreement can be treated on a net basis. Any outflow generated by increased needs related to market valuation changes should be included in the LCR calculated by identifying the largest absolute net 30-day collateral flow realised during the preceding 24 months. The absolute net collateral flow is based on both realised outflows and inflows. Supervisors may adjust the treatment flexibly according to circumstances. 124. Loss of funding on asset-backed securities, 49 covered bonds and other structured financing instruments: The scenario assumes the outflow of 100% of the funding transaction maturing within the 30-day period, when these instruments are issued by the bank itself (as this assumes that the re-financing market will not exist).

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125. Loss of funding on asset-backed commercial paper, conduits, securities investment vehicles and other such financing facilities: (100% of maturing amount and 100% of returnable assets). Banks having structured financing facilities that include the issuance of short-term debt instruments, such as asset backed commercial paper, should fully consider the potential liquidity risk arising from these structures. These risks include, but are not limited to, (i) the inability to refinance maturing debt, and (ii) the existence of derivatives or derivative-like components contractually written into the documentation associated with the structure that would allow the “return” of assets in a financing arrangement, or that require the original asset transferor to provide liquidity, effectively ending the financing arrangement (“liquidity puts”) within the 30-day period. Where the structured financing activities of a bank are conducted through a special purpose entity50 (such as a special purpose vehicle, conduit or structured investment vehicle - SIV), the bank should, in determining the HQLA requirements, look through to the maturity of the debt instruments issued by the entity and any embedded options in financing arrangements that may potentially trigger the “return” of assets or the need for liquidity, irrespective of whether or not the SPV is consolidated.

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126. Drawdowns on committed credit and liquidity facilities: For the purpose of the standard, credit and liquidity facilities are defined as explicit contractual agreements or obligations to extend funds at a future date to retail or wholesale counterparties. For the purpose of the standard, these facilities only include contractually irrevocable (“committed”) or conditionally revocable agreements to extend funds in the future. Unconditionally revocable facilities that are unconditionally cancellable by the bank (in particular, those without a precondition of a material change in the credit condition of the borrower) are excluded from this section and included in “Other Contingent Funding Liabilities”. These off balance sheet facilities or funding commitments can have long or short-term maturities, with short-term facilities frequently renewing or automatically rolling-over. In a stressed environment, it will likely be difficult for customers drawing on facilities of any maturity, even short-term maturities, to be able to quickly pay back the borrowings. Therefore, for purposes of this standard, all facilities that are assumed to be drawn (as outlined in the paragraphs below) will remain outstanding at the amounts assigned throughout the duration of the test, regardless of maturity. 127. For the purposes of this standard, the currently undrawn portion of these facilities is calculated net of any HQLA eligible for the stock of HQLA, if the HQLA have already been posted as collateral by the counterparty to secure the facilities or that are contractually obliged to be posted when the counterparty will draw down the facility (eg a liquidity facility structured as a repo facility), if the bank is legally entitled and operationally capable to re-use the collateral in new cash raising transactions once the facility is drawn, and there is no undue correlation between the probability of drawing the facility and the market value of the
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collateral. The collateral can be netted against the outstanding amount of the facility to the extent that this collateral is not already counted in the stock of HQLA, in line with the principle in paragraph 72 that items cannot be double-counted in the standard. 128. A liquidity facility is defined as any committed, undrawn back-up facility that would be utilised to refinance the debt obligations of a customer in situations where such a customer is unable to rollover that debt in financial markets (eg pursuant to a commercial paper programme, secured financing transactions, obligations to redeem units, etc). For the purpose of this standard, the amount of the commitment to be treated as a liquidity facility is the amount of the currently outstanding debt issued by the customer (or proportionate share, if a syndicated facility) maturing within a 30 day period that is backstopped by the facility. The portion of a liquidity facility that is backing debt that does not mature within the 30-day window is excluded from the scope of the definition of a facility. Any additional capacity of the facility (ie the remaining commitment) would be treated as a committed credit facility with its associated drawdown rate as specified in paragraph 131. General working capital facilities for corporate entities (eg revolving credit facilities in place for general corporate or working capital purposes) will not be classified as liquidity facilities, but as credit facilities. 129. Notwithstanding the above, any facilities provided to hedge funds, money market funds and special purpose funding vehicles, for example SPEs (as defined in paragraph 125) or conduits, or other vehicles used to

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finance the banks own assets, should be captured in their entirety as a liquidity facility to other legal entities. 130. For that portion of financing programs that are captured in paragraphs 124 and 125 (ie are maturing or have liquidity puts that may be exercised in the 30-day horizon), banks that are providers of associated liquidity facilities do not need to double count the maturing financing instrument and the liquidity facility for consolidated programs. 131. Any contractual loan drawdowns from committed facilities 51 and estimated drawdowns from revocable facilities within the 30-day period should be fully reflected as outflows. (a) Committed credit and liquidity facilities to retail and small business customers: Banks should assume a 5% drawdown of the undrawn portion of these facilities. (b) Committed credit facilities to non-financial corporates, sovereigns and central banks, PSEs and multilateral development banks: Banks should assume a 10% drawdown of the undrawn portion of these credit facilities. (c) Committed liquidity facilities to non-financial corporates, sovereigns and central banks, PSEs, and multilateral development banks: Banks should assume a 30% drawdown of the undrawn portion of these liquidity facilities. (d) Committed credit and liquidity facilities extended to banks subject to prudential supervision: Banks should assume a 40% drawdown of the undrawn portion of these facilities. (e) Committed credit facilities to other financial institutions including securities firms, insurance companies, fiduciaries and beneficiaries:

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Banks should assume a 40% drawdown of the undrawn portion of these credit facilities. (f) Committed liquidity facilities to other financial institutions including securities firms, insurance companies, fiduciaries, and beneficiaries: Banks should assume a 100% drawdown of the undrawn portion of these liquidity facilities. (g) Committed credit and liquidity facilities to other legal entities (including SPEs (as defined on paragraph 125), conduits and special purpose vehicles,54 and other entities not included in the prior categories): Banks should assume a 100% drawdown of the undrawn portion of these facilities. 132. Contractual obligations to extend funds within a 30-day period. Any contractual lending obligations to financial institutions not captured elsewhere in this standard should be captured here at a 100% outflow rate. 133. If the total of all contractual obligations to extend funds to retail and non-financial corporate clients within the next 30 calendar days (not captured in the prior categories) exceeds 50% of the total contractual inflows due in the next 30 calendar days from these clients, the difference should be reported as a 100% outflow. 134. Other contingent funding obligations: (run-off rates at national discretion). National supervisors will work with supervised institutions in their jurisdictions to determine the liquidity risk impact of these contingent liabilities and the resulting stock of HQLA that should accordingly be maintained. Supervisors should disclose the run-off rates they assign to each category publicly.

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135. These contingent funding obligations may be either contractual or non-contractual and are not lending commitments. Non-contractual contingent funding obligations include associations with, or sponsorship of, products sold or services provided that may require the support or extension of funds in the future under stressed conditions. Non-contractual obligations may be embedded in financial products and instruments sold, sponsored, or originated by the institution that can give rise to unplanned balance sheet growth arising from support given for reputational risk considerations. These include products and instruments for which the customer or holder has specific expectations regarding the liquidity and marketability of the product or instrument and for which failure to satisfy customer expectations in a commercially reasonable manner would likely cause material reputational damage to the institution or otherwise impair ongoing viability. 136. Some of these contingent funding obligations are explicitly contingent upon a credit or other event that is not always related to the liquidity events simulated in the stress scenario, but may nevertheless have the potential to cause significant liquidity drains in times of stress. For this standard, each supervisor and bank should consider which of these “other contingent funding obligations” may materialise under the assumed stress events. The potential liquidity exposures to these contingent funding obligations are to be treated as a nationally determined behavioural assumption where it is up to the supervisor to determine whether and to what extent these contingent outflows are to be included in the LCR. All identified contractual and non-contractual contingent liabilities and their assumptions should be reported, along with their related triggers.
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Supervisors and banks should, at a minimum, use historical behaviour in determining appropriate outflows. 137. Non contractual contingent funding obligations related to potential liquidity draws from joint ventures or minority investments in entities, which are not consolidated per paragraph 164 should be captured where there is the expectation that the bank will be the main liquidity provider when the entity is in need of liquidity. The amount included should be calculated in accordance with the methodology agreed by the bank’s supervisor. 138. In the case of contingent funding obligations stemming from trade finance instruments, national authorities can apply a relatively low run-off rate (eg 5% or less). Trade finance instruments consist of trade-related obligations directly underpinned by the movement of goods or the provision of services, such as: - documentary trade letters of credit, documentary and clean collection, import bills, and export bills; and - guarantees directly related to trade finance obligations, such as shipping guarantees. 139. Lending commitments, such as direct import or export financing for non-financial corporate firms, are excluded from this treatment and banks will apply the draw-down rates specified in paragraph 131. 140. National authorities should determine the run-off rates for the other contingent funding obligations listed below in accordance with paragraph 134. Other contingent funding obligations include products and instruments such as:
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- unconditionally revocable "uncommitted" credit and liquidity facilities; - guarantees and letters of credit unrelated to trade finance obligations (as described in paragraph 138); - non-contractual obligations such as: - potential requests for debt repurchases of the bank's own debt or that of related conduits, securities investment vehicles and other such financing facilities; - structured products where customers anticipate ready marketability, such as adjustable rate notes and variable rate demand notes (VRDNs); and - managed funds that are marketed with the objective of maintaining a stable value such as money market mutual funds or other types of stable value collective investment funds etc. - For issuers with an affiliated dealer or market maker, there may be a need to include an amount of the outstanding debt securities (unsecured and secured, term as well as short-term) having maturities greater than 30 calendar days, to cover the potential repurchase of such outstanding securities. - Non contractual obligations where customer short positions are covered by other customers’ collateral: A minimum 50% run-off factor of the contingent obligations should be applied where banks have internally matched client assets against other clients’ short positions where the collateral does not qualify as Level 1 or Level 2, and the bank may be obligated to find additional sources of funding for these positions in the event of client withdrawals. 141. Other contractual cash outflows: (100%). Any other contractual cash outflows within the next 30 calendar days should be captured in this
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standard, such as outflows to cover unsecured collateral borrowings, uncovered short positions, dividends or contractual interest payments, with explanation given as to what comprises this bucket. Outflows related to operating costs, however, are not included in this standard.

2. Cash inflows
142. When considering its available cash inflows, the bank should only include contractual inflows (including interest payments) from outstanding exposures that are fully performing and for which the bank has no reason to expect a default within the 30-day time horizon. Contingent inflows are not included in total net cash inflows. 143. Banks and supervisors need to monitor the concentration of expected inflows across wholesale counterparties in the context of banks’ liquidity management in order to ensure that their liquidity position is not overly dependent on the arrival of expected inflows from one or a limited number of wholesale counterparties. 144. Cap on total inflows: In order to prevent banks from relying solely on anticipated inflows to meet their liquidity requirement, and also to ensure a minimum level of HQLA holdings, the amount of inflows that can offset outflows is capped at 75% of total expected cash outflows as calculated in the standard. This requires that a bank must maintain a minimum amount of stock of HQLA equal to 25% of the total net cash outflows. (i) Secured lending, including reverse repos and securities borrowing 145. A bank should assume that maturing reverse repurchase or securities borrowing agreements secured by Level 1 assets will be rolled-over and will not give rise to any cash inflows (0%).
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Maturing reverse repurchase or securities lending agreements secured by Level 2 HQLA will lead to cash inflows equivalent to the relevant haircut for the specific assets. A bank is assumed not to roll-over maturing reverse repurchase or securities borrowing agreements secured by non-HQLA assets, and can assume to receive back 100% of the cash related to those agreements. Collateralised loans extended to customers for the purpose of taking leveraged trading positions (“margin loans”) should also be considered as a form of secured lending; however, for this scenario banks may recognise no more than 50% of contractual inflows from maturing margin loans made against non-HQLA collateral. This treatment is in line with the assumptions outlined for secured funding in the outflows section. 146. As an exception to paragraph 145, if the collateral obtained through reverse repo, securities borrowing, or collateral swaps, which matures within the 30-day horizon, is re-used (ie rehypothecated) and is used to cover short positions that could be extended beyond 30 days, a bank should assume that such reverse repo or securities borrowing arrangements will be rolled-over and will not give rise to any cash inflows (0%), reflecting its need to continue to cover the short position or to re-purchase the relevant securities. Short positions include both instances where in its ‘matched book’ the bank sold short a security outright as part of a trading or hedging strategy and instances where the bank is short a security in the ‘matched’ repo book (ie it has borrowed a security for a given period and lent the security out for a longer period).

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147. In the case of a bank’s short positions, if the short position is being covered by an unsecured security borrowing, the bank should assume the unsecured security borrowing of collateral from financial market participants would run-off in full, leading to a 100% outflow of either cash or HQLA to secure the borrowing, or cash to close out the short position by buying back the security. This should be recorded as a 100% other contractual outflow according to paragraph 141. If, however, the bank’s short position is being covered by a collateralised securities financing transaction, the bank should assume the short position will be maintained throughout the 30-day period and receive a 0% outflow. 148. Despite the roll-over assumptions in paragraphs 145 and 146, a bank should manage its collateral such that it is able to fulfil obligations to return collateral whenever the counterparty decides not to roll-over any reverse repo or securities lending transaction. This is especially the case for non-HQLA collateral, since such outflows are not captured in the LCR framework.

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Supervisors should monitor the bank's collateral management.

(ii) Committed facilities
149. No credit facilities, liquidity facilities or other contingent funding facilities that the bank holds at other institutions for its own purposes are assumed to be able to be drawn. Such facilities receive a 0% inflow rate, meaning that this scenario does not consider inflows from committed credit or liquidity facilities. This is to reduce the contagion risk of liquidity shortages at one bank causing shortages at other banks and to reflect the risk that other banks may not be in a position to honour credit facilities, or may decide to incur the legal and reputational risk involved in not honouring the commitment, in order to conserve their own liquidity or reduce their exposure to that bank.

(iii) Other inflows by counterparty
150. For all other types of transactions, either secured or unsecured, the inflow rate will be determined by counterparty. In order to reflect the need for a bank to conduct ongoing loan origination/roll-over with different types of counterparties, even during a time of stress, a set of limits on contractual inflows by counterparty type is applied. 151. When considering loan payments, the bank should only include inflows from fully performing loans. Further, inflows should only be taken at the latest possible date, based on the contractual rights available to counterparties.

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For revolving credit facilities, this assumes that the existing loan is rolled over and that any remaining balances are treated in the same way as a committed facility according to paragraph 131. 152. Inflows from loans that have no specific maturity (ie have non-defined or open maturity) should not be included; therefore, no assumptions should be applied as to when maturity of such loans would occur. An exception to this would be minimum payments of principal, fee or interest associated with an open maturity loan, provided that such payments are contractually due within 30 days. These minimum payment amounts should be captured as inflows at the rates prescribed in paragraphs 153 and 154.

(a) Retail and small business customer inflows
153. This scenario assumes that banks will receive all payments (including interest payments and instalments) from retail and small business customers that are fully performing and contractually due within a 30-day horizon. At the same time, however, banks are assumed to continue to extend loans to retail and small business customers, at a rate of 50% of contractual inflows. This results in a net inflow number of 50% of the contractual amount.

(b) Other wholesale inflows
154. This scenario assumes that banks will receive all payments (including interest payments and instalments) from wholesale customers that are fully performing and contractually due within the 30-day horizon.

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In addition, banks are assumed to continue to extend loans to wholesale clients, at a rate of 0% of inflows for financial institutions and central banks, and 50% for all others, including non-financial corporates, sovereigns, multilateral development banks, and PSEs. This will result in an inflow percentage of: - 100% for financial institution and central bank counterparties; and - 50% for non-financial wholesale counterparties. 155. Inflows from securities maturing within 30 days not included in the stock of HQLA should be treated in the same category as inflows from financial institutions (ie 100% inflow). Banks may also recognise in this category inflows from the release of balances held in segregated accounts in accordance with regulatory requirements for the protection of customer trading assets, provided that these segregated balances are maintained in HQLA. This inflow should be calculated in line with the treatment of other related outflows and inflows covered in this standard. Level 1 and Level 2 securities maturing within 30 days should be included in the stock of liquid assets, provided that they meet all operational and definitional requirements, as laid out in paragraphs 28-54. 156. Operational deposits: Deposits held at other financial institutions for operational purposes, as outlined in paragraphs 93-103, such as for clearing, custody, and cash management purposes, are assumed to stay at those institutions, and no inflows can be counted for these funds – ie they will receive a 0% inflow rate, as noted in paragraph 98. 157. The same treatment applies for deposits held at the centralised institution in a cooperative banking network, that are assumed to stay at the centralised institution as outlined in paragraphs 105 and 106; in other

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words, the depositing bank should not count any inflow for these funds – ie they will receive a 0% inflow rate.

(iv) Other cash inflows
158. Derivatives cash inflows: the sum of all net cash inflows should receive a 100% inflow factor. The amounts of derivatives cash inflows and outflows should be calculated in accordance with the methodology described in paragraph 116. 159. Where derivatives are collateralised by HQLA, cash inflows should be calculated net of any corresponding cash or contractual collateral outflows that would result, all other things being equal, from contractual obligations for cash or collateral to be posted by the bank, given these contractual obligations would reduce the stock of HQLA. This is in accordance with the principle that banks should not double-count liquidity inflows or outflows. 160. Other contractual cash inflows: Other contractual cash inflows should be captured here, with explanation given to what comprises this bucket. Inflow percentages should be determined as appropriate for each type of inflow by supervisors in each jurisdiction. Cash inflows related to non-financial revenues are not taken into account in the calculation of the net cash outflows for the purposes of this standard.

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III. Application issues for the LCR
161. This section outlines a number of issues related to the application of the LCR. These issues include the frequency with which banks calculate and report the LCR, the scope of application of the LCR (whether they apply at group or entity level and to foreign bank branches) and the aggregation of currencies within the LCR.

A. Frequency of calculation and reporting
162. The LCR should be used on an ongoing basis to help monitor and control liquidity risk. The LCR should be reported to supervisors at least monthly, with the operational capacity to increase the frequency to weekly or even daily in stressed situations at the discretion of the supervisor. The time lag in reporting should be as short as feasible and ideally should not surpass two weeks. 163. Banks are expected to inform supervisors of their LCR and their liquidity profile on an ongoing basis. Banks should also notify supervisors immediately if their LCR has fallen, or is expected to fall, below 100%.

B. Scope of application
164. The application of the requirements in this document follow the existing scope of application set out in Part I (Scope of Application) of the Basel II Framework.

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The LCR standard and monitoring tools should be applied to all internationally active banks on a consolidated basis, but may be used for other banks and on any subset of entities of internationally active banks as well to ensure greater consistency and a level playing field between domestic and cross-border banks. The LCR standard and monitoring tools should be applied consistently wherever they are applied. 165. National supervisors should determine which investments in banking, securities and financial entities of a banking group that are not consolidated per paragraph 164 should be considered significant, taking into account the liquidity impact of such investments on the group under the LCR standard. Normally, a non-controlling investment (eg a joint-venture or minority-owned entity) can be regarded as significant if the banking group will be the main liquidity provider of such investment in times of stress (for example, when the other shareholders are non-banks or where the bank is operationally involved in the day-to-day management and monitoring of the entity’s liquidity risk). National supervisors should agree with each relevant bank on a case-by-case basis on an appropriate methodology for how to quantify such potential liquidity draws, in particular, those arising from the need to support the investment in times of stress out of reputational concerns for the purpose of calculating the LCR standard. To the extent that such liquidity draws are not included elsewhere, they should be treated under “Other contingent funding obligations”, as described in paragraph 137. 166. Regardless of the scope of application of the LCR, in keeping with Principle 6 as outlined in the Sound Principles, a bank should actively monitor and control liquidity risk exposures and funding needs at the level of individual legal entities, foreign branches and subsidiaries, and
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the group as a whole, taking into account legal, regulatory and operational limitations to the transferability of liquidity. 167. To ensure consistency in applying the consolidated LCR across jurisdictions, further information is provided below on two application issues.

1. Differences in home / host liquidity requirements
168. While most of the parameters in the LCR are internationally “harmonised”, national differences in liquidity treatment may occur in those items subject to national discretion (eg deposit run-off rates, contingent funding obligations, market valuation changes on derivative transactions, etc) and where more stringent parameters are adopted by some supervisors. 169. When calculating the LCR on a consolidated basis, a cross-border banking group should apply the liquidity parameters adopted in the home jurisdiction to all legal entities being consolidated except for the treatment of retail / small business deposits that should follow the relevant parameters adopted in host jurisdictions in which the entities (branch or subsidiary) operate. This approach will enable the stressed liquidity needs of legal entities of the group (including branches of those entities) operating in host jurisdictions to be more suitably reflected, given that deposit run-off rates in host jurisdictions are more influenced by jurisdiction-specific factors such as the type and effectiveness of deposit insurance schemes in place and the behaviour of local depositors. 170. Home requirements for retail and small business deposits should apply to the relevant legal entities (including branches of those entities) operating in host jurisdictions if: (i) there are no host requirements for retail and small business deposits in the particular jurisdictions;
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(ii) those entities operate in host jurisdictions that have not implemented the LCR; or (iii) the home supervisor decides that home requirements should be used that are stricter than the host requirements.

2. Treatment of liquidity transfer restrictions
171. As noted in paragraph 36, as a general principle, no excess liquidity should be recognised by a cross-border banking group in its consolidated LCR if there is reasonable doubt about the availability of such liquidity. Liquidity transfer restrictions (eg ring-fencing measures, non convertibility of local currency, foreign exchange controls, etc) in jurisdictions in which a banking group operates will affect the availability of liquidity by inhibiting the transfer of HQLA and fund flows within the group. The consolidated LCR should reflect such restrictions in a manner consistent with paragraph 36. For example, the eligible HQLA that are held by a legal entity being consolidated to meet its local LCR requirements (where applicable) can be included in the consolidated LCR to the extent that such HQLA are used to cover the total net cash outflows of that entity, notwithstanding that the assets are subject to liquidity transfer restrictions. If the HQLA held in excess of the total net cash outflows are not transferable, such surplus liquidity should be excluded from the standard. 172. For practical reasons, the liquidity transfer restrictions to be accounted for in the consolidated ratio are confined to existing restrictions imposed under applicable laws, regulations and supervisory requirements.

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A banking group should have processes in place to capture all liquidity transfer restrictions to the extent practicable, and to monitor the rules and regulations in the jurisdictions in which the group operates and assess their liquidity implications for the group as a whole.

C. Currencies
173. As outlined in paragraph 42, while the LCR is expected to be met on a consolidated basis and reported in a common currency, supervisors and banks should also be aware of the liquidity needs in each significant currency. As indicated in the LCR, the currencies of the stock of HQLA should be similar in composition to the operational needs of the bank. Banks and supervisors cannot assume that currencies will remain transferable and convertible in a stress period, even for currencies that in normal times are freely transferable and highly convertible.

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Summary Responses To the Commissions’ Green Paper on Shadow Banking 1. Executive Summary
The European Commission's consultation on shadow banking attracted high interest from stakeholders. The comments provided cover a broad range of issues and responded to all the questions raised by the European Commission Green Paper. The Commission received in total 140 contributions, of which 24 from Public Authorities; 47 from registered organisations; and, 64 from individual organisations. Five organisations asked for their submissions to remain confidential. The key messages received from stakeholders are broadly in line with the feedback received at the shadow banking conference, organised by the European Commission on 27 April 2012 in Brussels: - There is general support for the European Commission's initiative in this area. Work should continue to improve the regulatory system in the EU and to ensure global consistency - There is a growing consensus that supervision and a strengthened regulatory framework is needed to harness the shadow banking system - It is necessary to preserve a useful channel of financial intermediation that can provide benefits to the real economy at a time when bank financing is more constrained - The scope of regulation should be comprehensive and flexible enough to be adaptable to future developments
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- The room for regulatory arbitrage should be reduced and regulatory divergence in the EU eliminated - The focus should be on activities and entities that could pose systemic risk to the financial markets - Potential legislative measures should take existing legislation into account and should be proportionate; and - Transparency and data collection need to be improved in order to strengthen the basis for further policy decisions. In addition to the key messages, more detailed comments have been provided in response to the different areas covered by the Green Paper.

Scope and definition
Respondents to the consultation acknowledged that the term "shadow banking" is widely used and broadly supported, but some stakeholders suggested that the term should be changed. They argued that the current term is very broad and provides a negative connotation. Some stakeholders suggested that the term should better reflect the characteristics of the entities or activities and suggested to replace it by

"activities that are not regulated and not supervised"; "parallel banking"; or "market-based finance".
Some stakeholders underlined the need for more specified definitions. For example, issues such as credit activities, credit guarantees, leasing or finance companies providing credit or credit guarantees should be used in a more consistent manner, at least at European level.

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On the other hand, some respondents commented that a definition for shadow banking needs to be sufficiently flexible to be adaptable to future developments in the area of shadow banking. Other stakeholders suggested that the scope of shadow banking needs to be further specified. The Financial Stability Board (FSB) has put forward a definition which is acceptable to many stakeholders (in short: non-banks performing credit intermediation), although some of them argue that it should either be more comprehensive or should provide a better distinction between entities and activities. Stakeholders commented that shadow banking should only include entities and credit activities which are currently not (or not sufficiently) regulated and pose a systemic risk to the financial system. According to them credit intermediation and maturity transformation are key features of shadow banking activities. More focus should be on the issue of systemically relevant activities. Representatives of certain industries (e.g. investment funds, leasing companies, Factoring companies or credit insurance undertakings) argued that their activities should not be within the scope of shadow banking either because they don’t meet the definition, or because they are already subject to regulation and double regulation should be avoided.

General principles to follow
Many stakeholders underlined that shadow banking activities largely serve the real economy. Existing channels of financing should be preserved.

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However, some expressed concerns about the usefulness of certain activities in view of their contribution to the overall social welfare. Stakeholders in general expressed support for measures already taken at EU level, although some respondents suggested that non-binding measures might not be sufficient to address existing shortcomings of regulation. The point was made that new regulation should take current developments in other areas where existing regulation is currently being revised (CRD IV, Solvency II, etc.) into account, since they may alter the structural characteristics of the EU financial system. Stakeholders reminded that bank and non-bank activities are intertwined. Several stakeholders asked for a careful assessment of the potential consequences of any new initiatives and their cumulative impacts with other financial regulations to be implemented. Any legal measure should be proportionate and primarily targeted at entities and activities that pose significant systemic risk to the financial system. Support was expressed for the general principles for the supervision of shadow banking, including that it should: (i) Be performed at the appropriate level, i.e. national and/or European (ii) Be proportionate (iii) Take into account existing supervisory capacity and expertise (iv) Be integrated with the macro-prudential framework Other respondents proposed the elimination of existing differences in EU supervision in order to reduce regulatory arbitrage, at least in Europe, but
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also internationally. Ideally, stakeholders would like to see any response to "shadow banking" activities to be coordinated on a global level in a coherent way and stressed that coordination is needed between existing work streams at the level of FSB, IOSCO, ECB, ESMA and the Basel Committee. Some stakeholders expressed concerns whether traditional banking regulation per se may be appropriate to address the risks inherent in the shadow banking system. However, they underlined that activities that involve credit risk should be subject to similar solvency and liquidity requirements as credit institutions starting from a certain threshold, i.e. similar activities should be subject to similar regulations. In addition, respondents to the consultation (called for?) improved convergence and equivalence in the area of related international standards, such as Basel requirements or International Financial Reporting Standards (IFRS), which could result in improved transparency for example regarding off-balance sheet activities. Many stakeholders expressed support for an enhancement of the existing legal framework, (e.g. UCITs, AIFMD, EMIR, CRD, etc.), rather than the development of a separate regulatory regime focusing on shadow banking activities. They feared that this would avoid distortion of the competitiveness of the EU financial sector.

Key priorities
The Green Paper suggested five priorities for investigation, which were broadly in line with the FSB work plan:

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i. Banking regulation and interactions with shadow banking ii. Asset management regulation issues with a specific focus on Money Market Funds iii. Securities lending and repurchase agreements iv. Securitisation practices in terms of incentives alignment and transparency v. Other shadow banking entities which may constitute a source of systemic risk. Stakeholders expressed general support for the five proposed key areas where the Commission is further investigating options. However, a number of other suggestions have been provided. Some stakeholders argued for an extension of the scope of the existing banking supervisory regime as far as appropriate. Some stakeholders argued that Money Market Funds (MMFs) and Exchanged Traded Funds (ETFs) should not be subject to further regulation in view of the existing regulation on asset management and the ESMA guidelines, whereas others preferred these areas being subject to stricter regulation. On securities lending and repurchase agreements respondents argued for a holistic regulation addressing directly the issue of increased leverage but expressed also concerns regarding haircut requirements due to the potential risk of increased pro-cyclicality. Instead, the generation of "safe assets" would be critical, as some respondents stressed. Stakeholders did not insist on regulation on securitisation given that the
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EU regulatory framework has already been strengthened to deal with some of the issues. On other financial entities (e.g. financial companies or broker-dealers), which are not explicitly targeted by the Green Paper, it was strongly recommended to wait for the final outcome of the work conducted by the FSB in order to ensure a consistent international approach.

Monitoring and transparency
There was broad agreement amongst stakeholders that transparency should be enhanced with a view to improve supervision and market discipline. Data collection was seen by many respondents as a prerequisite for a better understanding of shadow banking activities and their implications in order to facilitate monitoring solutions, which would allow for better targeted interventions. Indirect regulation was regarded by a number of respondents as an efficient tool to capture some of the risks posed by shadow banks. It was suggested that for example the large exposures regime should act as a backstop regime also to shadow banking activities and tackle the risk of interconnectivity by ensuring proper identification of interconnections. Stakeholders did not object to the idea of regular monitoring and data collection in general and welcomed the work of the European Central Bank (ECB) in this area so far. In addition, they suggested that the role of the European Systemic Risk Board (ESRB) regarding monitoring macroeconomic risks by collecting and bundling EU wide information should be further clarified.

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Conclusion and next steps
The analysis of comments received suggests that there is support for regulatory measures in the EU subject to key principles, i.e. they have to improve financial stability, they are proportionate, they reduce regulatory arbitrage, they reflect the global characteristics of shadow banking, they improve transparency and they facilitate long-term growth. Following the Green Paper consultation and the public conference in April 2012, the European Commission has initiated a number of discussions with stakeholders and has launched specific and targeted consultations, e.g. on UCITS and on the resolution of non-banks. The objective was to gain additional information in view of the preparation of appropriate policy reactions. All information available will be taken into account for the development of policy proposals, which should be compatible with recommendations put forward by international organisations. A Communication by the European Commission is planned for Q1 2013 and will provide further details regarding areas for which legal proposals might be developed and their respective timing.

2. Feedback Statement 2.1. Introduction and international developments
The 2008 global financial crisis was caused by regulatory gaps, ineffective supervision, opaque markets and overly-complex products. The European Union has shown global leadership in implementing the G20 commitments and has undertaken the biggest financial regulatory reform ever. However, there is still an increasing area of non-bank credit activity, or shadow banking, which has not been the prime focus of prudential regulation and supervision to date.
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Although shadow banking performs important functions in the financial system, there is a common understanding that it can also pose potential threats to long-term financial stability. Against this background, the Commission considers it a priority to examine in detail the issues posed by shadow banking activities and entities. The objectives are to respond actively and further contribute to the global debate; to continue to increase the resilience of the Union’s financial system; and, to ensure that all financial activities contribute to economic growth. The European Commission Green Paper described shadow banking as "the system of credit intermediation that involves entities and activities (fully or partially) outside the regular banking system." This definition is in line with the definition proposed by the Financial Stability Board (FSB).

Developments at international level
In November 2011, G20 Leaders adopted the FSB report Shadow Banking: Strengthening Oversight and Regulation which set out a work plan to develop policy recommendations in 2012. On 18 November 2012 the FSB published for consultation (until 14 January 2013) an initial integrated set of policy recommendations to strengthen oversight and regulation of the shadow banking system. The set of documents published includes the following reports: - An integrated Overview of Policy Recommendations - Policy Framework for Strengthening Oversight and Regulation of Shadow Banking Entities
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- Policy recommendations to Address Shadow Banking Risks in Securities lending and Repos - Global Shadow Banking Monitoring Report 2012 These consultations will feed into the FSB's work to finalise a comprehensive and integrated set of policy recommendations to address shadow banking issues. These are then due to be endorsed by to the G20 leaders at the St. Petersburg Summit planned in September 2013. To finalise these policy measures, the FSB is also involving with other international standard-setters. In 2013 the Basel Committee on Banking Supervision (BCBS) will develop policy recommendations to mitigate the spill-over effects between the regular banking system and the shadow banking system. The International Organisation of Securities Commissions (IOSCO) has already set out final policy recommendations in its reports entitled "Policy Recommendations for Money Market Funds" and "Global Developments in Securitisation Markets". Two specific areas are directly investigated by the FSB: i) The regulation of other shadow banking entities posing systemic risks; and ii) The regulations of securities financing transactions. On these two topics, public consultations have been launched.

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Developments at the EU level
On 20 November 2012 the European Parliament adopted an own initiative report (Motion for Resolution) on shadow banking, in which it put forward the need for additional regulation of the shadow banking system. It mentions that shadow banks, such as hedge funds or trading houses, benefit the real economy by lending to risky ventures that regular banks avoid. However, if their loans turn bad, they may collapse, taking regular banks with them, because they lack a capital cushion. The report argues that better prudential oversight is needed to reduce shadow banking's systemic risks, without stifling its benefits to the economy. In response to the European Commission Green Paper the European Economic and Social Committee (EESC) adopted on 15 November 2012 a report, which concludes that measures need to be taken to address risks posed by the shadow banking system.

The size of the shadow banking sector
The FSB's 2012 Global Shadow Banking Monitoring Report issued on 18 November 2012 highlights 3 key developments: a) The global shadow banking system grew rapidly before the crisis (in parallel to the regular banking system), rising from USD 26 trillion in 2002 to USD 62 trillion in 2007. The size of the total system declined slightly in 2008 but increased subsequently, although at a slower pace, to reach USD 67 trillion (based on 2011 figures)

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b) There is considerable diversity in the relative size, composition and growth of the shadow banking system across jurisdictions c) The granularity of available data is improving with the share of unidentified non-bank financial intermediaries within overall non-bank intermediation falling from 36% in the year 2010 to 18% in the year 2011. However, further improvements are needed to better capture the size and nature of risks in the shadow banking system on a global basis. Stakeholders expressed concerns that the on-going reform of financial regulation of the banking (and insurance) sector may lead to a further growing market for non-regulated financial intermediaries. Therefore, measures need to be developed and have to become effective in time. Global coordination based on recommendations published by the FSB is crucial.

2.2. Responses to the Consultation 2.2.1. Summary of Responses General Comments
Consultation respondents provided very detailed responses to the specific questions raised by the Green Paper. Many of them also provided general comments covering a broad range of areas. Some respondents regarded the term shadow banking inappropriate since it seems to suggest – in particular when translated into other languages - that activities within the scope of the shadow banking definition are regarded as harmful and that there is a lack of regulation outside the banking sector in Europe.
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Although a large number of respondents agreed with the definition of shadow banking used in the Green Paper, some stakeholders argued that the definition developed by FSB is generally too broad. As a consequence certain sectors, entities or activities should not be captured by the definition, e.g. factoring, certain insurance activities and investment funds since they are already subject to regulation. On the other hand other stakeholders argued that the definition should be broad enough to catch as many activities as possible. Many stakeholders emphasised the need for global coordination in order to make sure that existing or future incentives for regulatory arbitrage are limited, in particular in view of the stricter regulation for banks and insurance entities currently under negotiation. Stakeholders stressed that an EU approach should not contradict recommendations developed by international organisations such as FSB, Basel or IOSCO. Some stakeholders warned that the benefits coming from the shadow banking system should be identified and conserved and they stressed the importance of considering the negative effects posed by any new regulation on different market participants. Other stakeholders argued that any future regulation should be proportionate and focused on entities/activities posing systemic risks to the financial system. The preference should be for enhancement of the existing legal framework instead of issuing a separate shadow banking regulation regime. Part of the policy reaction should be to look at the nonhomogenous supervisory architecture in Europe and increase the level of harmonisation.
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Existing and future policy proposals should be coherent. The point was made that the interconnectedness between the banking and the nonbanking sector was regarded as substantial. Therefore more transparency is needed in the banking sector. It was highlighted that there is a need for better information collection processes, greater market transparency and regular monitoring to identify areas of systemic risk.

Question a - Do you agree with the proposed definition of shadow banking?
Although most consultation respondents agreed with the proposed definition and expressed general support, some concerns were raised as to whether the definition is appropriate. Those respondents raising concerns argued that the proposed term is too broad and would therefore catch a variety of activities which should not be related to the shadow banking debate. They argued that the proposed definition would also cover certain activities already subject to regulation and which should not be treated the same way as non-regulated activities. Instead the focus should be more on systemic and potentially significant risks related to shadow banking. It should be more specifically looking at non regulated activities. Other respondents to the consultation expressed the view that the proposed definition is a good basis mainly because it covers entities as well as activities, which seemed to be a critical issue.

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Some stakeholders suggested defining entities/activities that should not be in the scope of shadow banking rather than the other way around. This would avoid that the approach becomes too broad. Others suggested that the definition should be operational, open and as broad as possible in order to be adaptable to changing market realities and entities and activities that should be included. A number of respondents stressed the need for compliance with the FSB definition and made a strong case for using a common global definition in order to limit the potential room for arbitrage and to ensure global consistency.

Question b - Do you agree with the preliminary list of shadow banking entities and activities? Should more entities and/or activities be analysed? If so, which ones?
The responses to the question were mixed. Although a number of consultation respondents expressed agreement, others raised strong concerns, in particular in view of the potential impacts of new regulation on certain sectors and business models. As a general remark some respondents emphasised that shadow banking systemic risks ought to be assessed based on activities rather than a list of entities. It was highlighted that to come up with a conclusive list would not be operational since there is not a "one size fits all" solution. Other consultation respondents agreed, but added that shadow banking should cover specific qualities of the financial system as whole, not just particular sectors of the financial industry, thus arguing for a more holistic approach.
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They argued that most entities and activities are already or should be subject to monitoring and regulation. Ultimately the objective should be to focus on the application of "same business, same rules". The point was made that the focus should be on conduits and vehicles which are not consolidated in the balance sheets of banks. Securities lending and repos between regulated counterparts are mostly carried out through central counterparts. Additional entities to be scrutinised are those performing "social lending" activities (e.g. peer-to-peer credit). Others suggested adding entities which are not only deposit-taking, e.g. treasury or risk capital funds, CCPs, securities lending and all operations involving collateral re-use, although warning that not all institutions leveraging their financial activities should be included. The insurance industry argued that insurance and reinsurance undertakings that issue or guarantee credit products should not be classified as shadow banking. A number of stakeholders suggested that certain activities should not be in the focus of the shadow banking debate. The argument was made, mainly by industry representatives, that activities for example in the area of securities lending and repo activities should be considered as shadow banking only with supplementary criteria (e.g. use of repo to gain leverage in excess of a certain hurdle). Others argued that the definition of MMF type funds within the sector of shadow banking is not satisfactory, as it suggests a link between risk run and deposit-like characteristics.

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The argument was made that the risk born by MMFs stems from the discrepancy between mark-to-market and published NAV in the specific case of MMFs measured at a constant value (C-NAVs). Another view expressed was that shadow banking should include all credit intermediation activities that are implicitly enhanced, indirectly enhanced or unenhanced by official guarantees. These activities include debt issued or guaranteed by government sponsored enterprises, which benefits from an implicit credit borne by the taxpayer; the off-balance sheet activities of depositary institutions, such as unfunded credit card loan commitments; and, lines of credits to conduits and bank-affiliated hedge funds. A number of respondents stressed that ETFs do not constitute per se shadow banking entities, because excessive leverage is only used by a small number of them, which seems to be already addressed by existing legislation. The point was made that most ETFs providing credit for banking counterparties can be better addressed through banking regulation or the UCITS framework. Since ETFs in the shadow banking sector represent only a fraction of investments funds in general, they should not be distinguished from other investment funds in the treatment of shadow banking entities. Other respondents argued for a narrower approach, comprising only entities which are unregulated or inadequately regulated.

Question c - Do you agree that shadow banking can contribute positively to the financial system? Are there other beneficial aspects from these activities that should be retained and promoted in the future?

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The positions expressed by respondents to the consultation were mixed on this question. A number of stakeholders acknowledged that there are benefits created by the shadow banking sector, e.g. the enhancement of innovation and competition or diversification of investments. They suggested that shadow banking also contributed to the wider economy by providing credible, sound and alternative investment opportunities and vital sources of financing for businesses. Other benefits mentioned included the following: - Shadow banking increases the number of financial firms and thus can reduce the size of market participants. In this sense it can help address the risks of ‘too big to fail’ financial institutions. - Shadow banking provides additional diversity in the financial ecosystem, helping to ensure that it does not become widely or mainly dependent on the behaviour of banks. - It is important not to create a system in which all or most of the players act like banks. - Shadow banking can provide financial services not necessarily offered by regular banks, such as market making, thereby improving market liquidity. - Shadow banking can help closing a funding gap and reinforce the stability of the financial system (a decentralised financial system avoids concentration of business; less transmission of systemic risk). - The emergence of alternative funding solutions should not be deterred by heavy regulation.

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Other stakeholders were more cautious in terms of the potential benefits and expressed support only if shadow banking facilitates long-term investment and thus were doubtful about benefit of financial innovation to growth. On the other hand several stakeholders argued that there are no benefits related to shadow banking activities, since their success appears only to be linked to the fact that they rely on a lack of regulation and are based on unfair competition. It was doubted that unregulated activities could be seen as contributing to a more stable financial system and add social welfare to the society as a whole. Some stakeholders were also concerned about access to finance for companies, in particular SMEs. They suggested that any new legislation should not work against the interest and needs of firms. As regards the possible risk diversification, some respondents expressed the view that shadow banking activities can even increase the risks for the real economy, since it is questionable whether they can provide an alternative source of funding during a period of crisis. Overall, stakeholders expressed a clear view that, notwithstanding the benefits, the inherent risks of shadow banking justify an appropriate policy response.

Question d - Do you agree with the description of channels through which shadow banking activities are creating new risks or transferring them to other parts of the financial system?

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Although there was general support for the description of the channels through which shadow banking systems are creating new risks, most respondents expressed reservations. One respondent expressed disagreement with the implicit assumption that institutions that facilitate or support shadow banking are doing this only to avoid regulatory intervention. Others argued that the description is only applicable to certain types of shadow banking activities, since there are many other non-bank activities which simply supply the market with additional liquidity, without using excessive leverage, e.g. asset management funds. In the same context, a number of respondents, mainly from the financial sector, argued that, in contrast to general assumptions, certain entities or activities, such as investment funds, do not pose systemic risks. For example, MMFs create less liquidity transformation than banks; asset-liability maturity mismatch is very limited; credit quality is high; and, there are already high standards for liquidity risk management ensuring that redemption requests are met. The argument was made that in some areas the level of regulation is already high, such as risk management and leverage, as covered by the UCITS and AIFM regime. In addition, fund managers can temporarily suspend redemptions or use "gates" to manage redemption requests. The high degree of existing regulation and supervision prevents investment funds from being used to circumvent banking regulation. Other areas of risk (for example hidden leverage, regulatory arbitrage, disorderly failures, massive sales and runs) where regarded by some respondents as overstated or not limited to the shadow banking sector

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alone, and thus specific regulation aimed at shadow banking activities was not regarded as the preferred response. A number of respondents expressed support for the risks mentioned in the Green Paper and stressed that four risk groups should in particular be addressed: (i) A more focused monitoring system should be put in place; (ii) A tighter and better coordinated regulation focussing on stability/health of financial system is needed; (iii) Convergence with other international regulatory systems, e.g. the US Dodd-Frank Act, might be useful; and (iv) Enhanced transparency and quantification of the impact of shadow banking activities is necessary. Another suggestion made was to investigate the separation between commercial banking activities and other activities of the banking group. This would be in follow-up to the report issued by the High Level Expert Group chaired by Erkki Liikanen.

Question e - Should other channels be considered through which shadow banking activities are creating new risks or transferring them to other parts of the financial system?
A number of respondents to the consultation stated that additional channels should be considered. Some respondents underlined that in addition to the general size of shadow banking, which can cause systemic risks, the reputational risk that shadow banking may entail for regular banks should be considered.

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Another issue mentioned was called the “Paradox of diversification”, meaning that the more financial institutions start to behave similarly in their diversification strategy to reduce individual risks, the more the correlation of assets classes will increase resulting in higher systemic risk. Also the risk of shadow banking institutions being used as instruments to hide illicit activities (e.g. tax fraud or money laundering strategies) was mentioned. Many respondents confirmed that a significant amount of the risk is linked to the complexity and lack of transparency of products, structures or activities in the area of shadow banking. It was mentioned that misalignments or even conflicts of interests may arise in securitisation-based credit intermediation, which do not exist for a traditional bank lending from its own balance sheet. This may result in a supply of poorly underwritten loans and structured securities, which could threaten the collapse of entire markets. Complexity was mentioned by some respondents as another channel through which risks can be created, since the longer the chain of financial intermediation in shadow banking is, the more entities will be exposed to the knock-on effects of dislocation at some point further up the chain. Moreover, the complexity of the links that may form between shadow banks could have destabilising network effects. In addition, the lower the quality of the loan, the longer the chain that may be required to enhance the quality of the assets to the standards needed to sell to money market mutual funds and other end investors, thereby creating more risks. Some respondents commented that complexity reduces transparency, which can be misleading for intermediaries, investors and regulators in terms of risk allocation.
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This may allow “risks to accumulate unnoticed and unchecked” giving rise to the possibility that, “when hidden risks suddenly become apparent, market participants effectively panic”. Opacity may also spawn “fraud, misconduct, and other opportunistic behaviour”. Others suggested that the reliance of shadow banking on collateralised wholesale market funding may amplify economic and market cycles by facilitating leverage when asset prices are buoyant and margins and haircuts are low. This can trigger rapid and deep deleveraging when confidence is punctured by a shock, causing asset prices to fall and margins and haircuts to rise. Pro-cyclicality is made worse by the interconnectedness with the traditional banking sector, which creates negative feedback loops.

Question f - Do you agree with the need for stricter monitoring and regulation of shadow banking entities and activities?
The majority of stakeholders agreed with the need for stricter monitoring and regulation of the shadow banking system. However, in most cases it was linked to conditions, such as: - It should be based on the principle of "same business, same rules" and has to be coherent and based on the capacity and expertise of the system of supervision; - Any new regulatory framework should not penalise the "good" side of shadow banking; - Access to finance for SMEs should not be impeded;
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- The opinions of FSB, ESRB, IOSCO, Basel Committee, EIOPA, ESMA, EBA should be taken into account; - It should be based on solid analysis of the real needs and the impacts; - Regulation needs to be targeted and proportionate; - Regulatory action needs to be coordinated on global level; and - The impact of on-going regulatory initiatives should be taken into account, e.g. in the area of European investment funds. In addition to stricter regulation it was mentioned that more detailed disclosure requirements and enhanced monitoring systems could be seen as a first step for improving the understanding of the shadow banking sector. Thus, there is no need to exclusively focus on regulation. It was suggested that a monitoring process should be put in place, including mapping, identification and detailed analysis of aspects posing systemic risk and room for regulatory arbitrage. Many respondents stressed that the EU should not miss this opportunity to demonstrate leadership and set the global agenda for future shadow banking regulation. An EU-wide shadowing banking data gap analysis should be commissioned to complete the work already started by the ECB and should include the input of EU practitioners, if possible. The European Commission should create a shadow banking data management taskforce to aid in the development of potential target-operating models to meet shadow banking policy objectives, including cost-benefit analyses.

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Question g Do you agree with the suggestions regarding identification and monitoring of the relevant entities and their activities? Do you think that the EU needs permanent processes for the collection and exchange of information on identification and supervisory practices between all EU supervisors, the Commission, the ECB and other central banks?
There was support for an EU central database building on a joint effort by public authorities and the financial services industry. The proposed EU permanent processes for the collection and exchange of information should be centralised and coordinated to limit reporting burden. It was proposed to consider an exemption for entities whose activities do not exceed certain thresholds or are not of a shadow banking nature. The monitoring at national level and informal exchange of information between EU supervisors was regarded as sufficient by other respondents, who argued against an exchange of information at the global level. Other comments were more critical and suggested that identification and monitoring must be carried out on the basis of the systemic risks. They considered that the proposed approach in the Green Paper generally does not achieve this; an entity/activity specific approach is necessary. Some stakeholders proposed that the ESRB should be given a mandate to coordinate the regular monitoring of the shadow banking sector, in line with the step by step approach followed by the FSB. Furthermore, the role of the ESRB should be clarified.

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For the purposes of monitoring, data and information from various sources will be needed, both aggregate and entity-specific as well as covering all financial sector.

Question h - Do you agree with the general principles for the supervision of shadow banking set out above?
There was a large degree of support for the proposed principles (Green Paper, page 6). However, concerns were raised that further details would be required for their implementation, e.g. regarding what would be deemed to be the 'appropriate level' and 'proportionate', and how supervision will be 'integrated within the macro prudential framework'. Furthermore, some respondents referred to the consolidation rules under IFRS as an important element of supervising non-bank activities. The point was made that, in general, supervision should be carried out on European level in order to get a better understanding of existing credit intermediation chains. In contrast, some respondents preferred a more national approach. Others commented that it is important to develop a mechanism that allows for the measurement of the level of implementation and appropriateness of the suggested principles. Some respondents highlighted that, since the shadow banking system will continue to evolve, it is important that regulation can be adapted to new developments. Others stressed the need for regulation and principles to be deliverable and operational.

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In addition, new policy should only be adopted subject to EU wide consultation and cost benefit analysis. Some respondents expressed disagreement with the principles, unless a more extensive mapping of shadow banking with an indication of the corresponding level of risk for each activity and entity is undertaken. Furthermore a clearer definition of priorities and exemptions should be developed before the principles are applied.

Question I - Do you agree with the general principles for regulatory responses set out above?
Stakeholders broadly agreed with the general principles for regulatory responses (Green Paper, page 7), but expressed some preferences and nuances to the approach: Stakeholders suggested that shadow banking entities and activities that incur credit risk (even those that do not collect customer deposits) should be subject to similar solvency and liquidity requirements as credit institutions once their level of activity passes a certain threshold. However, the different stages of development in different countries should be recalled in this context. Others warned that the extension of existing banking regulation to shadow banking entities should be carefully considered, in order to determine whether the provisions suitable for the banking sector will have the same effect on the shadow banking sector. In addition there has to be clear distinction between banks and shadow banks, so that credit institutions are not subjected to double regulation. It was suggested by some respondents that a regulatory response should be appropriately calibrated, in order to carefully consider how market
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activities are performed; avoid unintended consequences; preserve the benefits of shadow banking; and, ensure a level playing field between the regulated banking and non-regulated financial sectors performing similar activities. Any regulatory proposal should comply with the policy recommendations developed by FSB, IOSCO or the Basel Committee. Stakeholders stressed that, in their view, the most effective approach would be to focus on the extension or revision of existing mechanisms. They argued that any new measures would suffer from static definitions and that indirect regulation might not sufficiently target shadow banking concerns. Aspects such as tax avoidance schemes should also be taken into account. An approach based on economic substance and activity, rather than on fixed and narrowly-defined entities, was regarded as more effective. Instruments for addressing the links between regulated entities/activities and the shadow banking sector were regarded as necessary. It was suggested that for this purpose a number of micro-prudential instruments could be used to address macro-prudential aims, for example: - Bank capital buffers; - Sectorial capital requirements, such as specific risk weights on intra-financial system exposures; - Large exposures and activity limits; - Funding concentration limits; and

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- Minimum and "through the cycle" margin and haircut requirements for secured lending and financing transactions. Some respondents were concerned that the supply of "safe assets" will have to increase in order to balance the effects of other regulatory reforms, such as the OTCD reform or the effects of the crisis, including deleveraging. With the current general shortage of safe assets, the shadow banking system can play a role to fill this vacuum. From a regulatory perspective regard should always be had to the source of safe assets and the way in which they are provided (such as whether there is a title transfer in which ownership changes hands). Other respondents suggested that the first priority should be to establish a complete overview of the interconnectedness between all entities and activities and the banking system and to have an understanding of the unintended consequences for access to finance for the real economy. They highlighted that there is no "one-size fits all" approach, underlining the importance of flexibility and adaptability of new regulation to developments in the sector. The need for detailed impact assessments was mentioned. Other principles mentioned included safe and efficient market structures; non-distortion of competition or interference in price-building mechanism; and financial innovation and scrutiny of unintended consequences. Some stakeholders stressed the need for more consistent enforcement and a clarification of the powers of the ESRB, as well as the need for a close coordination between macro and micro prudential authorities and conduct-of-business regulators to avoid policy confusion.

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Others raised the issue of follow up and therefore the need for periodic assessment and review of effectiveness due to the innovative nature of shadow banking.

Question j - What measures could be envisaged to ensure international consistency in the treatment of shadow banking and avoid global regulatory arbitrage?
This issue was regarded by almost all stakeholders as key, in order to avoid the creation of loopholes or incentives for regulatory arbitrage at the international level. Most respondents therefore argued for consistent regulatory guidelines across countries. In particular the FSB and IOSCO were mentioned as organisations which should ensure international coordination. For example the adoption of an internationally-consistent definition for shadow banking systems was regarded as a crucial element. It was suggested that the EU should comply with the FSB's recommendations as far as possible and it should establish an integrated framework for macro and micro prudential supervision alongside global information and data exchange framework at global level. A regular exchange and sharing of information and data between authorities could be achieved by the implementation of the Global Legal Entity Identifier (LEI). Certain respondents highlighted that the existing regulatory framework, i.e. Basel 2 and 2.5, already contain sufficient regulatory instruments that would allow for a stronger focus on international consistency. The important role of peer reviews was mentioned in this context.
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Others suggested that more harmonisation through the removal of materially-unjustified differences (e.g. in accounting and consolidation rules) should be achieved. They stressed that risks related to the shadow banking sector are currently heightened to a varying extent across the EU, not only due to differences in regulation but also because of differences in interpretation and enforcement. To this end, a greater use of regulations instead of directives in EU legislation and direct supervision at EU level were mentioned as appropriate measures. On the other hand, some stakeholders warned that full harmonisation and coordination at the international level may not be achievable due to the different structures of different markets, e.g. MMFs. Others were more cautious and warned that global harmonisation would be unrealistic at this stage. However, they were optimistic that reliance on the FSB framework and more extensive use of peer reviews (e.g. by the IMF FSAP and FSB) could be beneficial.

Question k - What are your views on the current measures already taken at the EU level to deal with shadow banking issues?
Stakeholders summarised measures already taken at EU level, in particular legislation in the area of AIFMD, MiFID, UCITS or CRAs. These were broadly welcomed and regarded as appropriate measures for addressing key concerns.

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However, some respondents expressed concerns regarding the cumulative impact of the measures and commented that the effect on particular areas of financial markets (e.g. the sustainability of securitisation market) is currently neglected. Thus, any additional regulation to address risks posed by shadow banks should not overlap with existing regulation. Furthermore, potential existing loopholes in current legislation should be identified. It was also mentioned that indirect regulation via the banking and insurance sectors is a crucial element of a regulatory response to shadow banking. However, enlarging the scope of existing regulation should be done carefully. Others stressed the need for further evaluation of "soft rules" (Level II) developed by ESMA. One conclusion might be to make them legally binding in order to improve consistent application. Some commentators asked for caution regarding new proposals, since they took the view that certain entities, e.g. MMFs and ETFs, are already sufficiently regulated in the EU. Concerns were also expressed regarding extending provisions of CRD IV to non-deposit taking financial companies.

Question l - Do you agree with the analysis of the issues currently covered by the five key areas where the Commission is further investigating options?

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Stakeholders broadly agreed with the five areas mentioned (Green Paper, pages 11-13), which largely reflect the five work streams set up by the FSB. Hence, most respondents stressed that the final outcome of the FSB work should be taken into account. The following specific comments were made:

(i) Banking regulation
Most respondents believe that CRD/CRR IV will improve the regulation of shadow banks and will provide powers to set capital and liquidity guidance via a macro-prudential tool-kit. As regards the links between the banking and unregulated sectors, consolidation policy can play a role in ensuring the "same business, same rules" principle. Financial reporting requirements according to IFRS and capital guidance under CRDII/III, if applied consistently, provide a good basis for managing risks arising from banks' interaction with the shadow banking sector.

(ii) Asset management regulation issues
Most of the comments were related to MMFs and ETFs. Regarding MMFs the risks highlighted by IOSCO (runs, contagion risk, and implicit guarantee of sponsors for return of capital, constant NAV funds, rating risk) were mentioned. Views regarding valuation (constant versus variable NAV) were mixed. Some respondents suggested that MMFs are not vulnerable to massive redemptions and should not be considered shadow banking entities/activities, with the exception of C-NAV MMFs.
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They considered that MMFs are not a source of significant maturity transformation within Europe and represent limited risk. Others took the opposite view and argued for a substantial revision of MMF regulation. Other comments included a proposal to exclude certain asset classes, such as raw materials, from UCITS since they would not provide added value to the society, Regarding ETFs the ESMA guidelines were considered to establish a harmonized framework on the quality of collateral; prohibited transaction for re-use of collateral; prevention of conflicts of interest; and liquidity of the fund, although there seemed to be a preference for making those rules binding.

(iii) Securities lending and re-purchase agreements
Most stakeholders agreed with the focus in this area and suggested that the issue of increased leverage should be addressed directly, rather than indirectly, through regulation of securities markets. Other respondents suggested introducing adequate measures to deal with liquidity mismatches, concentration and roll-over risks in collateralised funding markets. European supervisory bodies could be allowed to monitor an asset encumbrance ratio. Some suggested exploring the issue of "who owns what" in securities financing transactions and to consider different policy options to address existing risks notably by looking at accounting rules or the introduction of quantitative limits. One respondent expressed concerns regarding the potential confusion of "re-use" and "re-hypothecation" as synonyms when in fact there is an important difference regarding the transfer of titles (which is the case for repos, but not for re-hypothecation).
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A number of stakeholders was not in favour of minimum margin or haircut requirements and argued that mandatory haircuts applied to the securities lending market are likely to increase, rather than reduce, pro-cyclicality. One concern expressed was that if investment managers were not able to protect their investors by increasing haircuts (and a mandatory minimum haircut may in effect become a maximum), they may stop lending altogether to certain counterparties. Many commentators agreed with the idea of increased transparency and the setting up of trade repositories for repos. From a macro-economic perspective, regulatory measures should be horizontal and focus on collateral management.

(iv) Securitisation
Only a few stakeholders commented on this by stating that securitisation issues are already covered by existing regulation (CRDII/III/IV, Basel Trading Book review). A renewed assessment of a need for review should wait until the implementation is completed. Overall there was not a strong push for further regulation in this area.

(v) Other shadow banking entities
This area is still under consideration by the FSB (work stream 3). Most respondents therefore asked for further clarification and suggested waiting for the outcome of the FSB work.

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Based on initial results of the FSB work, mapping of entities, risks and regulation was regarded as the right approach, with a clear focus on activities and not entities. In addition to the five key areas, a number of respondents argued for improvements regarding the overall transparency of the shadow banking sector and in particular in the area of repos and securities lending transactions. The setting up of trade repositories was broadly supported, mainly because this could help tracking counterparty risk and potential conflicts of interest. However, this should ideally be pursued in parallel to harmonised reporting and accounting requirements.

Question m - Are there additional issues that should be covered? If so, which ones?
Although most consultation respondents welcomed the scope and range of questions raised by the Green Paper, some listed a number of additional issues, including: - The introduction of a mandatory clearing obligation (Tri Party-Repo), as well as an obligation to trade on regulated markets for standardized outside-group transactions; - A clear focus on contingent liabilities in general, including not only those from banks, but from all potential "guarantors" and not limited to MMF-related step-in liabilities. This is because the high level of indebtedness of sovereigns and moral hazard created by government guarantees is a risk factor; - Regulators should look more into interconnections between shadow banking and the insurance sector.
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The core principles of Solvency II regime should be consistent with CRD IV; - Some techniques (dark pools and HFT) do not relate directly to shadow banking but they should be more in the focus, subject to monitoring and regulation if needed; and - The Prime Collateralised Securities (PCS) initiative launched at EU level in the area of securitisation should be promoted. For example it could be assessed by EBA and recognised as eligible asset in the context of CRD IV.

Question n - What modifications to the current EU regulatory framework, if any, would be necessary properly to address the risks and issues outlined above?
Stakeholders provided a number of ideas regarding modifications to the current EU regulatory framework, including: - It should be investigated if and how current rules for bank liquidity could be extended to all non-regulated bank entities, including shadow banking entities; - More attention should be paid to naked short selling and investment in raw materials; - The own capital requirements and future liquidity requirements, foreseen under the CRR for credit institutions engaging in securities loans transactions, should also apply in cases of chain transaction when one or more intermediaries are not credit institutions; - There should be support for the development and use of effective macro prudential oversight to monitor risks emerging in the system as
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a whole and the targeted and proportionate use of macro prudential policy tools. - Instead of new regulation, the focus should be more on increased disclosure, transparency, data collection and monitoring systems; and - Existing and well-functioning regulation, e.g. UCITS, should remain unchanged. A number of respondents argued that there are good reasons for a reform of MMFs in the area of minimum liquidity, valuation techniques, and credit ratings. Others argued in the opposite direction, maintaining that the current regulation of MMFs appropriately addresses inherent risks.

Question o - What other measures, such as increased monitoring or non-binding measures should be considered?
Stakeholders suggested a number of other measures that should be considered: - A constant reassessment of risk mapping exercise should be conducted by relevant authorities; - The regulatory system needs to be suitably dynamic in order to address new regulatory issues related to the inventiveness of shadow banking sector; - Transparency of supervisory systems can be improved by the publication of core indicators, such as supervisory personnel per employee in the financial sector etc.; - While the "single rule book" is supported, a framework should be set up allowing macro-prudential authorities some "constrained
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discretion" (with safeguards) in setting higher standards to deal with financial stability risks in their jurisdiction arising from SB. In addition, subject to the safeguards, it is necessary to allow for a flexible and targeted application of macro-prudential instruments to sectors, entities and activities (including a process enabling new instruments to be activated swiftly when need arises to address specific systemic risks concerns); - More transparency is needed, e.g. a European trade repository for repos; and - A better exchange of data and information between supervisors and the creation of EU databases without duplication of data or overburden regulated intermediaries would be beneficial in order to reduce systemic risks.

2.2.2. General Overview of the Consultation
In order to develop a deeper understanding of the issues, the European Commission launched a Green Paper and consultation from 19 March to 15 June 2012. The key objective of the Green Paper was to consult stakeholders on shadow banking issues: definition, risks and benefits, the need for stricter monitoring and regulation, outstanding issues and possible next steps. The Commission received in total 140 contributions, of which 24 from Public Authorities, 47 from registered organisations and 64 from individual organisations. Five organisations asked for their submission to remain confidential. The largest number of responses was submitted from stakeholders in the UK, France, and Germany and from EU based firms or associations.
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In terms of professional background, the most submissions came by far from the financial sector, including financial institutions and associations. A considerable number of submissions came from the public sector, governments, national banks and regulators.

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2.2.3. List of participants
1. National Bank of Romania 2. AXA Investment Managers 3. ABI Associazione Bancaria Italiana 4. Confidentiality requested 5. Nomura International plc 6. CNMV Advisory Committee of the Spanish Securities Market Law 7. Markit Inc 8. EIOPA – European Insurance and Occupational Pensions Authority 9. HFSB – Hedge Fund Standards Board 10. MFA – Managed Funds Association 11. European Network of Credit Unions 12. VGF - Verband Geschlossene Fonds 13. EBG - European Banking Group 14. DIHK – Deutscher Industrie- und Handelskammertag e.V. 15. Rolls Royce plc
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16. LeaseEurope AISBL 17. CLLS - City of London Law Society 18. IFCR - International Centre for Financial Regulation 19. Confidentiality requested 20. ESBG - European Savings Bansk Group 21. BBA - British Bankers' Association 22. Dansk Aktionaerforening 23. Eurofinas AISBL 24. Genworth Inc 25. Finance Watch AISBL 26. EBF - European Banking Federation 27. Government of Poland 28. Central Bank of Ireland 29. VÖB - Bundesverband Öffentlicher Banken Deutschlands 30. VNO-NCW and MKB Netherlands 31. ASF Association Française des Societes Financieres 32. Tamar Joulia Paris and Casey Campbell 33. Trade Union Pro Finland 34. Clifford Chance 35. FLA - Finance and Leasing Association 36. Ministry of Finance Finland 37. VVD Group – Volkspartij voor Vrijheid en Democratie 38. TSI True Sale International GmbH 39. MBIA UK Insurance Limited 40. AFGI Association of Financial Guaranty Insurers 41. GCAE - Group Consultatif Actuariel European 42. ZIA - Zentraler Immobilien Ausschuss e.V. 43. Lithuanian Free Market Institute 44. Royal Ministry of Finance Norway 45. FMA – Financial Market Authority Austria 46. Groupe GTI – Gestion et Titrisation Internationales 47. BdB – Bundesverband Deutscher Banken 48. APB - Portuguese Banking Association 49. Tiberiu Tudor Salantiu 50. UniCredit Group 51. ABFA – Asset Based Finance Association
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52. Mazars 53. AMUNDI Asset Management 54. BBF - Belgian Association of Factoring Companies 55. Financial Services User Group 56. CGPME 57. Jersey Financial Services Commission 58. MEDEF – Mouvement des Entreprises de France 59. Sciteb 60. Deutscher Factoring Verband e.V. 61. NFU - Nordic Financial Unions 62. BAK - Bundesarbeitskammer Austria 63. Confidentiality requested 64. Ministry of Finance Czech Republic 65. af2i – association française des investisseurs institutionnels 66. ICMA - ERC European Repo Council 67. ESRB – European Systemic Risk Board 68. DSGV – German Savings Banks Association 69. FAAN – Factoring and asset-based financing Association Netherlands 70. Melanie L. Fein 71. CNB – Czech National Bank 72. UNI Europa 73. Government of the Netherlands 74. IFC Forum 75. GDV – Gesamtverband der Deutschen Versicherungswirtschaft e.V. 76. RBS Group plc 77. KEPKA – Consumer Protection Centre Greece 78. IMMFA – Institutional Money Market Funds Association 79. Allianz SE 80. HSBC Global Asset Management 81. LMA - The Loan Market Association 82. Veblen Institute for Economic Reforms 83. Chris Barnard, Actuary, Germany 84. Maria Niewiadoma, Poland 85. ICISA – International Credit Insurance & Surety Association 86. Jeroen Spaargaren
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87. ABI - Association of British Insurers 88. Banco de Portugal 89. CBI – Confederation of British Industry 90. ICI - Investment Company Institute 91. IIF – Institute of International Finance 92. German Authorities – Deutsche Bundesbank, Bundesministerium der Finanzen, BaFin 93. ALFI – association of the luxembourg fund industry 94. AIMA – Alternative Investment Management Association 95. UBS AG 96. ISLA – International Securities Lending Association 97. IMA – Investment Management Association 98. afg – association française de la gestion financière 99. NATIXIS Asset Management 100. EACH – European Association of CCP Clearing Houses 101. EuroFinuse – EuroInvestors – The European Federation of Financial Services Users 102. Ministry of Business and Growth Denmark 103. Confidentiality requested 104. OFPE – Observatoire des Fonds de Près a l'Economie 105. EFAMA – European Fund and Asset Management Association 106. BARCLAYS 107. BVI – Bundesverband Investment und Asset Management e.V. 108. IntesaSanpaolo 109. EACB – European Association of Co-operative Banks 110. IRSG - International Regulatory Strategy Group 111. PricewaterhouseCoopers International Ltd 112. Confidentiality requested 113. FBF - Fédération Bancaire Française 114. INVERCO - Spanish Assoc. of Collective Investment Schemes and Pension Funds 115. SOMO - Centre for Research on Multinational Corporations 116. ICI Global 117. Federated Investors Inc 118. ICMA - Asset Management and Investors Council 119. BNP Paribas
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120. HM Treasury United Kingdom 121. CFA Institute 122. ifia - Irish Funds Industry Association 123. State Street Corporation 124. afme - Association for Financial Markets in Europe 125. BlackRock 126. AFTE - Association Française des Trésoriers d'Entreprise 127. Italian Ministry of economy and finance and Italian supervisory Authorities 128. JWG 129. Fidelity Investments 130. Swedish Authorities 131. Insurance Europe AISBL 132. French Authorities 133. LSEG - London Stock Exchange Group 134. Government of Ireland 135. Bundesrat Germany 136. Swedish Parliament 137. EBA - European Banking Authority 138. ECB-European Central Bank - Eurosystem 139. BusinessEurope 140. ESMA- European Securities and Markets Authority

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Morten Bech, Todd Keister

On the liquidity coverage ratio and monetary policy implementation
(Important Parts) Basel III introduces the first global framework for bank liquidity regulation. As monetary policy typically involves targeting the interest rate on interbank loans of the most liquid asset – central bank reserves – it is important to understand how this new requirement will impact the efficacy of current operational frameworks. We extend a standard model of monetary policy implementation in a corridor system to include the new liquidity regulation. Based on this model, we find that the regulation does not impair central banks’ ability to implement monetary policy, but operational frameworks may need to adjust. In response to the recent global financial crisis, the Basel Committee on Bank Supervision (BCBS) published a new international regulatory framework, known as Basel III, in December 2010 (BCBS (2010)). In addition to strengthening the existing bank capital rules, Basel III introduces – for the first time – a global framework for liquidity regulation. A key part of the framework is the liquidity coverage ratio (LCR), which requires banks to hold a sufficient stock of highly liquid assets to survive a 30-day period of market stress.

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The LCR is scheduled to be implemented in January 2015. The new liquidity regulation is likely to impact the process through which central banks implement monetary policy. In many jurisdictions, this process involves setting a target for the interest rate at which banks lend central bank reserves to one another, typically overnight and on an unsecured basis. Because these reserves are part of banks’ portfolio of highly liquid assets, the regulations will potentially alter banks’ demand for reserves, changing the relationship between market conditions and the resulting interest rate. Central banks will need to take these changes into account when deciding on monetary policy operations. In this special feature, we study the interactions that may arise between liquidity regulation and monetary policy implementation. Our discussion is based on a standard economic model for analysing the process of implementing monetary policy, which we extend to incorporate a liquidity requirement in the form of an LCR. The key takeaway from our analysis is that, while the LCR will not impair central banks’ ability to implement monetary policy, the process whereby this is done may need to adjust. Once the LCR is in place, central banks will need to consider not only how the size of an open market operation affects interest rates, but also how the structure of the operation affects bank balance sheets. In certain circumstances, central banks may choose to adjust their operational frameworks to better fit the new environment.

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At a minimum, they will need to monitor developments that materially affect the LCR of the banking system – just as they have traditionally monitored other factors that affect reserve markets. We begin with a short primer on the LCR – including its definition and a brief discussion of how far the banking system currently is from meeting the regulatory threshold. We also touch on how both interbank and lending facility borrowings affect a bank’s LCR. We then present a simple version of the textbook model of monetary policy implementation, followed by an extended version that includes an LCR requirement. Finally, we discuss how different types of open market operations affect bank balance sheets and the LCR calculations before offering some concluding remarks.

A primer on the liquidity coverage ratio
As stated by the Group of Central Bank Governors and Heads of Supervision, “[t]he aim of the Liquidity Coverage Ratio is to ensure that banks, in normal times, have a sound funding structure and hold sufficient liquid assets such that central banks are asked to perform as lenders of last resort and not as lenders of first resort.” The LCR builds on traditional liquidity “coverage” methodologies used internally by banks to assess exposure to stress events. The LCR requires that a bank’s stock of unencumbered high-quality liquid assets (HQLA) be larger than the projected net cash outflows (NCOF) over a 30-day horizon under a stress scenario specified by supervisors:

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High-quality liquid assets include central bank reserves, debt securities issued (or guaranteed) by public authorities, and highly rated non-financial corporate bonds and covered bonds. Total expected cash outflows are calculated by multiplying the size of various types of liabilities and off-balance sheet commitments by the rates at which they are expected to run off or be drawn down in the stress scenario. For example, unsecured interbank loans are assumed to run off completely if they come due during the stress scenario, whereas deposits are assumed to run off by 5 or 10%, depending on the characteristics of the deposit. The denominator of the LCR is on a “net” basis, as contractual inflows can be deducted from outflows, subject to a cap. The impact of the new regulation will depend in part on how close banks are to the LCR threshold once the regulation is implemented. If most banks satisfy the LCR requirement by a comfortable margin, the regulation’s effect on their behavior – and hence on the process of monetary policy implementation – will be fairly minor. If, however, many banks fall short of the new standards, the impact is more likely to be significant. Insofar as meeting the LCR requirement is costly for banks, it is conceivable that some banks may not exceed the regulatory threshold by a considerable margin, which could allow the LCR to impact the implementation of monetary policy.
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However, before we can address this issue, we need to understand how interbank loans and borrowing from the central bank affect the calculation of the LCR.

Conclusions
The introduction of the liquidity coverage ratio will influence banks’ liquidity management procedures and, hence, their demand for funds in the interbank market. Central banks that conduct monetary policy by setting a target for the interest rate in this market will, therefore, need to take this change into account. In this feature, we analyse how the introduction of an LCR affects the process of monetary policy implementation in the context of a simple, well known model of banks’ reserve management. This analysis points to three basic conclusions. First, the LCR will not impair the ability of central banks to implement monetary policy, but the process by which they do so may change. Second, correctly anticipating an open market operation’s effect on interest rates will require central banks to consider not only the size of the operation, but also the way the operation is structured and how it impacts on bank balance sheets. Finally, the LCR may increase the steepness of the very short end of the yield curve by introducing an additional premium for interbank loans that extend beyond 30 days.

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Sovereign risk – a world without risk-free assets
Panel comments by Mr Patrick Honohan, Governor of the Central Bank of Ireland, at the BIS Conference on “Sovereign risk – a world without risk-free assets”, Basel, 8 January 2013. What’s new about sovereign risk since the crisis began? Conceptually, not so much, I would suggest – and nothing that cannot be fully explained within standard models of finance. But in practice, and in particular in the euro area, two linked elements that were always potentially present or implicit have leapt into prominence in a way and to an extent that was not foreseen. The first is that markets have begun to price default risk in a sovereign’s home-currency; The second is the contamination of the functioning and economic effectiveness of banks by the weak credit rating of their sovereigns (as well as vice versa). I have to admit to the possibility that my remarks may be subject to some professional deformation here, in that my perspective on these matters is likely coloured by my pre-occupation with the situation in Ireland. Ireland has certainly displayed these two elements in a dramatic way, but they are evidently present in half a dozen other euro area countries also and to an extent which has had implications for the functioning of the Eurosystem as a whole, and therefore on the global financial system. Let me take these two points in turn.
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First the pricing-in of sovereign default risk in “home currency”.

Why did the default premium suddenly emerge?
Evidently, even though everyone understood the rules, no such pricing-in occurred for the first decade of the Eurosystem (Figure 1). Risk appetite was high for much of that period, but the market’s perception of sovereign risk must also have remained low. (Perhaps, despite Treaty prohibitions, market participants assumed that any sovereign that got into trouble would be bailed-out). Indeed, sovereign spreads in the euro area were almost totally insensitive to credit ratings before the crisis (Figure 2). One often-heard interpretation of what happened during that decade is that the complacent market environment relaxed the budget constraint on euro-area sovereigns and led them to borrow recklessly. Actually this story doesn’t fit the facts very well. After all, although sovereign debt ratios in most of the Eurosystem did not fall as much as they could and should have on the good years, at least they did not increase dramatically before the crisis (Figure 4). (Private debt ratios, and in particular the size of the bank and near-bank systems did increase, but that is a somewhat different story, to which I will turn shortly). It’s possible alternatively that there was a multiple equilibrium here, with the “good” or low interest equilibrium (with a self-fulfilling degree of confidence in the creditworthiness of all the sovereigns) being selected by the market at the start of the euro, and events during the financial crisis – not least those associated with Greece – having tripped the system into the “bad” or high interest equilibrium with default risk premia moving a
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number of sovereigns into a more challenging debt sustainability position. Most likely, what we have seen is a combination of factors: (i) a sharp reduction in risk appetite resulting in even little-changed debt ratios, as in Italy, looking more challenging and in need of a risk-premium; and in addition (for most countries) (ii) a sharp increase in debt ratios as governments reacted to the crisis (including, but not at all confined to, the socialisation in most countries of some private banking losses through their assumption by governments) (Figure 4 again). The increased sensitivity of sovereign spreads to ratings, and the increased range of ratings themselves – both illustrated in Figure 2 – suggest that both factors are at work. (As spreads widened in stressed countries, their fluctuations – which would not concern hold-to-maturity investors – added a risk factor for others and probably ratcheted up the average level of the spreads.) In the specific case of Ireland, the depth of the recession and the remarkably high elasticity of tax revenues and the Government deficit to the downturn, combined with the unfortunate decision to lock-in a very comprehensive bank guarantee before the potential scale of the banking losses could at all be appreciated, meant that Ireland’s actual and prospective general government debt made a shocking turnaround from about 25 per cent of GDP in 2007 to 117 per cent just five years later. Historians will debate the exact triggers for the market’s loss of confidence in the Irish sovereign. Even as late as April 2010, after the first sampling indicated the scale of the banking losses, sovereign spreads were little more than 1 per cent.

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By November of that year (just a few weeks after the Deauville statement which persuaded the markets that private sector holders of euro sovereign debt would not be immune from loss-sharing) large banking outflows and spreads exceeding five per cent made recourse to official assistance inevitable. (Figure 3 shows the plot with some relevant news stories flagged). Perhaps the most significant take-away from the sequence of spikes and troughs is the fact that some of them clearly relate to news that is country-specific, some of them to euro area general news. The same is doubtless true for all of the stressed sovereigns.

Default risk vs. devaluation risk vs. redenomination risk
It’s worth pausing to recall that raw sovereign spreads such as we are seeing today in the euro area are not remotely unprecedented in pre-euro history. On the contrary, they were the norm as is illustrated by Figure 1. The difference is that these spreads reflected a combination of default risk and currency risk. During the last fiscal crisis of the 1980s Irish sovereign spreads ballooned out also. But that was for local currency denominated debt. Eurobond borrowing by the Irish Government remained at fairly tight spreads despite the high overall debt ratio (higher than today), and the fact that almost half of the national debt was denominated in foreign currency. The high spreads reflected devaluation expectations and currency risk generally.
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And there were devaluations, though less than was baked into the spreads – by between 250 and 300 basis points on average during the last ten years of that ill-fated regime, the narrow-band EMS. It is not that default and devaluation are close substitutes; not at all, and for several reasons. For one thing, default has potential reputational consequences for the issuer qualitatively different to those of devaluation. In addition, though, devaluation affects not only the international value of the Government’s debt promises, but also that of all other contracts denominated in local currency; as a result, depending on the speed of price-resetting (pass-through) it can affect competitiveness throughout the economy. These differences have not been sufficiently emphasised, I feel, in recent discussion. As an example, I could mention the Irish devaluation of August 1986. The main goal of this important action was restoration of wage competitiveness, not a lowering of the real value of the local currency-denominated debt. (Indeed, I recall that some domestic policymakers were confused on this point and thought that the debt burden would actually increase as a result of translation effect on the foreign currency debt!) Such currency risk can be so extreme as to make it impossible for the sovereign to issue any sizable amount of local-currency denominated debt to international lenders. In the literature, such countries – all in the developing world (and not including Ireland, cf. Figure 5) – were said to suffer from “Original Sin”.

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Happily, the number of countries suffering “Original Sin” has been diminishing in recent years. Instead, we have to acknowledge the emergence in market pricing of a new phenomenon, “redenomination risk”. How can we recognise redenomination risk? This is not straightforward, not least because the term could refer to a number of different scenarios. One suggested way of approaching the question is to use econometric estimates of the cross-sectional determinants of sovereign spreads for foreign currency-denominated borrowing to predict current spreads in stressed euro area countries: a positive residual might suggest a redenomination risk premium. Comparisons of current spreads of euro area sovereigns in euro and in foreign currency-denominated borrowings provides for an alternative approach. My own favourite approach is to look at the co-movement in the time series of euro area country spreads. Some of this co-movement can be attributed to fluctuations in market risk-appetite; the remainder could be interpreted as a system-wide redenomination premium. This brief summary already suggests the complexity and ambiguity of some of the concepts involved and their measurement. Evidently, redenomination risk, as imagined by market commentators, combines default and currency risk in a novel way not contemplated by the Treaty that established the euro area.

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The ECB has made clear its determination to do what is necessary to preserve the euro and remove unfounded euro break-up premia in sovereign yields. The OMT, designed as a backstop to inhibit negative self-fulfilling market dynamics, provides the necessary tools to deliver on that commitment. The programme does not go overboard in the direction of removing the incentive for governments to manage their finances in such a way as to recover and retain the confidence of the market, but it will ensure that disciplined governments will not have to pay spreads that could only reflect market concerns about a system break-up. As announced, the ECB will only buy bonds at the shorter end of the maturity spectrum, but the OMT can be expected to have an influence transmitted by market forces throughout the yield curve, and indeed spreads have tightened right across all maturities since the OMT was announced. Still, it is not to be expected that the OMT will by itself restore the tight uniformity of spreads that prevailed for the first decade of the euro. Forcing such a tight uniformity would not be generally considered safe absent more reliable alternative mechanisms for ensuring disciplined fiscal policy in the countries concerned. More likely would be a potentially extended period of sovereign spreads that, albeit narrower than at their worst, remain material.

Sovereign spreads and the banks
That being so, we need to ask what are the consequences of these spreads for the rest of the economy, and in particular for the operation of the banking system.
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Regardless of the condition of the balance sheet and the profit and loss account of the banks, experience shows how hard it is for banks in a jurisdiction where the sovereign is under stress to access the money markets on the finest terms. In essence, the market fears that a stressed sovereign could in extremis reach to the banks as a source of last resort financing – if necessary using national legislation to do so. From such a perspective, providers of funds to banks will tend to price-in the possibility that, at the margin, they could end up as indirect providers of funds to a stressed sovereign. There are many examples in history of this happening, and the consequences for bank funding costs have often been severe. In other words, while we have all become sensitised to the pressure which socialized banking losses can place on the sovereign, markets are also acutely aware of the potential damaging links in the other direction. Either way, there are consequences for the funding costs of both the sovereign and the banks. Given the scale of banking in the euro area, even a relatively small difference in funding costs can be consequential. Once again, the Irish situation dramatises what can happen when the two-way feedback loop between banks and sovereign causes a loss of access to risk-free rates. As is well known, the Irish banks have suffered severe loan losses in the aftermath of the bursting of the property price and construction bubble which they had so enthusiastically financed. Very sizable capital injections (about 50 per cent of GNP from the

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Irish Government alone – a sum which proved too great to be financed without the protection of an IMF programme) have ensured that the Irish banks more than satisfy regulatory requirements once again, but their future profitability is constrained by the emergence and likely persistence of the sovereign spreads, and the knock-on effect of the spreads on the banks’ funding costs. Euro-area risk-free rates are not now the most relevant indicator of the marginal cost of funds to the Irish banking sector. It is, of course, true that the Irish banks (like those in other stressed countries) have been drawing heavily on ECB refinancing facilities during the crisis, especially following the huge outflow of funds that occurred in early 2009 and again in the last few months of 2010. This access to refinancing has been vital to the continuing operation of the banking system, and it has come at the policy rate. (Let me mention as an aside a curious feature of the current monetary policy environment in the euro area. The two key ECB rates – the main refinancing operations rate and the deposit rate – are 75 basis points and zero, respectively. Access to both the refinancing and deposit facilities are both close to all-time highs. But in practice, the bulk of the refinancing is going to banks in the stressed countries, while the bulk of the deposits are placed by banks in non-stressed countries. To the extent that the stressed countries have tended to have weaker economic performance during the crisis, this pattern might be considered paradoxical. But it is of course a reflection and semi-automatic consequence of the
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fragmentation which has developed in the euro area. To be sure, the ECB policy rate is clearly below the marginal cost of funds in the stressed countries.) But access to ECB funds at the policy rate is limited by the availability of eligible collateral and the haircuts that are applied to such collateral (despite the relaxation of eligibility criteria). About 20 per cent of the total financing of the three going concern Irish controlled banks comes from this source at present (16 per cent of the balance sheet total). Competition for deposits therefore remains strong and rates high. It’s not just that higher bank funding costs will now be passed on to new borrowers, adding headwinds to the economic recovery, though that is certainly a factor. Indeed, the lower policy interest rates set by the ECB since the crisis began have only been partly transmitted to borrowers in Ireland and in the other stressed euro area countries (Figure 6). (As is seen by the results of a recursive regression exercise, the pass-through from policy rate to Irish residential mortgage SVR rates has halved since the start of the crisis – Figure 7.) Some of this can be rationalised as reflecting a higher credit risk-premium being charged by the banks, but some is also due to the higher marginal cost of funds. Worse still for the health of the banks, and their ability to contribute to the economic recovery, is the fact that they are still coping with the consequences of their marginal cost of funds having delinked so sizably from the ECB policy rate.

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These consequences arise because of the long-term mortgage contracts the banks made when they assumed that their marginal cost of funds would always remain close to the (risk-free) policy rate. Suffice it to say that a large block of residential mortgages was granted at interest rates which track the ECB policy rate plus a very low spread. These tracker mortgages, many of which have an average remaining maturity of 15–20 years or more, yield less than the marginal cost of funds (Figure 8 which is drawn on the assumption, not strictly valid, that the average spread of the trackers over policy rate was unchanged over time). In effect, by assuming that their cost of funds would not deviate much from the ECB policy rate, the banks exposed themselves to a very large “basis risk”. In principle, they could escape this trap if there were a willing purchaser (public or private) with access to funding at a cost that is not contaminated by the sovereign stress. Until such a purchaser comes forward, the banks will have to continue to fund this portfolio at a loss, even on performing mortgages, whose effects will spill over onto their customers and their owners (not least the State).

Conclusion
Irish Sovereign spreads may no longer be bloated by redenomination risk, but at 300 basis points at the long-end, they do seem to reflect a credit risk premium that is poor reward, so far, for what has been a sizable fiscal adjustment effort. Reflecting on where we have got to, it seems that there are distinct parallels with the fiscal crisis of the EMS period.

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As I mentioned, spreads (then reflecting devaluation risk) exceeded what would have been needed ex post to compensate for actual exchange rate movements by almost the same amount (250–300 basis points). Those spreads were transmitted to the banking system then also. The Irish financial situation is relatively extreme, and as such illustrates clearly some of the key problems that have been faced also in other stressed parts of the euro area. While it has delivered a much lower inflation rate, the euro is no longer insulating financial markets from the impact of excessive debt in member countries. The early insulation of the monetary transmission mechanism from fiscal problems of participating countries has worn through. The pernicious feedback loop from banks to sovereign and from sovereign to banks that re-emerged in the crisis remains strong and damaging. Getting back to the “good” equilibrium will require a healing process which removes the market’s fear of default. It is inevitably a protracted process needing not only firm adherence to consistently disciplined policies but also the creation of institutions that can prevent future crises, or at least cope with them better if they cannot be avoided.

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Principles for effective risk data aggregation and risk reporting
January 2013 The financial crisis that began in 2007 revealed that many banks, including global systemically important banks (G-SIBs), were unable to aggregate risk exposures and identify concentrations fully, quickly and accurately. This meant that banks' ability to take risk decisions in a timely fashion was seriously impaired with wide-ranging consequences for the banks themselves and for the stability of the financial system as a whole. The Basel Committee's Principles for effective risk data aggregation will strengthen banks' risk data aggregation capabilities and internal risk reporting practices. Implementation of the principles will strengthen risk management at banks - in particular, G-SIBs - thereby enhancing their ability to cope with stress and crisis situations. An earlier version of the principles published today was issued for consultation in June 2012. The Committee wishes to thank those who provided feedback and comments as these were instrumental in revising and finalising the principles.

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Principles for effective risk data aggregation and risk reporting
Where is the wisdom we have lost in knowledge? Where is the knowledge we have lost in information? T. S. Eliot. The Rock (1934)

Introduction
1. One of the most significant lessons learned from the global financial crisis that began in 2007 was that banks’ information technology (IT) and data architectures were inadequate to support the broad management of financial risks. Many banks lacked the ability to aggregate risk exposures and identify concentrations quickly and accurately at the bank group level, across business lines and between legal entities. Some banks were unable to manage their risks properly because of weak risk data aggregation capabilities and risk reporting practices. This had severe consequences to the banks themselves and to the stability of the financial system as a whole. 2. In response, the Basel Committee issued supplemental Pillar 2 (supervisory review process) guidance to enhance banks’ ability to identify and manage bank-wide risks. In particular, the Committee emphasised that a sound risk management system should have appropriate management information systems (MIS) at the business and bank-wide level. The Basel Committee also included references to data aggregation as part of its guidance on corporate governance.

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3. Improving banks’ ability to aggregate risk data will improve their resolvability. For global systemically important banks (G-SIBs) in particular, it is essential that resolution authorities have access to aggregate risk data that complies with the FSB’s Key Attributes of Effective Resolution Regimes for Financial Institutions as well as the principles set out below. For recovery, a robust data framework will help banks and supervisors anticipate problems ahead. It will also improve the prospects of finding alternative options to restore financial strength and viability when the firm comes under severe stress. For example, it could improve the prospects of finding a suitable merger partner. 4. Many in the banking industry recognise the benefits of improving their risk data aggregation capabilities and are working towards this goal. They see the improvements in terms of strengthening the capability and the status of the risk function to make judgements. This leads to gains in efficiency, reduced probability of losses and enhanced strategic decision-making, and ultimately increased profitability. 5. Supervisors observe that making improvements in risk data aggregation capabilities and risk reporting practices remains a challenge for banks, and supervisors would like to see more progress, in particular, at G-SIBs. Moreover, as the memories of the crisis fade over time, there is a danger that the enhancement of banks’ capabilities in these areas may receive a slower-track treatment.

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This is because IT systems, data and reporting processes require significant investments of financial and human resources with benefits that may only be realised over the long-term. 6. The Financial Stability Board (FSB) has several international initiatives underway to ensure continued progress is made in strengthening firms’ risk data aggregation capabilities and risk reporting practices, which is essential to support financial stability. These include: • The development of the Principles for effective risk data aggregation and risk reporting included in this report. This work stems from a recommendation in the FSB’s Progress report on implementing the recommendations on enhanced supervision, issued on 4 November 2011: “The FSB, in collaboration with the standard setters, will develop a set of supervisory expectations to move firms’, particularly SIFIs, data aggregation capabilities to a level where supervisors, firms, and other users (eg resolution authorities) of the data are confident that the MIS reports accurately capture the risks. A timeline should be set for all SIFIs to meet supervisory expectations; the deadline for G-SIBs to meet these expectations should be the beginning of 2016, which is the date when the added loss absorbency requirement begins to be phased in for G-SIBs.” • The development of a new common data template for global systemically important financial institutions (G-SIFIs) in order to address key information gaps identified during the crisis, such as bi-lateral exposures and exposures to countries/sectors/instruments.

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This should provide the authorities with a stronger framework for assessing potential systemic risks. • A public-private sector initiative to develop a Legal Entity Identifier (LEI) system. The LEI system will identify unique parties to financial transactions across the globe and is designed to be a key building block for improvements in the quality of financial data across the globe. 7. There are also other initiatives and requirements relating to data that will have to be implemented in the following years. The Committee considers that upgraded risk data aggregation and risk reporting practices will allow banks to comply effectively with those initiatives.

Definition
8. For the purpose of this paper, the term “risk data aggregation” means defining, gathering and processing risk data according to the bank’s risk reporting requirements to enable the bank to measure its performance against its risk tolerance/appetite. This includes sorting, merging or breaking down sets of data.

Objectives
9. This paper presents a set of principles to strengthen banks’ risk data aggregation capabilities and internal risk reporting practices (the Principles). In turn, effective implementation of the Principles is expected to enhance risk management and decision-making processes at banks.

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10. The adoption of these Principles will enable fundamental improvements to the management of banks. The Principles are expected to support a bank’s efforts to: • Enhance the infrastructure for reporting key information, particularly that used by the board and senior management to identify, monitor and manage risks; • Improve the decision-making process throughout the banking organisation; • Enhance the management of information across legal entities, while facilitating a comprehensive assessment of risk exposures at the global consolidated level; • Reduce the probability and severity of losses resulting from risk management weaknesses; • Improve the speed at which information is available and hence decisions can be made; and • Improve the organisation’s quality of strategic planning and the ability to manage the risk of new products and services. 11. Strong risk management capabilities are an integral part of the franchise value of a bank. Effective implementation of the Principles should increase the value of the bank. The Committee believes that the long-term benefits of improved risk data aggregation capabilities and risk reporting practices will outweigh the investment costs incurred by banks.

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12. For bank supervisors, these Principles will complement other efforts to improve the intensity and effectiveness of bank supervision. For resolution authorities, improved risk data aggregation should enable smoother bank resolution, thereby reducing the potential recourse to taxpayers.

Scope and initial considerations
13. These Principles are initially addressed to SIBs and apply at both the banking group and on a solo basis. Common and clearly stated supervisory expectations regarding risk data aggregation and risk reporting are necessary for these institutions. National supervisors may nevertheless choose to apply the Principles to a wider range of banks, in a way that is proportionate to the size, nature and complexity of these banks’ operations. 14. Banks identified as G-SIBs by the FSB in November 2011 or November 2012 must meet these Principles by January 2016; G-SIBs designated in subsequent annual updates will need to meet the Principles within three years of their designation. G-SIBs subject to the 2016 timeline are expected to start making progress towards effectively implementing the Principles from early 2013. National supervisors and the Basel Committee will monitor and assess this progress in accordance with section V of this document. 15. It is strongly suggested that national supervisors also apply these Principles to banks identified as D-SIBs by their national supervisors three years after their designation as D-SIBs.

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16. The Principles and supervisory expectations contained in this paper apply to a bank’s risk management data. This includes data that is critical to enabling the bank to manage the risks it faces. Risk data and reports should provide management with the ability to monitor and track risks relative to the bank’s risk tolerance/appetite. 17. These Principles also apply to all key internal risk management models, including but not limited to, Pillar 1 regulatory capital models (eg internal ratings-based approaches for credit risk and advanced measurement approaches for operational risk), Pillar 2 capital models and other key risk management models (eg value-at-risk). 18. The Principles apply to a bank’s group risk management processes. However, banks may also benefit from applying the Principles to other processes, such as financial and operational processes, as well as supervisory reporting. 19. All the Principles included in this paper are also applicable to processes that have been outsourced to third parties. 20. The Principles cover four closely related topics: • Overarching governance and infrastructure • Risk data aggregation capabilities • Risk reporting practices • Supervisory review, tools and cooperation

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21. Risk data aggregation capabilities and risk reporting practices are considered separately in this paper, but they are clearly inter-linked and cannot exist in isolation. High quality risk management reports rely on the existence of strong risk data aggregation capabilities, and sound infrastructure and governance ensures the information flow from one to the other. 22. Banks should meet all risk data aggregation and risk reporting principles simultaneously. However, trade-offs among Principles could be accepted in exceptional circumstances such as urgent/ad hoc requests of information on new or unknown areas of risk. There should be no trade-offs that materially impact risk management decisions. Decision-makers at banks, in particular the board and senior management, should be aware of these trade-offs and the limitations or shortcomings associated with them. Supervisors expect banks to have policies and processes in place regarding the application of trade-offs. Banks should be able to explain the impact of these trade-offs on their decision- making process through qualitative reports and, to the extent possible, quantitative measures. 23. The concept of materiality used in this paper means that data and reports can exceptionally exclude information only if it does not affect the decision-making process in a bank (ie decision-makers, in particular the board and senior management, would have been influenced by the omitted information or made a different judgment if the correct information had been known).

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In applying the materiality concept, banks will take into account considerations that go beyond the number or size of the exposures not included, such as the type of risks involved, or the evolving and dynamic nature of the banking business. Banks should also take into account the potential future impact of the information excluded on the decision-making process at their institutions. Supervisors expect banks to be able to explain the omissions of information as a result of applying the materiality concept. 24. Banks should develop forward looking reporting capabilities to provide early warnings of any potential breaches of risk limits that may exceed the bank’s risk tolerance/appetite. These risk reporting capabilities should also allow banks to conduct a flexible and effective stress testing which is capable of providing forward-looking risk assessments. Supervisors expect risk management reports to enable banks to anticipate problems and provide a forward looking assessment of risk. 25. Expert judgment may occasionally be applied to incomplete data to facilitate the aggregation process, as well as the interpretation of results within the risk reporting process. Reliance on expert judgment in place of complete and accurate data should occur only on an exception basis, and should not materially impact the bank’s compliance with the Principles. When expert judgment is applied, supervisors expect that the process be clearly documented and transparent so as to allow for an independent review of the process followed and the criteria used in the decision-making process.

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I. Overarching governance and infrastructure
26. A bank should have in place a strong governance framework, risk data architecture and IT infrastructure. These are preconditions to ensure compliance with the other Principles included in this document. In particular, a bank’s board should oversee senior management’s ownership of implementing all the risk data aggregation and risk reporting principles and the strategy to meet them within a timeframe agreed with their supervisors.

Principle 1
Governance – A bank’s risk data aggregation capabilities and risk reporting practices should be subject to strong governance arrangements consistent with other principles and guidance established by the Basel Committee. 27. A bank’s board and senior management should promote the identification, assessment and management of data quality risks as part of its overall risk management framework. The framework should include agreed service level standards for both outsourced and in-house risk data-related processes, and a firm’s policies on data confidentiality, integrity and availability, as well as risk management policies. 28. A bank’s board and senior management should review and approve the bank’s group risk data aggregation and risk reporting framework and ensure that adequate resources are deployed. 29. A bank’s risk data aggregation capabilities and risk reporting practices should be:
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(a) Fully documented and subject to high standards of validation. This validation should be independent and review the bank’s compliance with the Principles in this document. The primary purpose of the independent validation is to ensure that a bank's risk data aggregation and reporting processes are functioning as intended and are appropriate for the bank's risk profile. Independent validation activities should be aligned and integrated with the other independent review activities within the bank's risk management program, and encompass all components of the bank's risk data aggregation and reporting processes. Common practices suggest that the independent validation of risk data aggregation and risk reporting practices should be conducted using staff with specific IT, data and reporting expertise. (b) Considered as part of any new initiatives, including acquisitions and/or divestitures, new product development, as well as broader process and IT change initiatives. When considering a material acquisition, a bank’s due diligence process should assess the risk data aggregation capabilities and risk reporting practices of the acquired entity, as well as the impact on its own risk data aggregation capabilities and risk reporting practices. The impact on risk data aggregation should be considered explicitly by the board and inform the decision to proceed. The bank should establish a timeframe to integrate and align the acquired risk data aggregation capabilities and risk reporting practices within its own framework. (c) Unaffected by the bank’s group structure.
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The group structure should not hinder risk data aggregation capabilities at a consolidated level or at any relevant level within the organisation (eg sub-consolidated level, jurisdiction of operation level). In particular, risk data aggregation capabilities should be independent from the choices a bank makes regarding its legal organisation and geographical presence. 30. A bank’s senior management should be fully aware of and understand the limitations that prevent full risk data aggregation, in terms of coverage (eg risks not captured or subsidiaries not included), in technical terms (eg model performance indicators or degree of reliance on manual processes) or in legal terms (legal impediments to data sharing across jurisdictions). Senior management should ensure that the bank’s IT strategy includes ways to improve risk data aggregation capabilities and risk reporting practices and to remedy any shortcomings against the Principles set forth in this document taking into account the evolving needs of the business. Senior management should also identify data critical to risk data aggregation and IT infrastructure initiatives through its strategic IT planning process, and support these initiatives through the allocation of appropriate levels of financial and human resources. 31. A bank’s board is responsible for determining its own risk reporting requirements and should be aware of limitations that prevent full risk data aggregation in the reports it receives. The board should also be aware of the bank’s implementation of, and ongoing compliance with the Principles set out in this document.

Principle 2
Data architecture and IT infrastructure – A bank should design, build and maintain data architecture and IT infrastructure which fully supports its
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risk data aggregation capabilities and risk reporting practices not only in normal times but also during times of stress or crisis, while still meeting the other Principles. 32. Risk data aggregation capabilities and risk reporting practices should be given direct consideration as part of a bank’s business continuity planning processes and be subject to a business impact analysis. 33. A bank should establish integrated data taxonomies and architecture across the banking group, which includes information on the characteristics of the data (metadata), as well as use of single identifiers and/or unified naming conventions for data including legal entities, counterparties, customers and accounts. 34. Roles and responsibilities should be established as they relate to the ownership and quality of risk data and information for both the business and IT functions. The owners (business and IT functions), in partnership with risk managers, should ensure there are adequate controls throughout the lifecycle of the data and for all aspects of the technology infrastructure. The role of the business owner includes ensuring data is correctly entered by the relevant front office unit, kept current and aligned with the data definitions, and also ensuring that risk data aggregation capabilities and risk reporting practices are consistent with firms’ policies.

II. Risk data aggregation capabilities
35. Banks should develop and maintain strong risk data aggregation capabilities to ensure that risk management reports reflect the risks in a reliable way (ie meeting data aggregation expectations is necessary to meet reporting expectations). Compliance with these Principles should not be at the expense of each other.
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These risk data aggregation capabilities should meet all Principles below simultaneously in accordance with paragraph 22 of this document.

Principle 3
Accuracy and Integrity – A bank should be able to generate accurate and reliable risk data to meet normal and stress/crisis reporting accuracy requirements. Data should be aggregated on a largely automated basis so as to minimise the probability of errors. 36. A bank should aggregate risk data in a way that is accurate and reliable. (a) Controls surrounding risk data should be as robust as those applicable to accounting data. (b) Where a bank relies on manual processes and desktop applications (eg spreadsheets, databases) and has specific risk units that use these applications for software development, it should have effective mitigants in place (eg end-user computing policies and procedures) and other effective controls that are consistently applied across the bank’s processes. (c) Risk data should be reconciled with bank’s sources, including accounting data where appropriate, to ensure that the risk data is accurate. (d) A bank should strive towards a single authoritative source for risk data per each type of risk. (e) A bank’s risk personnel should have sufficient access to risk data to ensure they can appropriately aggregate, validate and reconcile the data to risk reports.
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37. As a precondition, a bank should have a “dictionary” of the concepts used, such that data is defined consistently across an organisation. 38. There should be an appropriate balance between automated and manual systems. Where professional judgements are required, human intervention may be appropriate. For many other processes, a higher degree of automation is desirable to reduce the risk of errors. 39. Supervisors expect banks to document and explain all of their risk data aggregation processes whether automated or manual (judgement based or otherwise). Documentation should include an explanation of the appropriateness of any manual workarounds, a description of their criticality to the accuracy of risk data aggregation and proposed actions to reduce the impact. 40. Supervisors expect banks to measure and monitor the accuracy of data and to develop appropriate escalation channels and action plans to be in place to rectify poor data quality.

Principle 4
Completeness – A bank should be able to capture and aggregate all material risk data across the banking group. Data should be available by business line, legal entity, asset type, industry, region and other groupings, as relevant for the risk in question, that permit identifying and reporting risk exposures, concentrations and emerging risks.

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41. A bank’s risk data aggregation capabilities should include all material risk exposures, including those that are off-balance sheet. 42. A banking organisation is not required to express all forms of risk in a common metric or basis, but risk data aggregation capabilities should be the same regardless of the choice of risk aggregation systems implemented. However, each system should make clear the specific approach used to aggregate exposures for any given risk measure, in order to allow the board and senior management to assess the results properly. 43. Supervisors expect banks to produce aggregated risk data that is complete and to measure and monitor the completeness of their risk data. Where risk data is not entirely complete, the impact should not be critical to the bank’s ability to manage its risks effectively. Supervisors expect banks’ data to be materially complete, with any exceptions identified and explained.

Principle 5
Timeliness – A bank should be able to generate aggregate and up-to-date risk data in a timely manner while also meeting the principles relating to accuracy and integrity, completeness and adaptability. The precise timing will depend upon the nature and potential volatility of the risk being measured as well as its criticality to the overall risk profile of the bank. The precise timing will also depend on the bank-specific frequency requirements for risk management reporting, under both normal and stress/crisis situations, set based on the characteristics and overall risk profile of the bank.
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44. A bank’s risk data aggregation capabilities should ensure that it is able to produce aggregate risk information on a timely basis to meet all risk management reporting requirements. 45. The Basel Committee acknowledges that different types of data will be required at different speeds, depending on the type of risk, and that certain risk data may be needed faster in a stress/crisis situation. Banks need to build their risk systems to be capable of producing aggregated risk data rapidly during times of stress/crisis for all critical risks. 46. Critical risks include but are not limited to: (a) The aggregated credit exposure to a large corporate borrower. By comparison, groups of retail exposures may not change as critically in a short period of time but may still include significant concentrations; (b) Counterparty credit risk exposures, including, for example, derivatives; (c) Trading exposures, positions, operating limits, and market concentrations by sector and region data; (d) Liquidity risk indicators such as cash flows/settlements and funding; and (e) Operational risk indicators that are time-critical (eg systems availability, unauthorised access). 47. Supervisors will review that the bank specific frequency requirements, for both normal and stress/crisis situations, generate aggregate and up-to-date risk data in a timely manner.

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Principle 6
Adaptability – A bank should be able to generate aggregate risk data to meet a broad range of on-demand, ad hoc risk management reporting requests, including requests during stress/crisis situations, requests due to changing internal needs and requests to meet supervisory queries. 48. A bank’s risk data aggregation capabilities should be flexible and adaptable to meet ad hoc data requests, as needed, and to assess emerging risks. Adaptability will enable banks to conduct better risk management, including forecasting information, as well as to support stress testing and scenario analyses. 49. Adaptability includes: (a) Data aggregation processes that are flexible and enable risk data to be aggregated for assessment and quick decision-making; (b) Capabilities for data customisation to users’ needs (eg dashboards, key takeaways, anomalies), to drill down as needed, and to produce quick summary reports; (c) Capabilities to incorporate new developments on the organisation of the business and/or external factors that influence the bank’s risk profile; and (d) Capabilities to incorporate changes in the regulatory framework. 50. Supervisors expect banks to be able to generate subsets of data based on requested scenarios or resulting from economic events. For example, a bank should be able to aggregate risk data quickly on country credit exposures as of a specified date based on a list of countries,
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as well as industry credit exposures as of a specified date based on a list of industry types across all business lines and geographic areas.

III. Risk reporting practices
51. Accurate, complete and timely data is a foundation for effective risk management. However, data alone does not guarantee that the board and senior management will receive appropriate information to make effective decisions about risk. To manage risk effectively, the right information needs to be presented to the right people at the right time. Risk reports based on risk data should be accurate, clear and complete. They should contain the correct content and be presented to the appropriate decision-makers in a time that allows for an appropriate response. To effectively achieve their objectives, risk reports should comply with the following principles. Compliance with these principles should not be at the expense of each other in accordance with paragraph 22 of this document.

Principle 7
Accuracy - Risk management reports should accurately and precisely convey aggregated risk data and reflect risk in an exact manner. Reports should be reconciled and validated. 52. Risk management reports should be accurate and precise to ensure a bank’s board and senior management can rely with confidence on the aggregated information to make critical decisions about risk.
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53. To ensure the accuracy of the reports, a bank should maintain, at a minimum, the following: (a) Defined requirements and processes to reconcile reports to risk data; (b) Automated and manual edit and reasonableness checks, including an inventory of the validation rules that are applied to quantitative information. The inventory should include explanations of the conventions used to describe any mathematical or logical relationships that should be verified through these validations or checks; and (c) Integrated procedures for identifying, reporting and explaining data errors or weaknesses in data integrity via exceptions reports. 54. Approximations are an integral part of risk reporting and risk management. Results from models, scenario analyses, and stress testing are examples of approximations that provide critical information for managing risk. While the expectations for approximations may be different than for other types of risk reporting, banks should follow the reporting principles in this document and establish expectations for the reliability of approximations (accuracy, timeliness, etc) to ensure that management can rely with confidence on the information to make critical decisions about risk. This includes principles regarding data used to drive these approximations. 55. Supervisors expect that a bank’s senior management should establish accuracy and precision requirements for both regular and stress/crisis reporting, including critical position and exposure information.
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These requirements should reflect the criticality of decisions that will be based on this information. 56. Supervisors expect banks to consider accuracy requirements analogous to accounting materiality. For example, if omission or misstatement could influence the risk decisions of users, this may be considered material. A bank should be able to support the rationale for accuracy requirements. Supervisors expect a bank to consider precision requirements based on validation, testing or reconciliation processes and results.

Principle 8
Comprehensiveness - Risk management reports should cover all material risk areas within the organisation. The depth and scope of these reports should be consistent with the size and complexity of the bank’s operations and risk profile, as well as the requirements of the recipients. 57. Risk management reports should include exposure and position information for all significant risk areas (eg credit risk, market risk, liquidity risk, operational risk) and all significant components of those risk areas (eg single name, country and industry sector for credit risk). Risk management reports should also cover risk-related measures (eg regulatory and economic capital). 58. Reports should identify emerging risk concentrations, provide information in the context of limits and risk appetite/tolerance and propose recommendations for action where appropriate.
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Risk reports should include the current status of measures agreed by the board or senior management to reduce risk or deal with specific risk situations. This includes providing the ability to monitor emerging trends through forward-looking forecasts and stress tests. 59. Supervisors expect banks to determine risk reporting requirements that best suit their own business models and risk profiles. Supervisors will need to be satisfied with the choices a bank makes in terms of risk coverage, analysis and interpretation, scalability and comparability across group institutions. For example, an aggregated risk report should include, but not be limited to, the following information: capital adequacy, regulatory capital, capital and liquidity ratio projections, credit risk, market risk, operational risk, liquidity risk, stress testing results, inter- and intra-risk concentrations, and funding positions and plans. 60. Supervisors expect that risk management reports to the board and senior management provide a forward-looking assessment of risk and should not just rely on current and past data. The reports should contain forecasts or scenarios for key market variables and the effects on the bank so as to inform the board and senior management of the likely trajectory of the bank’s capital and risk profile in the future.

Principle 9
Clarity and usefulness - Risk management reports should communicate information in a clear and concise manner. Reports should be easy to understand yet comprehensive enough to facilitate informed decision-making.
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Reports should include meaningful information tailored to the needs of the recipients. 61. A bank’s risk reports should contribute to sound risk management and decision-making by their relevant recipients, including, in particular, the board and senior management. Risk reports should ensure that information is meaningful and tailored to the needs of the recipients. 62. Reports should include an appropriate balance between risk data, analysis and interpretation, and qualitative explanations. The balance of qualitative versus quantitative information will vary at different levels within the organisation and will also depend on the level of aggregation that is applied to the reports. Higher up in the organisation, more aggregation is expected and therefore a greater degree of qualitative interpretation will be necessary. 63. Reporting policies and procedures should recognise the differing information needs of the board, senior management, and the other levels of the organisation (for example risk committees). 64. As one of the key recipients of risk management reports, the bank’s board is responsible for determining its own risk reporting requirements and complying with its obligations to shareholders and other relevant stakeholders. The board should ensure that it is asking for and receiving relevant information that will allow it to fulfil its governance mandate relating to the bank and the risks to which it is exposed. This will allow the board to ensure it is operating within its risk tolerance/appetite.
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65. The board should alert senior management when risk reports do not meet its requirements and do not provide the right level and type of information to set and monitor adherence to the bank’s risk tolerance/appetite. The board should indicate whether it is receiving the right balance of detail and quantitative versus qualitative information. 66. Senior management is also a key recipient of risk reports and it is responsible for determining its own risk reporting requirements. Senior management should ensure that it is receiving relevant information that will allow it to fulfil its management mandate relative to the bank and the risks to which it is exposed. 67. A bank should develop an inventory and classification of risk data items which includes a reference to the concepts used to elaborate the reports. 68. Supervisors expect that reports will be clear and useful. Reports should reflect an appropriate balance between detailed data, qualitative discussion, explanation and recommended conclusions. Interpretation and explanations of the data, including observed trends, should be clear. 69. Supervisors expect a bank to confirm periodically with recipients that the information aggregated and reported is relevant and appropriate, in terms of both amount and quality, to the governance and decision-making process.

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Principle 10
Frequency – The board and senior management (or other recipients as appropriate) should set the frequency of risk management report production and distribution. Frequency requirements should reflect the needs of the recipients, the nature of the risk reported, and the speed, at which the risk can change, as well as the importance of reports in contributing to sound risk management and effective and efficient decision-making across the bank. The frequency of reports should be increased during times of stress/crisis. 70. The frequency of risk reports will vary according to the type of risk, purpose and recipients. A bank should assess periodically the purpose of each report and set requirements for how quickly the reports need to be produced in both normal and stress/crisis situations. A bank should routinely test its ability to produce accurate reports within established timeframes, particularly in stress/crisis situations. 71. Supervisors expect that in times of stress/crisis all relevant and critical credit, market and liquidity position/exposure reports are available within a very short period of time to react effectively to evolving risks. Some position/exposure information may be needed immediately (intraday) to allow for timely and effective reactions.

Principle 11
Distribution - Risk management reports should be distributed to the relevant parties while ensuring confidentiality is maintained.

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72. Procedures should be in place to allow for rapid collection and analysis of risk data and timely dissemination of reports to all appropriate recipients. This should be balanced with the need to ensure confidentiality as appropriate. 73. Supervisors expect a bank to confirm periodically that the relevant recipients receive timely reports.

IV. Supervisory review, tools and cooperation
74. Supervisors will have an important role to play in monitoring and providing incentives for a bank’s implementation of, and ongoing compliance with the Principles. They should also review compliance with the Principles across banks to determine whether the Principles themselves are achieving their desired outcome and whether further enhancements are required.

Principle 12
Review - Supervisors should periodically review and evaluate a bank’s compliance with the eleven Principles above. 75. Supervisors should review a bank’s compliance with the Principles in the preceding sections. Reviews should be incorporated into the regular programme of supervisory reviews and may be supplemented by thematic reviews covering multiple banks with respect to a single or selected issue. Supervisors may test a bank’s compliance with the Principles through occasional requests for information to be provided on selected risk issues (for example, exposures to certain risk factors) within short deadlines,
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thereby testing the capacity of a bank to aggregate risk data rapidly and produce risk reports. Supervisors should have access to the appropriate reports to be able to perform this review. 76. Supervisors should draw on reviews conducted by the internal or external auditors to inform their assessments of compliance with the Principles. Supervisors may require work to be carried out by a bank’s internal audit functions or by experts independent from the bank. Supervisors must have access to all appropriate documents such as internal validation and audit reports, and should be able to meet with and discuss risk data aggregation capabilities with the external auditors or independent experts from the bank, when appropriate. 77. Supervisors should test a bank’s capabilities to aggregate data and produce reports in both stress/crisis and steady-state environments, including sudden sharp increases in business volumes.

Principle 13
Remedial actions and supervisory measures - Supervisors should have and use the appropriate tools and resources to require effective and timely remedial action by a bank to address deficiencies in its risk data aggregation capabilities and risk reporting practices. Supervisors should have the ability to use a range of tools, including Pillar 2. 78. Supervisors should require effective and timely remedial action by a bank to address deficiencies in its risk data aggregation capabilities and risk reporting practices and internal controls.
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79. Supervisors should have a range of tools at their disposal to address material deficiencies in a bank’s risk data aggregation and reporting capabilities. Such tools may include, but are not limited to, requiring a bank to take remedial action; increasing the intensity of supervision; requiring an independent review by a third party, such as external auditors; and the possible use of capital add-ons as both a risk mitigant and incentive under Pillar 2. 80. Supervisors should be able to set limits on a bank’s risks or the growth in their activities where deficiencies in risk data aggregation and reporting are assessed as causing significant weaknesses in risk management capabilities. 81. For new business initiatives, supervisors may require that banks’ implementation plans ensure that robust risk data aggregation is possible before allowing a new business venture or acquisition to proceed. 82. When a supervisor requires a bank to take remedial action, the supervisor should set a timetable for completion of the action. Supervisors should have escalation procedures in place to require more stringent or accelerated remedial action in the event that a bank does not adequately address the deficiencies identified, or in the case that supervisors deem further action is warranted.

Principle 14
Home/host cooperation - Supervisors should cooperate with relevant supervisors in other jurisdictions regarding the supervision and review of the Principles, and the implementation of any remedial action if necessary. 83. Effective cooperation and appropriate information sharing between the home and host supervisory authorities should contribute to the
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robustness of a bank’s risk management practices across a bank’s operations in multiple jurisdictions. Wherever possible, supervisors should avoid performing redundant and uncoordinated reviews related to risk data aggregation and risk reporting. 84. Cooperation can take the form of sharing of information within the constraints of applicable laws, as well as discussion between supervisors on a bilateral or multilateral basis (eg through colleges of supervisors), including, but not limited to, regular meetings. Communication by conference call and email may be particularly useful in tracking required remedial actions. Cooperation through colleges should be in line with the Basel Committee’s Good practice principles on supervisory colleges. 85. Supervisors should discuss their experiences regarding the quality of risk data aggregation capabilities and risk reporting practices in different parts of the group. This should include any impediments to risk data aggregation and risk reporting arising from cross-border issues and also whether risk data is distributed appropriately across the group. Such exchanges will enable supervisors to identify significant concerns at an early stage and to respond promptly and effectively.

V. Implementation timeline and transitional arrangements
86. Supervisors expect that a bank’s data and IT infrastructures will be enhanced in the coming years to ensure that its risk data aggregation capabilities and risk reporting practices are sufficiently robust and flexible enough to address their potential needs in normal times and particularly during times of stress/crisis.
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87. National banking supervisors will start discussing implementation of the Principles with G-SIB’s senior management in early 2013. This will ensure that banks they develop a strategy to meet the Principles by 2016. 88. In order for G-SIBs to meet the Principles in accordance with the 2016 timeline, national banking supervisors will discuss banks’ analysis of risk data aggregation capabilities with their senior management and agree to timelines for required improvements. Supervisory approaches are likely to include requiring self-assessments by G-SIBs against these expectations in early 2013, with the goal of closing significant gaps before 2016. Supervisors may also engage technical experts to support their assessments of banks’ plans in respect of the 2016 deadline. 89. The Basel Committee will track G-SIBs progress towards complying with the Principles through its Standards Implementation Group (SIG) from 2013 onwards. This will include any observations on the effectiveness of the Principles themselves and whether any enhancements or other revisions of the Principles are necessary in order to achieve the desired outcomes. The Basel Committee will share its findings with the FSB at least annually starting from the end of 2013.

Annex 1 Terms used in the document Accuracy
Closeness of agreement between a measurement or record or representation and the value to be measured, recorded or represented. This definition applies to both risk data aggregation and risk reports.
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Adaptability

The ability of risk data aggregation capabilities to change (or be changed) in response to changed circumstances (internal or external).

Approximation Clarity

A result that is not necessarily exact, but acceptable for its given purpose. The ability of risk reporting to be easily understood and free from indistinctness or ambiguity.

Completeness

Availability of relevant risk data aggregated across all firm's constituent units (eg legal entities, business lines, jurisdictions, etc)

Comprehensiveness

Extent to which risk reports include or deal with all risks relevant to the firm.

Distribution

Ensuring that the adequate people or groups receive the appropriate risk reports.

Frequency Integrity

The rate at which risk reports are produced over time. Freedom of risk data from unauthorised alteration and unauthorised manipulation that compromise its accuracy, completeness and reliability.

Manual workarounds

Employing human-based processes and tools to transfer, manipulate or alter data used to be aggregated or reported.

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Precision

Closeness of agreement between indications or measured quantity values obtained by replicating measurements on the same or similar objects under specified conditions.

Reconciliation

The process of comparing items or outcomes and explaining the differences.

Risk tolerance/appetite

The level and type of risk a firm is able and willing to assume in its exposures and business activities, given its business and obligations to stakeholders. It is generally expressed through both quantitative and qualitative means.

Risk Data aggregation

Defining, gathering, and processing risk data according to the bank’s risk reporting requirements to enable the bank to measure its performance against its risk tolerance/appetite. This includes sorting, merging or breaking down sets of data.

Timeliness

Availability of aggregated risk data within such a timeframe as to enable a bank to produce risk reports at an established frequency.

Validation

The process by which the correctness (or not) of inputs, processing, and outputs is identified and quantified.

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Vice Chair Janet L. Yellen At the American Economic Association/American Finance Association Joint Luncheon, San Diego, California

Interconnectedness and Systemic Risk: Lessons from the Financial Crisis and Policy Implications
Thank you, Claudia, and thanks to the American Economic Association and the American Finance Association for the opportunity to speak to you on a topic of growing interest to our profession and of great importance to understanding the causes and implications of the financial crisis. Everyone here today, I'm sure, is familiar with the tumultuous events that introduced many Americans to the concept of systemic risk. To recap briefly, losses arising from leveraged investments caused a few important, but perhaps not essential, financial institutions to fail. At first, the damage appeared to be contained, but the resulting stresses revealed extensive interconnections among traditional banks, investment houses, and the rapidly growing and less regulated shadow banking sector. Market participants lost confidence in their trading partners, and, as the crisis unfolded, the financial sector struggled to cope with a massive withdrawal of liquidity, the collapse of one of its most prominent institutions, and a 40 percent drop in equity prices. The effects of the crisis were felt far beyond the financial sector as credit dried up and a mild recession became something far worse.

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You are also, no doubt, familiar with the political response to that crisis. After considerable debate, the Congress passed sweeping reform legislation designed to place the nation's financial infrastructure on a more solid foundation. I'm referring, of course, to the banking panic of 1907. The legislation that President Wilson signed in December 1913 created the Federal Reserve, providing the nation with a lender of last resort to respond to such crises. As we approach the centennial of the Federal Reserve System, it is striking how many of the challenges of that era remain with us today. In 1907, the correspondent banking networks that helped concentrate reserves in New York and other money centers also made the banking system highly interconnected. Today, our capability to monitor and model financial outcomes is vastly greater, and the tools available to the Federal Reserve are vastly more powerful, than the private capital and moral suasion that financier J. P. Morgan summoned in 1907 to stabilize the banks and trusts. But as we learned during the recent crisis, the financial system has also grown much larger and more complex, and our efforts to understand and influence it have, at best, only kept pace. Complex links among financial market participants and institutions are a hallmark of the modern global financial system. Across geographic and market boundaries, agents within the financial system engage in a diverse array of transactions and relationships that connect them to other participants.

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Indeed, much of the financial innovation that preceded the most recent financial crisis increased both the number and types of connections that linked borrowers and lenders in the economy. The rapid growth in securitization and derivatives markets prior to the crisis provides a stark example of this phenomenon.

As shown in figure 1, between 2000 and 2007, the notional value of collateralized debt obligations outstanding increased from less than $300 billion to more than $1.4 trillion. From 2004, the earliest date for which comprehensive data are available, to 2007, the outstanding notional amount of credit default swap (CDS) contracts increased tenfold, from $6 trillion to $60 trillion.

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This incredible growth in securitization and derivatives markets reflects a significant increase in the number, types, and complexity of network connections in the financial system. Financial economists have long stressed the benefits of interactions among financial intermediaries, and there is little doubt that some degree of interconnectedness is vital to the functioning of our financial system. Economists take a well-reasoned and dim view of autarky as the path to growth and stability. Banks and other financial intermediaries channel capital from savers, who often have short-term liquidity demands, into productive investments that typically require stable, long-term funding. Financial intermediaries work with one another because no single institution can hope to access the full range of available capital and investment opportunities in our complex economy. Connections among market actors also facilitate risk sharing, which can help minimize (though not eliminate) the uncertainty faced by individual agents. Yet experience--most importantly, our recent financial crisis--as well as a growing body of academic research suggests that interconnections among financial intermediaries are not an unalloyed good. Complex interactions among market actors may serve to amplify existing market frictions, information asymmetries, or other externalities. The difficult task before market participants, policymakers, and regulators with systemic risk responsibilities such as the Federal Reserve is to find ways to preserve the benefits of interconnectedness in financial markets while managing the potentially harmful side effects.

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Indeed, new regulations required by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act) and changes in supervisory practices by the Federal Reserve and other financial regulators are intended to do just that. In my remarks, I will discuss a few of the major regulatory and supervisory changes under way to address the potential for excessive systemic risk arising from the complexity and interconnectedness that characterize our financial system. The design of an appropriate regulatory framework entails tradeoffs between costs and benefits, and to illustrate them, I will discuss in some detail proposals currently under consideration to mitigate risk in over-the-counter (OTC) derivatives, which proved to be an important channel for the transmission of risk during the recent crisis. I am quite aware that some reforms in the wake of the financial crisis, including those pertaining to derivatives, have been controversial. In connection with recent rulemakings--and, more broadly, in the arena of public debate--critics have asked whether complexity and interconnectedness should be treated as potential sources of systemic risk. This is a legitimate question that the Federal Reserve welcomes and itself seeks to answer in its roles of researcher, regulator, and supervisor. Let me say at the outset, though, that a lack of complete certainty about potential outcomes is not a justification for inaction, considering the size of the threat encountered in the recent crisis. Responsible policymakers try to make decisions with the best information available but would always like to know more.

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With that in mind, I'll begin by briefly surveying research that highlights ways in which network structure and interconnectedness can give rise to or exacerbate systemic risk in the financial system.

The Economics of Interconnectedness and Systemic Risk
Academic research that explores the relationship between network structure and systemic risk is relatively new. Not surprisingly, interest in this field has increased considerably since the financial crisis. A search of economics research focusing on "systemic risk" or "interconnectedness" since 2007 yields 624 publications, twice as many as were produced in the previous 25 years. That's not to say that economists were blind to the importance of networks before the financial crisis. In 2000, Franklin Allen and Douglas Gale, for example, developed an important model of financial networks that provides insight into how networks can influence systemic risk. In the model studied by Allen and Gale, systemic risk arises through liquidity shocks that can have a domino effect, causing a problem at one bank to spread to others, potentially leading to failures throughout the system. In their model, interbank deposits are a primary mechanism for the transmission of liquidity shocks from one bank to another. Allen and Gale compare two canonical network structures: a "complete" network, in which all banks lend to and borrow from all other banks, and an "incomplete" network, in which each bank borrows from only one neighbor and lends to only one other neighbor.
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Figure 2, panel A, presents an example of a complete network, and figure 2, panel B, an example of an incomplete network. In the case of the complete network, banks benefit from diversified funding streams.

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A liquidity shock at one bank is less likely to cause the bankruptcy of another bank since the shock can be distributed among all banks in the system. In the incomplete network, funding is not diversified. A liquidity shock at one bank is more likely to cause liquidity problems at other connected banks because the same shock is spread over fewer banks and is therefore larger and more destabilizing. The principle behind this result is familiar and basic to economics: Diversification reduces risk and improves stability. While this idea is compelling, both economic research and the events of the financial crisis suggest that it is incomplete. In their classic paper on bank runs, Douglas Diamond and Philip Dybvig showed how rational and prudent actions by individual depositors to limit their own risks may be highly destabilizing to an institution designed to transform short-term liabilities into long-term assets. Xavier Freixas, Bruno Parigi, and Jean-Charles Rochet show that a similar kind of collective action problem can arise in a network akin to a modern check-clearing system in which credit extensions among banks allow claims on one institution to be fulfilled by another. Such a system is socially useful because it allows depositors to shift funds among banks without forcing banks to sell illiquid assets, thus enabling society as a whole to undertake more productive, long-term investment. But in times of stress or uncertainty, such systems can be subject to coordination failures: A "gridlock" equilibrium can arise in which depositors at each bank withdraw funds early in order to avoid losses arising from credit

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extensions to other banks whose depositors are also expected to force an early liquidation of assets. In Freixas, Parigi, and Rochet (2000), interbank credit extensions, while useful, can result in institutions that are "too interconnected to fail." These models underscore that the pattern of connections throughout a financial network determines the systemwide implications of liquidity shocks or other financial stresses in one part of the network. This finding is one reason why efforts to collect more and better data on the precise linkages among financial institutions are so important. Without such comprehensive and detailed data, it is simply not possible to understand how stress in one part of the network may spread and affect the entire system. Networks that are more interconnected are inherently more complex than those in which market participants have fewer links to one another, and complexity can exacerbate the kinds of coordination problems highlighted by Diamond and Dybvig and by Freixas, Parigi, and Rochet. Of course, "complexity" is difficult to define in a completely systematic and satisfactory manner, but one way emphasized in recent work by Hyun Song Shin is to consider the number of links required to connect savers to borrowers. Shin's analysis of interconnectedness among financial institutions is based on the idea that the ultimate amount of lending and borrowing that can occur in an economy is determined by economic fundamentals such as income growth, which change only slowly over time, whereas interbank claims can grow or contract far more quickly. Of course, claims within the entire financial system net out to zero, but they do affect the leverage of the institutions involved.

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In Shin's model, financial institutions seek to take on more leverage during a boom, when banks have strong capital positions and risks are perceived to be low, but can increase leverage, in the aggregate, only by borrowing and lending more intensively to each other. This causes the resulting network of intertwining claims to extend further and further. Conversely, when fundamental conditions or market sentiments change and financial institutions prefer to shed risk, they can deleverage in the short term only by withdrawing credit from one another. Such deleveraging can be particularly destabilizing in longer intermediation chains as debt claims that are called by one financial intermediary to shore up its own assets adversely affect the liability sides of other institutions' balance sheets. As deleveraging accelerates and more and more financial institutions hoard liquidity, other institutions may become concerned that their own funding may dry up and may preemptively withdraw funding from others. Fundamentally strong institutions are forced to liquidate assets at fire sale prices, which results in more deleveraging and instability. More-complex network structures are likely to be more opaque than less complex ones. For example, as the number of intermediaries standing between borrowers and lenders grows, it becomes increasingly difficult to understand how one member of the network fits into the overall system. The well-publicized difficulties that some mortgage borrowers have had in simply figuring out who owns their mortgages illustrates the extent to which lengthening intermediation chains have increased the complexity of the financial system.

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Moreover, in many cases, market participants may have strong incentives not to disclose their connections to one another. If a bank has a profitable relationship with a borrower, it may be unwilling to disclose it to other banks for fear that competitors will reduce or eliminate the rents that it earns. Ricardo Caballero and Alp Simsek illustrate how a lack of information can create systemic risk in financial networks. In a model that is structurally similar to the incomplete interbank network model of Allen and Gale, Caballero and Simsek examine how banks might respond to news of a liquidity shock when each bank knows the identities of its own counterparties but not the identities of its counterparties' counterparties. The authors posit that banks deal with this uncertainty by appealing to the "maximin principle": Each seeks to maximize profits under the assumption that the network is configured in the worst possible manner from its own perspective. Because each behaves as though the network structure is "stacked against it," when banks learn of an adverse liquidity shock, each tends to sell more of its illiquid assets and withdraw more funding from its counterparties than it would if it had access to complete information about the structure of interbank credit relationships. As in Shin's model, this excessive deleveraging can create a vicious cycle, magnifying the effects of the initial shock. The four models we've discussed thus far are aimed at exploring general features of financial networks. As such, they are necessarily somewhat abstract.

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With a few narrow exceptions, they treat all market participants as similar in size and in range of activities, and they use relatively simplistic network structures. In the past few years, research on financial networks has moved beyond stylized models of interbank relationships to examine the propagation of shocks in more-realistic settings. Recent research by Gai, Haldane, and Kapadia and by Cont, Moussa, and Santos examines how shocks propagate in network structures in which some banks are larger and more interconnected than others. Using numerical simulations, Gai, Haldane, and Kapadia show that, in concentrated networks, contagion occurs less frequently and is less severe for low degrees of network connectivity. Contagion is significantly more likely at higher levels of connectivity. In a concentrated financial network with a few key players, and when liquidity shocks are targeted at the most connected institutions, distress at highly connected banks spreads widely through the rest of the system. In this sense, the intuition of Allen and Gale--that highly connected networks are resilient to systemic shocks--can be misleading. In an empirical study of 3,000 Brazilian banks, Cont, Moussa, and Santos find that, not surprisingly, institutions with larger interbank exposures tend to be more systemically important. But, critically, they also find that an institution's position within the financial network plays a significant role. A bank that does business with a large number of relatively weak counterparties may have greater systemic importance than an institution with a similar number of counterparties that are better equipped to manage potential losses.
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The work of Gai, Haldane, and Kapadia and that of Cont, Moussa, and Santos suggest that detailed and comprehensive data on the structure of financial networks is needed to understand the systemic risks facing the financial system and to gauge the contributions to systemic risk by individual institutions. I will describe in a moment how the Federal Reserve is using such data to enhance its understanding of the OTC derivatives market. This line of research suggests that a one-size-fits-all approach to the regulation of financial intermediaries may not be appropriate. So, what have we learned from this brief tour through recent research on interconnectedness and systemic risk? We have seen how interconnectedness can be a source of strength for financial institutions, allowing them to diversify risk while providing liquidity and investment opportunities to savers that would not be available otherwise. But more-numerous and more-complex linkages also appear to make it more difficult for institutions to address certain types of externalities, such as those arising from incomplete information or a lack of coordination among market participants. These externalities may do little harm or may even be irrelevant in normal times, but they can be devastating during a crisis.

The Global Policy Response to Reduce Systemic Risk
Governments around the globe have responded to the financial crisis by adopting a strong, multifaceted, and coordinated reform agenda aimed at reducing systemic risk. At a meeting in Pittsburgh in September 2009, governments in the Group of Twenty (G-20) endorsed work already under way in the Basel
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Committee on Banking Supervision to improve capital and the management of liquidity risk in the banking system. I'll briefly review several Basel Committee initiatives that address interconnectedness and systemic risk, but first, let me focus on one in particular: higher capital requirements for global systemically important banks (GSIBs). Enhanced capital standards for GSIBs serve to limit the risks undertaken by the largest, most interconnected institutions whose distress has the greatest potential to impose negative externalities on the broader financial system. A framework of higher minimum regulatory capital standards for these institutions was issued by the Basel Committee in November 2011, and indicators of interconnectedness account for a significant proportion of the overall score used to determine whether a bank will be subject to higher standards. As shown by Gai, Haldane, and Kapadia, among others, highly interconnected firms can transmit shocks widely, impairing the rest of the financial system and the economy. We saw, for example, that when Lehman Brothers failed, the shock was transmitted through money market mutual funds to the short-term funding and interbank markets. While some participants in each of these sectors had direct exposures to Lehman, many more did not. Moreover, even in cases in which direct exposures to Lehman were manageable, the turmoil caused by Lehman's failure added stress to the system at a particularly unwelcome time.

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In this way, the failure of a highly interconnected institution such as Lehman imposes costs on society well in excess of those borne by the firm's shareholders and direct creditors. Accordingly, tying enhanced capital requirements to interconnectedness improves the resilience of the system. Of course, higher capital requirements are not costless; they may raise financing costs for some borrowers, and they have the potential to induce institutions to engage in regulatory arbitrage. An important ongoing agenda for research and policy is the design and implementation of data-based measures of interconnectedness to ensure that our understanding of financial system interconnections evolves in tandem with financial innovation. While enhanced capital standards for GSIBs are an important tool for managing systemic risk that arises through interconnectedness, they are not the only tool. The Basel Committee's program contains a number of initiatives that will help manage interconnectedness and systemic risk. These measures include countercyclical capital buffers, liquidity requirements, increased capital charges for exposures to large financial institutions, large exposure rules, and deductions from capital for equity investments in banks. These and other initiatives will all play a role in managing the effect of complexity and interconnectedness on financial stability. In fact, the multifaceted nature of the reform program is an important design principle.

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One of the lessons of the recent financial crisis was that capital alone is not sufficient to prevent or stem a crisis. Multiple channels for reform initiatives will enhance systemic stability.

Managing Tradeoffs between Reducing Systemic Risk and Increasing Costs: OTC Derivatives Market Reforms
In addition to the banking reforms I just discussed, the G-20 also committed to reduce risk in OTC derivatives markets by enacting reforms to improve transparency and decrease counterparty exposures among market participants. These policies must be considered carefully, as they are apt to increase the cost of financial intermediation and that of hedging risk. To illustrate the tradeoffs policymakers and regulators must manage when crafting such policies, I'll next discuss in some detail a set of initiatives currently being implemented by prudential, market, and systemic risk regulators around the world to address weaknesses in OTC derivatives markets. An OTC derivative is a privately negotiated contract between a pair of counterparties to exchange future cash flows that depend on the performance of an underlying asset or benchmark index. Unlike an immediate purchase or sale of assets, OTC derivatives require one or both sides of the transaction to make payments in the future. Counterparty risk is therefore a key element of OTC derivatives transactions. The scale and significance of counterparty risks in the OTC derivatives markets are large and, as we saw, can have economy-wide implications.

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The prudent management, regulation, and oversight of these risks are critical to ensuring that derivatives markets serve to diversify, rather than exacerbate, systemic risk. Significant problems with the functioning, regulation, and oversight of derivatives markets became apparent during the financial crisis. These problems are perhaps best exemplified by the widespread effects of large losses by American International Group, Inc. (AIG), on its OTC structured finance and credit derivatives positions. In the absence of government intervention, AIG's failure would have exposed its counterparties to substantial losses at a time of significant financial stress and uncertainty for them and the financial system. Indeed, for a time, the prospect of AIG's failure exacerbated the already impaired functioning in important segments of the OTC market, and, as that happened, it became more costly or even impossible for firms to manage financial risks. Derivatives positions originally undertaken by some firms to hedge risk could not be unwound and instead became sources of risk. AIG's failure revealed, in stark and spectacular fashion, systemic problems inherent in the structure and functioning of OTC derivatives markets that had increased the fragility of the financial system, exposing the rest of the economy to unnecessary systemic risks. Central clearing mandates, minimum margin standards, and data reporting requirements are among the tools that regulators now intend to use to mitigate counterparty risk and improve transparency, thus reducing uncertainty. The September 2009 commitment of the G-20 to require that standardized OTC derivatives be cleared through central counterparties is directly

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aimed at reducing systemic risk by changing the structure of the network of derivatives counterparty exposures. In the absence of a central counterparty, the network of counterparty exposures associated with a class of OTC contracts might look something like panel A in figure 3. Each market participant has counterparty risk exposures to one or more other market participants. Although each participant knows its own risk exposure, it is unlikely to have complete information on its counterparties' exposures to others. Such opacity can engender the kind of information-related gridlock that we observed in the fall of 2008 and that is explored in the research of Caballero and Simsek. Moreover, because market participants commonly have partially or fully offsetting positions with multiple counterparties, a fully bilateral network is inefficient from a risk-management standpoint: Gains in the value of positions with one counterparty cannot be netted against losses in the value of positions with other counterparties. By taking one side of every trade, a central counterparty serves to transform the mesh network shown in panel A of figure 3 into something that looks more like the hub-and-spoke network illustrated in panel B. This network structure has no effect on the exposure of individual market participants to the assets or indexes underlying the derivatives contracts in question, but it dramatically simplifies and improves the transparency of the network of counterparty risk exposures. Central clearing can yield important advantages over a fully bilateral market structure.

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The simpler hub-and-spoke network structure is more transparent, and the central counterparty is well positioned to impose common margin requirements on all market participants. Central clearing facilitates the netting of gains and losses across multiple market participants, which has the potential to significantly reduce each participant's aggregate counterparty risk exposure. Rather than managing its counterparty risk exposure to all other trading partners, a market participant needs to manage only its exposure to the central counterparty. The central counterparty acts as a pure intermediary and takes no net position in any of the underlying contracts that it clears, so it can experience losses only when a clearing member defaults and has posted insufficient margin to cover the cost of replacing its open positions. Central counterparties are typically designed to distribute any losses they do incur in a relatively predictable way across all clearing members. In this way, central clearing provides for a transparent mutualization of counterparty risks among participants. Central counterparties are designed to be narrowly focused on intermediation and not the provision of credit and liquidity. This structure improves the chances that, in the event of a significant market stress, market functioning will not be threatened by the failure of market infrastructure itself. Of course, the other side of this coin is that adding a central counterparty introduces a single point of failure for the network, making it critical that the central counterparty itself be well managed and well regulated.

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To help ensure this result, title VII of the Dodd-Frank Act adopted stronger safeguards than in the past for central counterparties that clear OTC derivatives. Title VIII aimed at strengthening the supervision of financial market utilities, including central counterparties designated as systemically important, by requiring annual examinations as well as ex ante reviews of material rule and operational changes. In April 2012, the international organizations that set standards for financial market infrastructures such as central counterparties published new and stronger standards for these entities. U.S. regulators, including the Federal Reserve, participated actively in this work and are expected to make formal proposals for incorporating the new standards into U.S. regulations as soon as possible. More fundamentally, however, a central counterparty's ability to manage risk is determined by its ability to accurately value the contracts it clears on a frequent and possibly real-time basis and to rapidly replace open positions at or near current prices in the event that a clearing member defaults. Requiring less-liquid and highly customized derivatives to be cleared would likely increase systemic risks, as clearinghouses would not be well positioned to manage the complex risks of such derivatives. The G-20 mandate explicitly recognizes this important limitation on the benefits of central clearing, and it requires only that standardized OTC derivatives be centrally cleared. Accordingly, the G-20 commitment has effectively managed the costs and benefits of central clearing in establishing a global clearing mandate. However, limiting central clearing to standardized derivatives means that a significant proportion of less standardized OTC contracts will continue

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to be written on a bilateral basis without the benefit of a central counterparty. The International Monetary Fund estimates that one-third of interest rate and credit derivatives and two-thirds of equity, commodity, and foreign exchange derivatives will not be suited to standardization and will remain non-centrally cleared. As more-standardized derivatives migrate to central clearing, it will be important to remain vigilant in managing the risks from non centrally-cleared derivatives exposures. One important tool for managing the systemic risks of non centrally-cleared derivatives is margin requirements. Globally, regulators have been working on standards for margin requirements on non-centrally-cleared derivatives that would provide for harmonized rules and a level playing field, which is crucial given the global nature of derivatives markets. In July, the Basel Committee and the International Organization of Securities Commissions proposed a framework for margin requirements on non-centrally-cleared derivatives. The finalized framework will inform rulemakings of the Federal Reserve and other U.S. regulators. The proposed framework would require financial firms and systemically important nonfinancial firms to collect two types of margin. First, they would be obligated to collect variation margin on a regular basis, so if a derivative loses market value, the party experiencing a loss must realize the loss immediately. This requirement codifies current best market practice, since the largest derivatives dealers already exchange variation margin daily.

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However, and importantly, the framework extends this prudent risk-management practice to other derivatives counterparties. Requiring timely payment of variation margin will go a long way toward ensuring that an AIG-like event will not happen again, since current exposures will not be allowed to build over time to unmanageable levels. Moreover, variation margin requirements will ensure that market participants will know that counterparties that they deal with will not be carrying large uncollateralized exposures that could impair their ability to perform in the future. Those requirements diminish the likelihood of the kind of information gridlock explored by Caballero and Simsek. More controversially, the proposed framework requires the collection of initial margin. While variation margin collateralizes current derivatives losses, initial margin collateralizes future losses that could occur in the event of a counterparty's default. In essence, initial margin is a kind of performance bond. In the event that a counterparty does not perform as required, the initial margin is used to replace the position with a new counterparty. It is here that some of the most significant policy tradeoffs arise, because higher initial margin requirements will make it more costly for market participants to use derivatives to hedge risk. Liquid resources that are set aside as initial margin cannot be deployed for other purposes. Given the sheer size and scope of derivatives markets, requiring initial margin on all derivatives transactions could result in significant opportunity and liquidity costs.
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In a public comment letter to the Federal Reserve and other regulators, the International Swaps and Derivatives Association estimated that initial margin requirements could lock up as much as $1.7 trillion in liquid assets globally. This number is eye opening, to say the least. In an effort to better gauge the liquidity costs of initial margin requirements, the Federal Reserve, as part of the international group of prudential and market regulators that issued the July proposal, has conducted a detailed impact study to quantify the liquidity costs associated with initial margin requirements. The results of this study, as well as comments received on the proposal, will help ensure that in the final framework, the need to reduce systemic risk is appropriately balanced against the resulting liquidity costs. Even in light of the significant costs of initial margin, it seems clear that some requirements are needed. The current use and application of initial margin is inconsistent, and a more robust and consistent margin regime for non-centrally-cleared derivatives will not only reduce systemic risk, but will also diminish the incentive to tinker with contract language as a way to evade clearing requirements. Robust and consistent initial margin requirements will help prevent the kind of contagion that was sparked by AIG: They would serve, in effect, to limit the effects of interconnectedness within the financial network. The failure of a financial counterparty could be contained in the manner described by Allen and Gale. As I noted in connection with variation margins, initial margin requirements would also improve transparency because derivative market
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participants will know that their counterparties are at least partially insulated from defaults. Of course, these benefits need to be appropriately balanced against the burdens imposed by initial margin. But it seems highly unlikely that the status quo is consistent with achieving the goals of the G-20 to reduce the potential for systemic risk in the OTC derivatives markets that could threaten the financial system. Finally, let me turn to data requirements. Both the research that I have highlighted today and practical experience demonstrate that market, prudential, and systemic risk authorities need detailed information on derivatives transactions and bilateral positions to assess evolving market risks and to execute their financial stability responsibilities. Indeed, the Federal Reserve has already used preliminary information from the Depository Trust & Clearing Corporation's Trade Information Warehouse to construct network graphs of the CDS market such as the one illustrated in figure 4. The data enable identification, for example, of firms, such as A and B in figure 4, that are large net sellers of protection. Such information can play a valuable role in supervision. Moreover, the analyses for monitoring and measuring systemic risks suggested and described by Gai, Haldane, and Kapadia and by Cont, Moussa, and Santos require this kind of detailed data to gain a holistic view of systemic risk. Title VII of the Dodd-Frank Act requires that data on U.S. swaps transactions be reported to swaps data repositories regulated by the Commodity Futures Trading Commission or to securities-based swaps
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data repositories regulated by the Securities and Exchange Commission. Similar European regulations impose trade reporting requirements on swaps transacted in Europe. But there is still no guarantee, due to confidentiality concerns and legal barriers to data sharing, that the data reported into these trade repositories will ultimately be accessible to all of the regulators who require the data to obtain a holistic view of the derivatives market. Given that the derivatives market is global in scope, access to those data is essential for authorities with systemic risk responsibilities, such as the Federal Reserve, to monitor and respond to risks. To make this point concrete, it is unclear whether we will be able, on a regular and comprehensive basis, to produce the sort of analysis illustrated by figure 4. In order to effectively monitor market developments and systemic risks, it is crucial that regulators across jurisdictions and countries share data on a consistent and regular basis. While better data and more transparency are important for monitoring and responding to the buildup of systemic risks, we do, of course, also recognize the confidentiality concerns. Information is a valuable resource to most financial market participants, and unnecessarily burdensome or overly revealing information disclosures could compromise the position of market participants and reduce incentives for trade, thus decreasing liquidity and market efficiency. Dodd-Frank's real-time reporting requirements for swaps transactions recognize this important point by allowing for delayed reporting of large "block trades" where immediate reporting could reveal and undermine a participant's position and ultimately discourage market transactions, depth, and liquidity.
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In this way, enhanced reporting and transparency requirements are being set to provide the public and regulators with useful information without compromising market integrity. Moreover, while market integrity and appropriate confidentiality are important considerations, the events of the financial crisis have clearly shown that effective systemic risk management demands more, and not less, data disclosure.

Concluding Remarks
I began this talk by describing the events surrounding the banking panic of 1907 and the founding of the Federal Reserve. A lesson from that episode, as relevant today as it was then, was that financial stability is essential to sustained economic growth and prosperity. Just as the banking panic of 1907 revealed fundamental weaknesses in our financial system, so, too, did the financial crisis of 2007 and 2008. The recent crisis showed that some financial innovations, over time, increased the system's vulnerability to financial shocks that could be transmitted throughout the entire economy with immediate and sustained consequences that we are still working through today. Some of these vulnerabilities were a consequence of innovations that increased the complexity and interconnectedness of aspects of the financial system. In response to the crisis and the weaknesses it revealed, governments around the globe are acting to improve financial stability and reduce the risks posed by a highly interconnected financial system.

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These efforts, of course, must account for the costs of new rules and ensure that these costs are clearly outweighed by the benefits. I am confident that the policies I have described today will make the economy more resilient to financial shocks and help reduce the risk of another crisis, while properly balancing these important benefits against the necessary costs. In striking this balance, government has been guided by new research that has added to our understanding of systemic risk. And this work continues. I have no doubt that some of you here today will perform that research and make those discoveries. So, allow me to close by offering my thanks, in advance, for those contributions. I hope my talk today has made it clear that the work of safeguarding our financial system will depend on these efforts and insights, which will empower policymakers to make the right decisions.

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Regulatory Resolutions for 2013
Remarks by Assistant Superintendent Mark Zelmer, Office of the Superintendent of Financial Institutions Canada (OSFI) to the 2013 RBC Capital Markets Canadian Bank CEO Conference

Introduction
Thank you for inviting me to speak to you today. I hope you enjoyed the holiday season and were able to take some time to relax with family and friends. This year is expected to be another interesting and challenging one as we continue to adjust to the aftershocks of the global financial crisis. To kick off, let me talk about some issues on the regulatory front. Last month OSFI joined the growing group of regulators that have met their commitment to implement Basel III in their domestic regulatory frameworks. But this is only the end of the beginning. There is more to come. So today I would like to outline some of the key regulatory issues that OSFI will be tackling over the course of 2013. A New Year’s Regulatory Resolution List if you like.

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Canadian banks are reporting gold-plated Basel III capital ratios
It is a testament to the underlying strength of the Canadian financial system that Canadian banks have been able to fully implement the Basel III capital rules from the start. And that is without the transition requirement training wheels that will be used in some other jurisdictions. Canadian deposit-taking institutions are now expected to comfortably meet the seven per cent Common Equity Tier 1 capital requirement on an “all-in” or 2019 basis. As a result, Canadian banks are now publicly reporting Basel III capital ratios on that basis. Let me stress that these are truly gold-plated capital ratios – especially when you compare them to those published by some foreign banks. Here’s why. First, many foreign banks appear to be reporting Basel III capital ratios on the basis of the rules that allow for the transition measures. So a seven per cent number posted by a Canadian bank is in fact significantly stronger than the same number posted by a bank that is phasing-in Basel III over the next six years. Second, different jurisdictions are handling the various options allowed for in Basel III in different ways. One example is how insurance subsidiaries are treated in the definition of capital. And, third, the quality of a bank’s capital ratio will obviously be affected if a jurisdiction has deviated from Basel III in its domestic capital rules.
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In Canada, we have faithfully implemented Basel III. And we expect the Basel peer review process will confirm that there are no material deviations in our domestic guidance. When you analyze the capital ratios of Canadian banks it is important to bear those differences in mind. The Basel Committee is doing what it can to shed as much light as possible on published capital ratios through the introduction of a new detailed reporting template later this year. But we are encouraging the Committee to consider whether more steps can be taken to address the reporting differences I just mentioned. After all, banks that report gold-plated capital ratios deserve some credit.

Some banks will be designated as D-SIBs
An important New Year’s resolution for OSFI will be to assess which banks in Canada should be designated as domestically systemically important (D-SIBs). We expect to announce our decision within a few months. Any bank receiving a D-SIB designation can also expect some additional prudential requirements, including having to carry more common equity. The extra capital requirements will take effect in January 2016; the start date for those that will be imposed internationally on globally systemically-important banks. This provides plenty of time for the designated banks to plan accordingly. But higher capital is not enough when it comes to managing issues associated with domestic systemic importance.
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That is why OSFI already conducts more intensive risk-based supervision for those institutions that are larger and more complex. In addition, OSFI and other federal agencies are working to ensure that the Financial Stability Board’s Key Attributes of Effective Resolution Regimes for Financial Institutions are implemented appropriately in Canada. For example, we have been helping major federally regulated financial institutions develop recovery plans and the Canada Deposit Insurance Corporation (CDIC) has been leading the work on resolution plans – also known as living wills.

An NVCC market should emerge
Another important resolution for us this year is contingent capital. As of January 1, Canadian deposit-taking institutions are no longer able to include new issues of preferred shares and subordinated debt in their Tier 1 and Total Capital ratios unless those instruments carry Non-Viability Contingent Capital (NVCC) conversion triggers. Existing instruments are being phased out of regulatory capital at a rate of ten per cent per year. Like living wills and other resolution measures, these new instruments are an important ingredient in making sure that all deposit-taking institutions can be resolved in an orderly fashion in times of stress without taxpayers being the first port of call for new capital. OSFI is looking forward to the emergence of a market in Canada for NVCC preferred shares and subordinated debt instruments in 2013.

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Basel liquidity standards will be clarified
On the liquidity front, the Basel Committee has approved the Liquidity Coverage Ratio (LCR) – a new liquidity standard that seeks to ensure that banks hold enough liquid assets to meet their funding commitments over a thirty day horizon. The remaining technical work to be completed this year includes making sure that the LCR will mesh well with central bank facilities, assessing what role market-based indicators might play in helping to define liquid assets, and completing work on appropriate disclosure requirements for bank liquidity and funding profiles. Work will also begin in earnest this year to flesh out a second liquidity standard – the Net Stable Funding Ratio (NSFR). This standard focuses more on the funding structure of a bank; i.e. the extent to which it relies on short-term versus medium to longer-term sources of funds. Meanwhile, OSFI needs to consider how our existing liquidity monitoring tools should be used in conjunction with these new international standards.

Bank information disclosures will be enhanced
So far I have mentioned various regulatory initiatives that are designed to boost bank capital and liquidity positions. But regulatory measures alone are not enough. You – the investors and market analysts – also have a role to play. You help to ensure that banks are subject to the discipline of well-informed financial markets.

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But you need good information to fulfill that role. As the Enhanced Disclosures Task Force recently commented: Disclosures that describe risks and risk management practices transparently help to build confidence in the firm’s management, which is particularly important in attracting debt and equity investors and may in turn support higher equity valuations. By enhancing investors’ understanding of banks’ risk exposures and risk management practices, high-quality risk disclosures may reduce uncertainty premiums and contribute to broader financial stability. You may be wondering: who is this task force and what did they recommend? The Task Force was established by the Financial Stability Board (FSB) last May. Most groups sponsored by the FSB are typically composed of senior officials from the public sector. By contrast, the Task Force consisted of a group of senior private-sector executives from leading asset management firms, investors and analysts, global banks, credit rating agencies and external auditors. Each task force member was allocated to a work-stream so that the latter comprised both users and preparers of financial reports. After consulting extensively with regulators and industry groups, the Task Force reported back to the Financial Stability Board in October. It offered 32 recommendations on how the disclosure of information on bank risk exposures and risk management practices could be enhanced.

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The report was welcomed by the FSB, which views it as a valuable step to improving the quality of risk disclosures. Canadian banks are currently reviewing the recommendations. Our goal at OSFI is to ensure that major Canadian banks continue to be among the best in terms of information disclosure. We recognize that some investors would welcome more information on the funding and liquidity profiles of Canadian banks. Thus, you may be interested in knowing that the Task Force made four recommendations in this area, including one that banks publish a table summarizing remaining maturities of assets, liabilities and off-balance-sheet commitments on a contractual basis. Another area where the Task Force had some good advice to offer relates to the wide variations in risk-weighted assets across countries. This has led to some concern about the reliability of the models used by banks to compute their risk exposures and the associated asset risk weights. The Basel Committee is on top of this issue. Two reports are being prepared that examine the factors driving the variation in risk weights in both the banking book and the trading book. Indeed, one of my OSFI colleagues, Richard Gresser, is co-chairing the trading book study. Their findings will be published soon. Meanwhile, the Task Force offered several recommendations on how banks could provide more information on the models used to compute risk weights for credit risk, market risk and operational risk.
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Our hope is that more information on the models used by banks to calculate their risk exposures and asset risk weights will increase investor confidence in those models and in the Basel III capital framework more generally.

Solo capital requirements: a new wave in capital regulation?
As you know, OSFI has traditionally focused on capital adequacy of banks and other deposit-taking institutions on a fully consolidated basis. By that I mean our formal capital guidance is defined in terms of a bank’s consolidated capital position; regardless of whether capital is carried at the parent bank level, or within a subsidiary that is fully consolidated for accounting and regulatory purposes. This approach has worked well for many years. Indeed, it has enabled Canadian deposit-taking institutions to manage their capital positions efficiently and limit situations where capital is trapped and cannot be used to satisfy Canadian regulatory requirements. Having said that, even back in the pre-crisis Basel II days, banks and their supervisors were encouraged to pay attention to the distribution of capital within a banking group and ensure that individual banks were adequately capitalized on a stand-alone or solo basis. But the issue is now gaining more prominence. The new D-SIB framework provides incentives for host jurisdictions to require banks that are systemic in their jurisdictions to hold more capital locally. In other words, all things equal, a potential drain of capital away from home jurisdictions.

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In addition, UK authorities are reportedly encouraging overseas banks to operate through locally-incorporated subsidiaries with their own separate capital and liquidity requirements. And last month, the Federal Reserve announced new draft rules that would tighten capital and liquidity requirements on foreign banks operating in the United States. Together, these events suggest we may be moving to a world where more attention will be placed on how capital and liquidity are allocated within a banking group. OSFI has been monitoring the distribution of capital within Canadian banks for some time now. However, the recent events that I just described are leading us to consider what kind of framework and expectations would make sense in the future for federally-regulated financial institutions here in Canada.

Conclusion
Let me end by reiterating my main points: 1. Canadian banks are reporting gold-plated Basel III capital ratios because they are not relying on the transitional arrangements contained in Basel III. 2. OSFI plans to announce which banks will be designated as D-SIBs and the associated prudential requirements within a few months. 3. OSFI is committed to ensuring that major Canadian banks continue to be among the best in information disclosure. 4. More attention is being paid internationally to the issue of solo capital requirements.
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OSFI is considering what kind of framework and expectations would make sense in the future for federally-regulated financial institutions in Canada. Thank you again for the opportunity to speak with you today about our regulatory resolutions for 2013. There is still a lot of work to be done. But I am confident the result of this work will be a safe, resilient financial system that will continue to earn the well-deserved confidence and trust of depositors, creditors and investors. I wish you a Happy New Year.

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Richard W. Fisher, president and CEO of the Federal Reserve Bank of Dallas.

Ending 'Too Big to Fail': A Proposal for Reform Before It's Too Late (With Reference to Patrick Henry, Complexity and Reality)
Remarks before the Committee for the Republic Washington, D.C. · January 16, 2013 It is an honor to be introduced by my college classmate, John Henry. John is a descendant of the iconic patriot, Patrick Henry. Most of John’s ancestors were prominent colonial Virginians and many were anti-crown. Patrick, however, was the most outspoken. Ask John why this was so, and he will answer: “Patrick was poor.” However poor he may have been, Patrick Henry was a rich orator. In one of his greatest speeches, he said: “Different men often see the same subject in different lights; and therefore, I hope that it will not be thought disrespectful to those gentlemen if, entertaining as I do, opinions of a character very opposite to theirs, I shall speak forth my sentiments freely, and without reserve. This is no time for ceremony … [it] is one of awful moment to this country.” Patrick Henry was addressing the repression of the American colonies by the British crown.
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Tonight, I wish to speak to a different kind of repression—the injustice of being held hostage to large financial institutions considered “too big to fail,” or TBTF for short. I submit that these institutions, as a result of their privileged status, exact an unfair tax upon the American people. Moreover, they interfere with the transmission of monetary policy and inhibit the advancement of our nation’s economic prosperity. I have spoken of this for several years, beginning with a speech on the “Pathology of Too-Big-to-Fail” in July 2009. My colleague, Harvey Rosenblum—a highly respected economist and the Dallas Fed’s director of research—and I and our staff have written about it extensively. Tomorrow, we will issue a special report that further elucidates our proposal for dealing with the pathology of TBTF. It also addresses the superior relative performance of community banks during the recent crisis and how they are being victimized by excessive regulation that stems from responses to the sins of their behemoth counterparts. I urge all of you to read that report. Now, Federal Reserve convention requires that I issue a disclaimer here: I speak only for the Federal Reserve Bank of Dallas, not for others associated with our central bank. That is usually abundantly clear. In many matters, my staff and I entertain opinions that are very different from those of many of our esteemed colleagues elsewhere in the Federal Reserve System.
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Today, I “speak forth my sentiments freely and without reserve” on the issue of TBTF, while meaning no disrespect to others who may hold different views.

The Problem of TBTF
Everyone and their sister knows that financial institutions deemed too big to fail were at the epicenter of the 2007–09 financial crisis. Previously thought of as islands of safety in a sea of risk, they became the enablers of a financial tsunami. Now that the storm has subsided, we submit that they are a key reason accommodative monetary policy and government policies have failed to adequately affect the economic recovery. Harvey Rosenblum and I first wrote about this in an article published in the Wall Street Journal in September 2009, “The Blob That Ate Monetary Policy.” Put simply, sick banks don’t lend. Sick—seriously undercapitalized — megabanks stopped their lending and capital market activities during the crisis and economic recovery. They brought economic growth to a standstill and spread their sickness to the rest of the banking system. Congress thought it would address the issue of TBTF through the Dodd–Frank Wall Street Reform and Consumer Protection Act. Preventing TBTF from ever occurring again is in the very preamble of the act. We contend that Dodd–Frank has not done enough to corral TBTF banks and that, on balance, the act has made things worse, not better.
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We submit that, in the short run, parts of Dodd–Frank have exacerbated weak economic growth by increasing regulatory uncertainty in key sectors of the U.S. economy. It has clearly benefited many lawyers and created new layers of bureaucracy. Despite its good intention, it has been counterproductive, working against solving the core problem it seeks to address.

Defining TBTF
Let me define what we mean when we speak of TBTF. The Dallas Fed’s definition is financial firms whose owners, managers and customers believe themselves to be exempt from the processes of bankruptcy and creative destruction. Such firms capture the financial upside of their actions but largely avoid payment—bankruptcy and closure—for actions gone wrong, in violation of one of the basic tenets of market capitalism (at least as it is supposed to be practiced in the United States). Such firms enjoy subsidies relative to their non-TBTF competitors. They are thus more likely to take greater risks in search of profits, protected by the presumption that bankruptcy is a highly unlikely outcome. The phenomenon of TBTF is the result of an implicit but widely taken-for-granted government-sanctioned policy of coming to the aid of the owners, managers and creditors of a financial institution deemed to be so large, interconnected and/or complex that its failure could substantially damage the financial system.

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By reducing a TBTF firm’s exposure to losses from excessive risk taking, such policies undermine the discipline that market forces normally assert on management decision making. The reduction of market discipline has been further eroded by implicit extensions of the federal safety net beyond commercial banks to their nonbank affiliates. Moreover, industry consolidation, fostered by subsidized growth (and during the crisis, encouraged by the federal government in the acquisitions of Merrill Lynch, Bear Stearns, Washington Mutual and Wachovia), has perpetuated and enlarged the weight of financial firms deemed TBTF. This reduces competition in lending. Dodd–Frank does not do enough to constrain the behemoth banks’ advantages. Indeed, given its complexity, it unwittingly exacerbates them.

Complexity Bites
Andrew Haldane, the highly respected member of the Financial Policy Committee of the Bank of England, addressed this at last summer’s Jackson Hole, Wyo., policymakers’ meeting in witty remarks titled, “The Dog and the Frisbee.” Here are some choice passages from that noteworthy speech. Haldane notes that regulators’ “… efforts to catch the crisis Frisbee have continued to escalate. Casual empiricism reveals an ever-growing number of regulators … Ever-larger litters have not, however, obviously improved the watchdogs’ Frisbee-catching abilities.
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[After all,] no regulator had the foresight to predict the financial crisis, although some have since exhibited supernatural powers of hindsight. “So what is the secret of the watchdogs’ failure? The answer is simple. Or rather, it is complexity … complex regulation … might not just be costly and cumbersome but sub-optimal. … In financial regulation, less may be more.” One is reminded of the comment French Prime Minister Clemenceau made about President Wilson’s 14 points: “Why 14?” he asked. “God did it in 10.” Were that we only had 14 points of financial regulation to contend with today. Haldane notes that Dodd–Frank comes against a background of ever-greater escalation of financial regulation. He points out that nationally chartered banks began to file the antecedents of “call reports” after the formation of the Office of the Comptroller of the Currency in 1863. The Federal Reserve Act of 1913 required state-chartered member banks to do the same, having them submitted to the Federal Reserve starting in 1917. They were short forms; in 1930, Haldane noted, these reports numbered 80 entries. “In 1986, [the ‘call reports’ submitted by bank holding companies] covered 547 columns in Excel, by 1999, 1,208 columns.

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By 2011 … 2,271 columns.” “Fortunately,” he adds wryly, “Excel had expanded sufficiently to capture the increase.” Though this growingly complex reporting failed to prevent detection of the seeds of the debacle of 2007–09, Dodd–Frank has layered on copious amounts of new complexity. The legislation has 16 titles and runs 848 pages. It spawns litter upon litter of regulations: More than 8,800 pages of regulations have already been proposed, and the process is not yet done. In his speech, Haldane noted—conservatively, in my view—that a survey of the Federal Register showed that complying with these new rules would require 2,260,631 labor hours each year. He added: “Of course, the costs of this regulatory edifice would be considered small if they delivered even modest improvements to regulators’ ability to avert future crises.” He then goes on to argue the wick is not worth the candle. And he concludes: “Modern finance is complex, perhaps too complex. Regulation of modern finance is complex, almost certainly too complex. That configuration spells trouble. As you do not fight fire with fire, you do not fight complexity with complexity. [The situation] requires a regulatory response grounded in simplicity, not complexity. Delivering that would require an about-turn.”

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The Dallas Fed’s Proposal: A Reasonable ‘About-Turn’
The Dallas Fed’s proposal offers an “about-turn” and a way to mend the flaws in Dodd–Frank. It fights unnecessary complexity with simplicity where appropriate. It eliminates much of the mumbo-jumbo, ineffective, costly complexity of Dodd–Frank. Of note, it would be especially helpful to non-TBTF banks that do not pose systemic or broad risk to the economy or the financial system. Our proposal would relieve small banks of some unnecessary burdens arising from Dodd–Frank that unfairly penalize them. Our proposal would effectively level the playing field for all banking organizations in the country and provide the best protection for taxpaying citizens. In a nutshell, we recommend that TBTF financial institutions be restructured into multiple business entities. Only the resulting downsized commercial banking operations—and not shadow banking affiliates or the parent company—would benefit from the safety net of federal deposit insurance and access to the Federal Reserve’s discount window.

Defining the Landscape
It is important to have an accurate view of the landscape of banking today in order to understand the impact of this proposal. As of third quarter 2012, there were approximately 5,600 commercial banking organizations in the U.S.

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The bulk of these—roughly 5,500—were community banks with assets of less than $10 billion. These community-focused organizations accounted for 98.6 percent of all banks but only 12 percent of total industry assets. Another group numbering nearly 70 banking organizations—with assets of between $10 billion and $250 billion—accounted for 1.2 percent of banks, while controlling 19 percent of industry assets. The remaining group, the megabanks—with assets of between $250 billion and $2.3 trillion—was made up of a mere 12 institutions. These dozen behemoths accounted for roughly 0.2 percent of all banks, but they held 69 percent of industry assets.

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The 12 institutions that presently account for 69 percent of total industry assets are candidates to be considered TBTF because of the threat they could pose to the financial system and the economy should one or more of them get into trouble. By contrast, should any of the other 99.8 percent of banking institutions get into trouble, the matter most likely would be settled with private-sector ownership changes and minimal governmental intervention. How and why does this work for 99.8 percent but not the other 0.2 percent?
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To answer this question, it helps to consider the sources of regulatory and market discipline imposed on each of the three groups of banks. Let’s look at two dimensions of regulatory discipline: Potential closure of the institution and the effectiveness of supervisory pressure on bank management practices. Do the owners and managers of a banking institution operate with the belief that their institution is subject to a bankruptcy process that works reasonably quickly to transfer ownership and control to another banking entity or entities? Is there a group of interested and involved shareholders that can exert a restraining force on franchise-threatening risk taking by the bank’s top management team? Can management be replaced and ownership value wiped out? Is the firm controlled de facto by its owners, or instead effectively management-controlled? In addition, we ask: To what extent do uninsured creditors of the banking entity impose risk-management discipline on management? This analytical framework is summarized in the following slide:

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Looking across line 1, it is clear that community banks are subject to considerable regulatory and shareholder discipline. They can and do fail. In the last few years, the Federal Deposit Insurance Corp. (FDIC) has built a reputation for regulators carrying out Joseph Schumpeter’s concept of “creative destruction” by taking over small banks on a Friday evening and reopening them on Monday morning under new ownership. “In on Friday, out by Monday” is the mantra of this process.

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Knowing the power of banking supervisors to close the institution, owners and managers of community banks heed supervisory suggestions to limit risk. Community banks often have a few significant shareholders who have a considerable portion of their wealth tied to the fate of the bank. Consequently, they exert substantial control over the behavior of management because risk and potential closure matter to them. Since community banks derive the bulk of their funding from federally insured deposits, they are simple rather than complex in their capital structure and rarely have uninsured and unsecured creditors. “Market discipline” over management practices is primarily exerted through shareholders. Of the three groups, the 70 regional and moderate-sized banking organizations depicted in line 2 are subject to a broader range of market discipline. Like community banks, these institutions are not exempt from the bankruptcy process; they can and do fail. But given their size, complexity and generally larger geographic footprint, the failure resolution and ownership transfer processes cannot always be accomplished over a weekend. In practice, owners and managers of mid-sized institutions are nonetheless aware of the downside consequences of the risks taken by the institution. Uninsured depositors and unsecured creditors are also aware of their unprotected status in the event the institution experiences financial difficulties.

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Mid-sized banking institutions receive a good dose of external discipline from both supervisors and market-based signals. TBTF megabanks, depicted in line 3, receive far too little regulatory and market discipline. This is unfortunate because their failure, if it were allowed, could disrupt financial markets and the economy. For all intents and purposes, we believe that TBTF banks have not been allowed to fail outright. Knowing this, the management of TBTF banks can, to a large extent, choose to resist the advice and guidance of their bank supervisors’ efforts to impose regulatory discipline. And for TBTF banks, the forces of market discipline from shareholders and unsecured creditors are limited. Let’s first consider discipline from shareholders. Having millions of stockholders has diluted shareholders’ ability to prevent the management of TBTF banks from pursuing corporate strategies that are profitable for management, though not necessarily for shareholders. As we learned during the crisis, adverse information on poor financial performance often is available too late for shareholder reaction or credit default swap (CDS) spreads to have any impact on management behavior. For example, during the financial crisis, shares in two of the largest bank holding companies (BHCs) declined more than 95 percent from their prior peak prices and their CDS spreads went haywire. The ratings agencies eventually reacted, in keeping with their tendency to be reactive rather than proactive. But the damage from excessive risk taking had already been done.

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And after the crisis? Judging from the behavior of many of the largest BHCs, with limited exception, efforts by shareholders of these institutions to meaningfully influence management compensation practices have been slow in coming. So much for shareholder discipline as a check on TBTF banks. Unfortunately, TBTF banks also do not face much external discipline from unsecured creditors. An important facet of TBTF is that the funding sources for megabanks extend far beyond insured deposits, as referenced by my mention of CDS spreads. The largest banks, not just the TBTF banks, fund themselves with a wide range of liabilities. These include large, negotiable CDs, which often exceed the FDIC insurance limit; federal funds purchased from other banks, all of which are uninsured, and subordinated notes and bonds, generally unsecured. It is not unusual for such uninsured/unsecured liabilities to account for well over half the liabilities of TBTF institutions. If market discipline were to be imposed on TBTF institutions, one would expect it to come from uninsured/unsecured depositors, creditors and debt holders. But TBTF status exerts perverse market discipline on the risk-taking activities of these banks. Unsecured creditors recognize the implicit government guarantee of TBTF banks’ liabilities.

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As a result, unsecured depositors and creditors offer their funds at a lower cost to TBTF banks than to mid-sized and regional banks that face the risk of failure. This TBTF subsidy is quite large and has risen following the financial crisis. Recent estimates by the Bank for International Settlements, for example, suggest that the implicit government guarantee provides the largest U.S. BHCs with an average credit rating uplift of more than two notches, thereby lowering average funding costs a full percentage point relative to their smaller competitors. Our aforementioned friend from the Bank of England, Andrew Haldane, estimates the current implicit TBTF global subsidy to be roughly $300 billion per year for the 29 global institutions identified by the Financial Stability Board (2011) as “systemically important.” To put that $300 billion estimated annual subsidy in perspective, all the U.S. BHCs summed together reported 2011 earnings of $108 billion. Add to that the burdens stemming from the complexity of TBTF banks. Here is the basic organization diagram for a typical complex financial holding company:

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To simplify a complex issue, one might consider all the operations other than the commercial banking operation as shadow banking affiliates, including any special investment vehicles—or SIVs—of the commercial bank. Now, consider this table. It gives you a sense of the size and scope of some of the five largest BHCs, noting their nondeposit liabilities in billions of dollars and their number of total subsidiaries and countries of operation (according to the Financial Stability Oversight Council):

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For perspective, consider the sad case of Lehman Brothers. More than four years later, the Lehman bankruptcy is still not completely resolved. As of its 10-K regulatory filing in 2007, Lehman operated a mere 209 subsidiaries across only 21 countries and had total liabilities of $619 billion. By these metrics, Lehman was a small player compared with any of the Big Five. If Lehman Brothers was too big for a private-sector solution while still a going concern, what can we infer about the Big Five in the table?
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Correcting for the Drawbacks of Dodd–Frank
Dodd–Frank addresses this concern. Under the Orderly Liquidation Authority provisions of Dodd–Frank, a systemically important financial institution would receive debtor-in-possession financing from the U.S. Treasury over the period its operations needed to be stabilized. This is quasi-nationalization, just in a new, and untested, format. In Dallas, we consider government ownership of our financial institutions, even on a “temporary” basis, to be a clear distortion of our capitalist principles. Of course, an alternative would be to have another systemically important financial institution acquire the failing institution. We have been down that road already. All it does is compound the problem, expanding the risk posed by the even larger surviving behemoth organizations. In addition, perpetuating the practice of arranging shotgun marriages between giants at taxpayer expense worsens the funding disadvantage faced by the 99.8 percent remaining—small and regional banks. Merging large institutions is a form of discrimination that favors the unwieldy and dangerous TBTF banks over more focused, fit and disciplined banks. The approach of the Dallas Fed neither expands the reach of government nor further handicaps the 99.8 percent of community and regional banks. Nor does it fight complexity with complexity. It calls for reshaping TBTF banking institutions into smaller, less complex institutions that are: economically viable; profitable;
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competitively able to attract financial capital and talent; and of a size, complexity and scope that allows both regulatory and market discipline to restrain excessive risk taking. Our proposal is simple and easy to understand. It can be accomplished with minimal statutory modification and implemented with as little government intervention as possible. It calls first for rolling back the federal safety net to apply only to basic, traditional commercial banking. Second, it calls for clarifying, through simple, understandable disclosures, that the federal safety net applies only to the commercial bank and its customers and never ever to the customers of any other affiliated subsidiary or the holding company. The shadow banking activities of financial institutions must not receive taxpayer support. We recognize that undoing customer inertia and management habits at TBTF banking institutions may take many years. During such a period, TBTF banks could possibly sow the seeds for another financial crisis. For these reasons, additional action may be necessary. The TBTF BHCs may need to be downsized and restructured so that the safety-net-supported commercial banking part of the holding company can be effectively disciplined by regulators and market forces. And there will likely have to be additional restrictions (or possibly prohibitions) on the ability to move assets or liabilities from a shadow banking affiliate to a banking affiliate within the holding company. To illustrate how the first two points in our plan would work, I come back to the hypothetical structure of a complex financial holding company.
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Recall that this type of holding company has a commercial bank subsidiary and several subsidiaries that are not traditional commercial banks: insurance, securities underwriting and brokerage, finance company and others, many with a vast geographic reach.

Where the Government Safety Net Would Begin and End
Under our proposal, only the commercial bank would have access to deposit insurance provided by the FDIC and discount window loans provided by the Federal Reserve. These two features of the safety net would explicitly, by statute, become unavailable to any shadow banking affiliate, special investment vehicle of the commercial bank or any obligations of the parent holding company. This is largely the current case—but in theory, not in practice. And consistent enforcement is viewed as unlikely.

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Reinforced by a New Covenant
To reinforce the statute and its credibility, every customer, creditor and counterparty of every shadow banking affiliate and of the senior holding company would be required to agree to and sign a new covenant, a simple disclosure statement that acknowledges their unprotected status. A sample disclosure need be no more complex than this:

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This two-part step should begin to remove the implicit TBTF subsidy provided to BHCs and their shadow banking operations. Entities other than commercial banks have inappropriately benefited from an implicit safety net. Our proposal promotes competition in light of market and regulatory discipline, replacing the status quo of subsidized and perverse incentives to take excessive risk. As indicated earlier, some government intervention may be necessary to accelerate the imposition of effective market discipline. We believe that market forces should be relied upon as much as practicable.

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However, entrenched oligopoly forces, in combination with customer inertia, will likely only be overcome through government-sanctioned reorganization and restructuring of the TBTF BHCs. A subsidy once given is nearly impossible to take away. Thus, it appears we may need a push, using as little government intervention as possible to realign incentives, reestablish a competitive landscape and level the playing field.

Why Protect the 0.2 Percent?
My team at the Dallas Fed and I are confident this simple treatment to the complex problem and risks posed by TBTF institutions would be the most effective treatment. Think about it this way: At present, 99.8 percent of the banking organizations in America are subject to sufficient regulatory or shareholder/market discipline to contain the risk of misbehavior that could threaten the stability of the financial system. Zero-point-two percent are not. Their very existence threatens both economic and financial stability. Furthermore, to contain that risk, regulators and many small banks are tied up in regulatory and legal knots at an enormous direct cost to them and a large indirect cost to our economy. Zero-point-two percent. If the administration and the Congress could agree as recently as two weeks ago on legislation that affects 1 percent of taxpayers, surely it can process a solution that affects 0.2 percent of the nation’s banks and is less complex and far more effective than Dodd–Frank.

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Making a Time of ‘Awful Moment’ a Time of Promise
The time has come to change the decision making paradigm. There should be more than the present two solutions: bailout or the end-of-the-economic-world-as-we-have-known-it. Both choices are unacceptable. The next financial crisis could cost more than two years of economic output, borne by millions of U.S. taxpayers. That horrendous cost must be weighed against the supposed benefits of maintaining the TBTF status quo. To us, the remedy is obvious: end TBTF now. End TBTF by reintroducing market forces instead of complex rules, and in so doing, level the playing field for all banking institutions. I return to Patrick Henry. He noted that “it is natural to man to indulge in the illusions of hope. We are apt to shut our eyes against a painful truth, and listen to the song of that siren till she transforms us.” We labor under the siren song of Dodd–Frank and the recent run-up in the pricing of TBTF bank stocks and credit, indulging in the illusion of hope that this complex legislation will end too big to fail and right the banking system. We shut our eyes to the painful truth that TBTF represents an ongoing danger not just to financial stability, but also to fair competition. The Dallas Fed offers a modest but, we believe, far more effective fix to Dodd–Frank. This plan is not without its costs.

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But it is less costly than all the alternatives put forward and it seriously reduces the likelihood of another horrendous and costly financial crisis. This need not be a time of “awful moment.” It should instead be a time of promise. Treating the pathology of TBTF now would be a big step toward a more stable and prosperous economic system, one that relies on fundamental principles of capitalism rather than regulatory complexity and increasing government intervention. Thank you.

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Tougher credit rating rules confirmed by European Parliament's vote
New rules on when and how credit rating agencies may rate state debts and private firms' financial health were approved by Parliament on Wednesday. They will allow agencies to issue unsolicited sovereign debt ratings only on set dates, and enable private investors to sue them for negligence. Agencies' shareholdings in rated firms will be capped, to reduce conflicts of interest. MEPs also ensured that the ratings are clearer by requiring agencies to explain the key factors underlying them. Ratings must not seek to influence state policies, and agencies themselves must not advocate any policy changes, adds the text. The rules have already been provisionally agreed with the Council. "We are taking some steps forward with this new regulation, fully in line with its basic spirit, which is to enable firms to do their own internal ratings. These should provide viable, comparable and reliable alternatives to those of the rating oligopoly", said lead MEP Leonardo Domenici (S&D, IT).

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Set dates for sovereign debt ratings
Unsolicited sovereign ratings could be published at least two but no more than three times a year, on dates published by the rating agency at the end of the previous year. Furthermore, these ratings could be published only after markets in the EU have closed and at least one hour before they reopen.

Agencies to be liable for ratings
Investors who rely on a credit rating could sue the agency that issued it for damages if it breaches the rules set out in this legislation either intentionally or by gross negligence, regardless whether there is any contractual relationship between the parties. Such breaches would include, for example, issuing a rating compromised by a conflict of interests or outside the published calendar.

Reducing over-reliance on ratings
To reduce over-reliance on ratings, MEPs urge credit institutions and investment firms to develop their own rating capacities, to enable them to prepare their own risk assessments. The European Commission should also consider developing a European creditworthiness assessment, adds the text. By 2020 no EU legislation should directly refer to external ratings, and financial institutions must not be any more obliged to automatically sell assets in the event of a downgrade.

Capping shareholdings
A credit rating agency will have to refrain from issuing ratings, or disclose that its ratings may be affected, if a shareholder or member holding 10 % of the voting rights in that agency has invested in the rated entity. The new rules will also bar anyone from simultaneously holding stakes of more than 5% in more than one credit rating agency, unless the agencies concerned belong to the same group.

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The Domenici report on the regulation was adopted by 579 votes to 58, with 60 abstentions and that on the directive by 599 votes to 27, with 68 abstentions.

Article 1 Subject matter
This Regulation introduces a common regulatory approach in order to enhance the integrity, transparency, responsibility, good governance and independence of credit rating activities, contributing to the quality of credit ratings issued in the Union, thereby contributing to the smooth functioning of the internal market while achieving a high level of consumer and investor protection. It lays down conditions for the issuing of credit ratings and rules on the organisation and conduct of credit rating agencies, including their shareholders and members, to promote credit rating agencies' independence, the avoidance of conflicts of interest and the enhancement of consumer and investor protection. This Regulation also lays down obligations for issuers, originators and sponsors established in the Union regarding structured finance instruments.

Article 5ba Over-reliance on credit ratings in Union law
Without prejudice to its right of initiative, the Commission shall continue to review references to credit ratings in Union law which trigger or have the potential to trigger sole or mechanistic reliance on credit ratings by competent authorities or financial market participants, with a view to eliminating all references to ratings in Union law by 1 January 2020, provided that appropriate alternatives to credit risk assessment have been identified and implemented.

Article 6a Conflicts of interest concerning investments in credit rating agencies
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1. A shareholder or a member of a credit rating agency holding at least 5 % of the capital or the voting rights in a credit rating agency or in a company which has the power to exercise dominant influence or control over the registered credit rating agency, shall be prohibited from: (a) holding 5 % or more of the capital of any other credit rating agency; (b) having the right or the power to exercise 5 % or more of the voting rights in any other credit rating agency; (c) having the right or the power to appoint or remove members of the administrative, management or supervisory body of any other credit rating agency; (d) being member of the administrative, management or supervisory body of any other credit rating agency; (e) exercising or having the power to exercise dominant influence or control over any other credit rating agency. The prohibition referred to in point (a) of the first subparagraph does not apply to holdings in diversified collective investment schemes, including managed funds such as pension funds or life insurance, provided that the holdings in diversified collective investment schemes do not put him or her in a position to exercise significant influence on the business activities of those schemes.

Article -8a Sovereign debt ratings
1. Sovereign debt ratings shall be issued in a manner, which ensures that the individual specificity of a particular Member State has been analysed. A statement announcing revision of a given group of countries shall be prohibited, if not accompanied by individual country reports. Those reports shall be made publicly available.

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2. Public communications other than credit ratings, rating outlooks or accompanying press releases, as referred to in point 5 of Part I of Section D of Annex I, which relate to potential changes of sovereign ratings shall not be based on information stemming from the sphere of the rated entity, where such information has been released without the consent of the rated entity, unless it is available from generally accessible sources or unless there are no legitimate reasons for the rated entity not to give its consent to the release of the information. 3. A credit rating agency shall, taking into consideration the provisions in second subparagraph of Article 8(5), publish on its website and send to ESMA on an annual basis, in accordance with point 3 of Part III of Section D of Annex I, a calendar at the end of the month of December for the next 12 months, setting a maximum of three dates for the publication of unsolicited sovereign ratings and related outlooks and setting the dates for the publication of solicited sovereign ratings and related outlooks. Such dates shall be set on a Friday. 4. Deviation of the publication of sovereign rating or related rating outlooks from the calendar shall only be possible in as much as this is necessary for the credit rating agency to comply with its obligations under Article 8(2), Article 10(1) and Article 11(1) and shall be accompanied by a detailed explanation of the reasons for the deviation from the announced calendar.

Article 8c Use of multiple credit rating agencies
1. Where an issuer or a related third party intends to mandate at least two credit rating agencies for the credit rating of the same issuance or entity, the issuer shall consider the possibility to mandate at least one credit rating agency which does not have more than 10 % of the total market share and which can be evaluated by the issuer as capable for rating the relevant issuance or entity, provided that, based on the list of ESMA mentioned in paragraph 2, there is a credit rating agency available for rating the specific issuance or entity.

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Where the issuer does not mandate at least one credit rating agency which does not have more than 10 % of the total market share, this shall be recorded. 2. With a view to facilitating the evaluation by the issuer under paragraph 1, ESMA shall annually publish on its website a list of registered credit rating agencies, indicating their total market share and the types of ratings issued, which can be used by the issuer as a starting point for its evaluation. 3. For the purposes of this Article, the total market share shall be measured by annual turnover generated from credit rating activities and ancillary services, at group level.

Article 35a Civil liability
1. Where a credit rating agency has committed intentionally or with gross negligence any of the infringements listed in Annex III having an impact on a credit rating, an investor or issuer may claim damages from that credit rating agency for damage caused to them due to that infringement. An investor may claim damages under this Article where it establishes that it has reasonably relied, in accordance with Article 5a or otherwise with due care, on a credit rating for a decision to invest into, hold onto or divest from a financial instrument covered by that credit rating. An issuer may claim damages under this Article where it establishes that it or its financial instruments are covered by that credit rating and the infringement was not caused by misleading and inaccurate information provided by the issuer to the credit rating agency, directly or through information publicly available. 5. Civil liability as referred to in paragraph 1 may be limited in advance only where all of the following conditions are complied with: (a) the limitation is reasonable and proportionate; and (b) the limitation is allowed by the relevant national law as determined in
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accordance with paragraph 5a. Where a limitation of civil liability does not comply with the conditions referred to in the first subparagraph it shall have no legal effect. 5a. The terms “damage”, “intention”, “gross negligence”, “reasonably relied”, “due care”, “impact”, “reasonable” and “proportionate” which are referred to in this Article but are not defined in this Regulation, shall be interpreted and applied in accordance with the applicable national law as determined by the relevant rules of private international law. Matters concerning the civil liability of a credit rating agency and which are not at all covered by this Regulation shall be governed by the applicable national law as determined by the relevant rules of private international law. The competent court to decide on a claim for civil liability brought by an investor shall be determined by the relevant rules of private international law. 5b. This Article does not exclude further civil liability claims in accordance with national law.

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Michel BARNIER

The European banking union, a precondition to financial stability and a historical step forward for European integration
Ladies and Gentlemen, First of all, I would like to thank the European Corporate Governance Institute, and Chairman Jörgen HOLMQUIST, for inviting me. Let me also thank: the National Bank of Belgium, the host of this conference; as well as the US Securities and Exchange Commission and Columbia Law School. Ladies and Gentlemen, As you know, the Council of European Finance Ministers reached a historic agreement last week. Member States have agreed to hand over the key supervisory tasks over their banks to the European Central Bank. This is the first step towards the Banking Union. The ECB will be in a position to detect risks to the viability of banks. And require banks to take the necessary actions. It will be competent to grant and revoke licences for credit institutions.

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It will ensure compliance with capital requirements. This Single Supervisory Mechanism (SSM) will be a great asset for financial stability in Europe. Before I will say a few words on the modalities of the SSM and the next steps of the Banking Union, I would like to explain the key rationale for the SSM.

I – The Single Supervisory Mechanism should bring three major benefits to Europe 1. First, it is a precondition to put an end to the negative feedback loop between banks and sovereigns.
Between 2008 and 2011, EU taxpayers granted banks €4,5 trillion in loans and guarantees. This has had very concrete consequences. In some countries it has resulted in soaring rates at which countries can finance themselves on the markets and a severe drop in market confidence. Therefore, we need to move from national backstops to a European backstop. This is the purpose of the European Stability Mechanism. But this new fund will only be able to recapitalise banks directly once all European banks are properly supervised. This is why an agreement on the SSM was so deeply needed.

2. Second, we need the SSM to reduce the fragmentation of the banking system.
The current crisis has led to a re-nationalisation of bank activities.
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With less cross-border funding and many lost opportunities for citizens and businesses. The differentiated perception of risks led to disparity of spreads on sovereign bonds as well as in the interbank market. We all know the consequences: similar companies in different parts of Europe operating on the same markets may be subject to significantly different costs of borrowing. The SSM will restore confidence in the European banking sector. It is likely to have a positive impact on the spreads and consolidate the Single Market.

3. Third, we need the SSM to complete the monetary union.
Monetary policy is an important tool to deal with economic shocks. But it depends to a large extent on private banks which transmit monetary impulses to the real economy. If we want an efficiently functioning monetary policy, we need a single European banking system. And it starts with a single European supervisory system. Therefore the SSM is not just a way to restore confidence and deal with the crisis in the short-term. It is also a way to consolidate our economy in the longer-term. For all these reasons, the last week's agreement is a major milestone in the history of European integration. Let me now move to the content of the SSM agreement.
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II – How will the new Single Supervisory Mechanism work?
There are five important points which deserve attention.

1. First, the scope of the new supervision
Some Member States wanted the new supervision to be restricted to "systemically important" banks. But we know that small or medium-size banks can endanger the entire financial system. The failures of banks like Northern Rock, Dexia or Bankia are clear reminders of that. Moreover, we cannot have two supervisory mechanisms for banks operating in the same market. It would be inherently unstable. Therefore I am glad that the SSM will cover all 6,000 banks in the Euro area. The ECB will set the rules and be able to assume directly all relevant supervisory tasks whenever it considers it appropriate. For each one of these 6,000 banks. However, it seems logical that the ECB focuses its direct supervision on the banks which can generate significant prudential risks – through their size or risk profile. Member States decided last week to clarify the division of labour between the ECB and national authorities. Within a unified supervisory system, the ECB will have direct responsibility for around 150 banks with assets of more than 30 billion Euros, or representing more than 20 % of a Member State’s national output.

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Other banks will still be looked after primarily by national supervisors within the same unified supervisory system. The ECB will have the power to step in directly at any moment, if need be. Besides, national supervisors will also remain in charge of tasks like consumer protection, money laundering and branches of third country banks.

2. Second, the governance of the new mechanism
Bank supervision is a new task for the ECB. We had to make sure that this task is clearly separated from the monetary policy functions of the ECB. That is why we proposed to create within the ECB a Supervisory Board alongside the Governing Council. In addition, to ensure the democratic accountability of the new system the ECB will report to the European Parliament on its role as a Single Supervisor.

3. Third, the participation of non-Euro area Member States in the SSM
The SSM is open to all Member States, also those outside the Euro area. The final decision-making body of the ECB is the Governing Council, which includes only representatives from Euro area Member States. Therefore, it was important to allow non-Euro area Member States to participate in the SSM on an equal footing.

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The creation within the ECB of the Supervisory Board alongside the Governing Council solves this issue, with a mediation panel to resolve differences.

4. Fourth, the case of non-Euro area Member States which do not wish to participate in the new mechanism
Some countries have expressed their wish not to join the SSM for now. In this context, the UK, Sweden and the Czech Republic have expressed concerns about the ECB's new powers. In particular, they questioned the ECB's voting rights within the European Banking Authority (EBA). I understand these concerns. And last week's agreement does preserve the influence of non-Eurozone Member States within EBA. According to the new voting modalities, any EBA decisions will have to be approved by a majority of countries outside the Banking Union. EBA will have the task of fostering a single rulebook for all 27 countries of the single market. It will also work on enhancing convergence of supervisory practices via a single supervisory handbook.

5. Finally, the timing
Let me reiterate one point: an effective SSM is a prerequisite if we want to open the way for the European Stability Mechanism to directly recapitalise banks. And to break the vicious circle between banks and sovereigns. Therefore we had no time to lose.

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That said, the Member States found last week that a phasing-in approach was necessary. That is why they decided that the new mechanism will become fully operational in March 2014. And before that happens, the ECB will be able to take over supervision of ailing banks, at the request of the European Stability Mechanism.

III – Finally, let me conclude by adding a few words on next steps.
The SSM is a great first step towards a proper Banking Union. But the Banking Union does not stop with the SSM.

1. First, the Banking Union will build on a single rulebook.
The single rulebook will be applicable to all 27 Member States. It will include rules on key issues such as: Capital requirements: Our "CRD 4" proposal is crucial for financial stability. It is currently being discussed in the so called "trilogues" and we hope to reach an agreement very soon. And our banks are ready for it as demonstrated by stress tests conducted by the European Banking Authority. But our major partners should also follow. Starting with the US. As the two largest financial markets in the world, we both have a duty to set the example and show leadership. We need to ensure a coordinated approach for the implementation of these important rules. Deposit guarantee schemes are another important aspect of the single rulebook. We need to ensure that each Member State has a fully funded scheme in place.

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We also need rules on Bank resolution: Our proposal for a common European resolution framework provides that shareholders and creditors should bear the cost of resolution before any external funding is granted. And that private sector solutions should be found instead of using taxpayers' money. Finally, the single rulebook could include rules on the structure of the banking sector. The Liikanen report has proposed solutions to separate deposit taking from more risky activities. Our reflection in this field is still on-going.

2. Secondly - the Banking Union will also need a single resolution authority.
The SSM will help us prevent crises. But we also need to anticipate the cases where a crisis would nonetheless occur. We of course need to ensure that each Member State sets up national funds for resolution and deposit guarantees. But a fully-fledged Banking Union would require going even further and creating a single resolution authority. In case of cross-border failures, it would be more efficient than a network of national resolution authorities. This is in particular needed so that we can ensure speedy and credible reactions to addressing banking crises. Ladies and Gentlemen, With last week's agreement, EU countries have fulfilled the commitment they made in June. The SSM now has to be discussed in the European Parliament. The rapporteurs Sven GIEGOLD and Marianne THYSSEN have already done a great job.

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I am confident that the final agreement will be reached soon. This would be good news for financial stability, for public finances in the Eurozone and for the world economy, which would get a boost from a return of full confidence in the Eurozone. I am also confident that, in five years' time, the SSM will be considered as the key step to putting our financial house in order. And a milestone in a new phase of European integration, which should lead us to a genuine financial, budgetary, economic and political union. Thank you for your attention.

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José Manuel Durão Barroso, President of the European Commission Statement by President Barroso on the Cyprus Presidency of the Council European Parliament plenary session/Strasbourg Mr. President, President Christofias, Honourable members, I want to start by thanking and also congratulating President Christofias, and through him all the people and authorities involved in the running of the Cyprus Presidency. I want to pay tribute today to Cyprus that, as one of our smallest member states, with its particular geographical location and itself facing important political and economic challenges these days, has proved its pro European commitment, professionalism and efficiency during its Council Presidency. Together we have reached important results during this period, and I am convinced that Cyprus will continue to make an important contribution to our Union beyond its term of Presidency. President Christofias, thank you very much for your kind words regarding the role the Commission and myself have played in contributing to your very successful Presidency. Honourable members, Our debate today gives us the opportunity to take stock of what has been achieved so far, and what is still on the table. During six months not all problems can be solved. Not all files can be closed. Nevertheless, a lot of important groundwork has been done in 2012 which, in that sense, was a crucial year:
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Crisis-hit Eurozone countries have made important progress in bringing their budgets in order and in tackling deep-rooted structural problems. They have done so with determination and resolve. At every phase, they have been driven forward, advised and assisted by the European institutions. This process needs to continue; The ever-sceptical financial markets have taken note of these efforts and acknowledged them; Private investors are finding their way back to Eurozone countries in need; Competitiveness, notably of the least competitive member states, is improving, leading to the gradual rebalancing the Eurozone so far has lacked; Overall public finances are improving, slowly but surely. We have safeguarded the integrity of the Eurozone. We have stopped the existential threat hanging over us earlier. Of course, we must avoid any kind of complacency. As long as unemployment remains very high, the crisis is certainly not over yet. And I've been extremely clear saying that we still have a crisis in front of us, namely a social crisis, very deep in some of our Members States. But we have turned a page in the crisis. No more, no less. And we are now ready to write the next chapter of the recovery. Mr President, Honourable members, This next chapter will be about building confidence by further strengthening our economic governance, by completing the banking
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union and by exploiting every means possible to create growth – sustainable growth - and jobs and to address the most pressing social problems in our countries. The Commission will continue to take the lead in this. The line the Commission has been defending, and will continue to defend, is of course about putting our public finances in order. Because without that there is no confidence, without confidence there is no investment, without investment there is no growth. But this is just part of the answer. We have at the same time highlighted how important it is to have reforms for competitiveness and also investment, because investment is indispensable for growth. I wish all governments of Europe could share the same priority the Commission is giving to the need for investment at European level. We will continue to firmly defend the European interest. And we will continue to work hand in hand with this Parliament. The European Union and its member states have to continue on the path of reform. We have yet to prove the sustainability of this process. Looking at the past year I feel encouraged that we will be successful. In fact, this is the main lesson I draw from what happened and from what didn't happen over the last few months: those speculating against the Euro have underestimated the political capital that is invested in it. Let us continue to prove them wrong, and beware not to disinvest at such a crucial moment, just when our investment is starting - and I underline: starting to pay off. A lot still has to be done. This is also why it is crucial to complete our work at European level.
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Despite the important efforts deployed by the Cyprus Presidency and by many of you in the European Parliament, we have not been able to finalise the Two Pack. And the Two Pack is essential to make progress in the economy governance within the community method. After over a year of negotiations, with thirteen trilogue meetings, I believe it's time to conclude and send, once again, the signal that Europe is capable of decisive action. This is the first opportunity we have to keep the reform momentum going. Likewise, we have not had the chance to break the deadlock in the negotiations on the multiannual financial framework, something both Parliament and the Commission would have welcomed. The Cyprus Presidency made the first attempt to reach a consensus. However, the conditions were not yet met to reach agreement. Clearly, these have been the most difficult and complex budget negotiations ever. Now, negotiations have reached a point where, I must say, further cuts risk weakening the European Union as such, while our common goal should be to strengthen our Union. The MFF is a fundamental European tool for growth, for investment, for solidarity - concrete solidarity. The Commission will continue to work towards an agreement between member states and also between our institutions. We have highlighted constantly that the approval of this Parliament is indispensable. And we need that agreement. We have seen, in the extremely difficult negotiations on the European Union's budget for 2013 and the amending budget for 2012, where, by the way, the Cyprus presidency made a tremendous and at the end successful
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effort - negative for us would be, if we could not have the predictability that a multiannual budget can give for investment in Europe. And I will also keep fighting for the truly European parts of the package, notably those aimed at growth and jobs. But as I said, we are not yet there. Further efforts will be needed to bring positions together. This will be difficult but certainly not impossible. That was also clear from the debate on the road towards a European banking union. The centrepiece of the Cypriot Presidency was to make progress on the Commission's proposals for a Single Supervisory Mechanism. And in this, we have achieved a significant breakthrough, both on the Council and on the Parliament side. Parliament has worked on this very efficiently and the Thyssen and Giegold reports are constructive and supportive, and in very many points rather similar to the approach taken by the Council. I hope making the final step for formal adoption is a matter of weeks, not months. Next should be a swift conclusion on the pending proposals on bank capital rules, bank resolution and deposit guarantees. Following the adoption of the SSM the Commission will make a formal legislative proposal for a single resolution mechanism in the banking sector before the summer. I consider this a matter of utmost political priority. This proposal will be by no means less important than the SSM, and neither will it be less complex to frame in legal, technical and political terms.

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At the same time, we have not neglected to prepare the ground for the major debate needed before the European elections: in presenting our Blueprint on a Deep and Genuine EMU, the Commission stuck its neck out. That is our role. It's the only way for Europe to keep its focus on the long road still ahead, to provide coherence and also to structure to our day-to-day efforts. The focus that we had to give to the financial sector, the fiscal situation and to questions of economic governance does not mean Europe is losing sight of the real economy. On the contrary, real economy is and should be our first priority. And in this sense the contribution, in the last six months, made by the Cyprus presidency, needs to be highlighted here: After some 30 years of debate, and based on Commission proposals, an agreement was finally reached between member states - even if not all on the Single European Patent; We have concluded negotiations on a Free Trade Agreement with Singapore, and you have given the final consent to trade deals with Central America, and with Colombia and Peru; and we have agreed to launch negotiations for a Free Trade Agreement with Japan. We took stock of the implementation of the Digital Agenda for Europe, halfway through its 5-year strategy, and found that it had achieved many of its targets and is on track to meet most of the others; The Commission presented its proposal for a Council Recommendation on Youth Guarantees. First discussions have taken place in the Council. It is key that we prioritise for job and training opportunities for those hit hardest by the crisis.

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This is a matter where Member States can give a concrete demonstration that they are committed to growth and to tackle the very serious problem of unemployment, namely youth unemployment; A very good contribution of the Cyprus Presidency was the Limassol declaration, giving a new impetus to our integrated maritime policy. This is a matter very close to my heart. I was happy to be in Cyprus for that occasion and I believe this can be a real contribution to boost growth; Finally, and I could of course quote other matters, but among the most important, progress was also made on the Asylum Package and it has brought us very close to concluding the discussions on the Common European Asylum System and with your groundwork, important steps have been achieved in negotiating with this House on the Schengen Governance package, preparing the ground for an agreement in early 2013. Mr President, Honourable members, I truly believe that over the last few months, while many important and difficult challenges remain, notably the social ones, we have regained trust, we have reaffirmed composure and recovered momentum. The Cyprus Presidency can therefore look back with satisfaction at a number of important achievements in economically and socially difficult times. During these last six months, Cyprus has shown its European commitment in holding its first Council rotating Presidency. It will be our job over the months to come, through serious efforts, to show that Europe works and delivers - each of us with his or her own role to play, but never forgetting our collective responsibility as a Union.

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I thank you for your attention.

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The European Banking Union
Towards a banking union In June 2012, EU leaders agreed to deepen economic and monetary union as one of the remedies of the current crisis. At that meeting (European Council of 28/29 June), the leaders discussed the report entitled 'Towards a Genuine Economic and Monetary Union', prepared by the President of the European Council in close collaboration with the President of the European Commission, the Chair of the Eurogroup and the President of the European Central Bank. This report set out the main building blocks towards deeper economic and monetary integration, including banking union.

1. What do we want to achieve with banking union? 1.1 What is the banking union that we wish to implement?
When the financial crisis spread to Europe in 2008, we had 27 different banking regulatory systems in place, all based on national rules and national rescue measures. Some form of European coordination existed but it was related to exchanges of information and rather informal cooperation procedures. This was not sufficient to respond to the financial sector crisis and its contagion to sovereigns. A fully-fledged banking union will be key to supporting economic and monetary integration.

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Pooled monetary responsibilities have indeed spurred closer economic and financial integration, and increased the possibility of cross-border effects in the event of bank crises. Common and more integrated banking supervision for the Euro area is one important pillar to make sure that supervision abides by the highest standards. This will build the necessary trust between Member States which is a condition for using common backstops, notably the direct recapitalization by the ESM of banks. Once common supervision for the Euro area is in place, the Commission's intention is to build on existing proposals for deposit guarantee schemes and bank recovery and resolution, moving towards a more integrated approach also in these areas.

1.2 Why do we want to achieve this banking union?
1.2.a. To break the link between Member States and their banks: Between October 2008 and October 2011, European countries have mobilised €4.5 trillion in public support and guarantees to their banks. This is not acceptable. With its proposal on capital requirements for banks ("CRD IV"), the Commission wants to ensure that the capital of banking institutions is sufficient both in quantity and in quality to face future shocks. The future European Stability Mechanism (ESM) could have the possibility to recapitalise banks directly once a single supervisory mechanism is established for banks in the euro area. This will contribute to breaking the vicious circle between banks and sovereigns as the ESM loans would not add to the debt burden of countries facing intense market pressure.
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1.2.b. To restore the credibility of the financial sector: The proposals already tabled by the European Commission to improve regulation of the financial system represent a solid basis to go further in the harmonisation of the rules, which will be made easier in the framework of a banking union. The European single supervisory system for banks will enable a fully rigorous and independent supervision of our banking sector. Giving to the ECB the ultimate responsibility for supervision of banks in the euro area will contribute to increasing confidence between the banks and in this way increase financial stability in the euro area. 1.2.c. To preserve tax payers' money: In early June, there were proposed EU rules for bank recovery and resolution. To make sure that supervisory authorities have all the tools they need to deal with bank failures without taxpayers' money. This also aims to protect taxpayers' money and deposits. 1.2.d. To make sure that banks serve society and the real economy: With our financial regulation agenda, we are improving financial markets' effectiveness, integrity and transparency in order to make sure that the funds available finance the economy.

2. EU banking union: what have we done so far?
For each of the four pillars of the banking union (i.e. single rulebook; supervision; deposit guarantees; and bank resolution), the Commission has already taken action providing a solid basis for developing them further.

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2.1 Measures to allow for more integrated banking supervision
Three European supervisory authorities (ESAs) started work on 1 January 2011 to provide a supervisory framework: 2.1.a. The European Banking Authority (EBA) which deals with banking supervision, including the supervision of the recapitalisation of banks, as well as the coordination and dispute settlement of national supervisors. 2.1.b. The European Securities and Markets Authority (ESMA) which deals with the supervision of capital markets. 2.1.c. The European Insurance and Occupational Pensions Authority (EIOPA), which deals with insurance supervision. The 27 national supervisors are represented in all three supervisory authorities. Their role is to contribute to the development of a single rulebook for financial regulation in Europe, solve cross-border problems, prevent the build-up of risks, and help restore confidence. In addition, the European Systemic Risk Board (ESRB) has been tasked with the macro-prudential oversight of the financial system within the Union. This new financial supervision framework has been in place since November 2010.

2.2 Towards a single rule book for the banking sector
The European Council of June 2009 unanimously recommended establishing a single rulebook applicable to all the financial institutions in the single market.

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With its proposal on capital requirements for banks ("CRD IV"), the Commission launched the process of implementing for the European Union the new global standards on bank capital agreed at G20 level (most commonly known as the Basel III agreement). It is recalled that banking institutions entered the crisis with capital that was insufficient both in quantity and in quality, leading to unprecedented support from national authorities. Europe is playing a leading role on this matter, applying these rules to more than 8,000 banks, representing 53% of global assets. The Commission proposals are currently being discussed by the Council and the European Parliament and the Commission is determined that an agreement be reached shortly. With this legislation the Commission also wants to set up a governance framework giving bank supervisors new powers to monitor banks more closely and take action through possible sanctions when they spot risks, for example to reduce credit when it looks like it is growing into a bubble. European supervisors would intervene in some cases, for example when national supervisors disagree in cross-border situations. Further, the completion of the financial regulation agenda forms integral part of the banking union.

2.3 Action taken to offer more protection to bank depositors
Thanks to EU legislation, bank deposits in any Member State are already guaranteed up to €100,000 per depositor if a bank fails. From a financial stability perspective, this guarantee prevents depositors from making panic withdrawals from their banks, thereby preventing severe economic consequences.
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In July 2010, the Commission proposed to go further, with a harmonisation and simplification of protected deposits, faster pay-outs and improved financing of schemes, notably through ex-ante funding of deposit guarantee schemes and a mandatory mutual borrowing facility between the national schemes. The idea behind this is that if a national deposit guarantee scheme finds itself depleted, it can borrow from another national fund. This would be the first step towards a pan-EU deposit guarantee scheme. In managing a number of bank crises over recent years, national authorities have often created a new structure out of the failing bank and transferred some critical functions of the bank to this structure, such as safeguarding deposits. These resolution mechanisms make sure that depositors never lose access to their savings (for example in the case of Northern Rock, the bank was split into a good bank, which contained the deposits and good mortgage loans, and a so-called "bad bank" winding down the impaired loans).

3. Banking union and bank recapitalisation
The EU has already taken action as regards the recapitalisation of banks in several ways. For instance, extensive financial sector conditionality has been included in the policy requirements addressed to Member States that have received international financial assistance. With respect to the banking sector, the required policy measures consist, on the one hand, of the orderly winding-down of non-viable institutions and, on the other hand, of the restructuring of viable banks.

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Higher capital requirements, recapitalisations of banks, stress tests, deleveraging targets as well as enhancing the regulatory and supervisory frameworks have also been part of the policy initiatives.
While not specific to programme countries, these stabilisation measures are most easily implemented in the context of international financial assistance. The European Financial Stability Facility (EFSF) can provide loans to non-programme euro area Member States for the specific purpose of recapitalising financial institutions, with the appropriate conditionality, institution-specific as well as horizontal, including structural reform of the domestic financial sector.

A single supervisory mechanism
On 12 September 2012 the European Commission proposed a single supervisory mechanism (SSM) for banks led by the European Central Bank (ECB) in order to strengthen the Economic and Monetary Union. The set of proposals is a first step towards an integrated “banking union” which includes further components such as a single rulebook, common deposit protection and a single bank resolution mechanisms. The proposals concern: 1. A regulation giving strong powers for the supervision of all banks in the euro area to the ECB and national supervisory authorities i.e. the creation of a single supervisory mechanism; 2. A regulation with limited and specific changes to the regulation setting up the European Banking Authority (EBA) to ensure a balance in its decision making structures between the euro area and non-euro area Member States;

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3. A communication outlining the Commission's overall vision for rolling out the banking union, covering the single rulebook, common deposit protection and a single bank resolution mechanism.

The European Commission proposes new ECB powers for banking supervision as part of a banking union
Proposals for a single supervisory mechanism (SSM) for banks in the euro area are an important step in strengthening the Economic and Monetary Union (EMU). In the new single mechanism, ultimate responsibility for specific supervisory tasks related to the financial stability of all Euro area banks will lie with the European Central Bank (ECB). National supervisors will continue to play an important role in day-to-day supervision and in preparing and implementing ECB decisions. The Commission is also proposing today that the European Banking Authority (EBA) develop a Single Supervisory Handbook to preserve the integrity of the single market and ensure coherence in banking supervision for all 27 EU countries.

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Basel Committee on Banking Supervision (BCBS) Charter January 2013
I. Purpose and role 1. Mandate
The BCBS is the primary global standard-setter for the prudential regulation of banks and provides a forum for cooperation on banking supervisory matters. Its mandate is to strengthen the regulation, supervision and practices of banks worldwide with the purpose of enhancing financial stability.

2. Activities
The BCBS seeks to achieve its mandate through the following activities: (a) Exchanging information on developments in the banking sector and financial markets, to help identify current or emerging risks for the global financial system; (b) Sharing supervisory issues, approaches and techniques to promote common understanding and to improve cross-border cooperation; (c) Establishing and promoting global standards for the regulation and supervision of banks as well as guidelines and sound practices; (d) Addressing regulatory and supervisory gaps that pose risks to financial stability; (e) Monitoring the implementation of BCBS standards in member countriesand beyond with the purpose of ensuring their timely, consistent and effective implementation and contributing to a "level playing field" among internationally-active banks; (f) Consulting with central banks and bank supervisory authorities which are not members of the BCBS to benefit from their input into the BCBS
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policy formulation process and to promote the implementation of BCBS standards, guidelines and sound practices beyond BCBS member countries; and (g) Coordinating and cooperating with other financial sector standard setters and international bodies, particularly those involved in promoting financial stability.

3. Legal status
The BCBS does not possess any formal supranational authority. Its decisions do not have legal force. Rather, the BCBS relies on its members' commitments, as described in Section 5, to achieve its mandate.

II. Membership 4. BCBS members
BCBS members include organisations with direct banking supervisory authority and central banks. After consulting the Committee, the BCBS Chairman may invite other organisations to become BCBS observers. BCBS membership and observer status will be reviewed periodically. In accepting new members, due regard will be given to the importance of their national banking sectors to international financial stability. The Committee will make recommendations to its oversight body, the Group of Governors and Heads of Supervision, for changes in BCBS membership. The Secretariat will publish the list of BCBS members and observers on its website.
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5. BCBS members' responsibilities
BCBS members are committed to: (a) Work together to achieve the mandate of the BCBS; (b) Promote financial stability; (c) Continuously enhance their quality of banking regulation and supervision; (d) Actively contribute to the development of BCBS standards, guidelines and sound practices; (e) Implement and apply BCBS standards in their domestic jurisdictions 2 within the pre-defined timeframe established by the Committee; (f) Undergo and participate in BCBS reviews to assess the consistency and effectiveness of domestic rules and supervisory practices in relation to BCBS standards; and (g) Promote the interests of global financial stability and not solely national interests, while participating in BCBS work and decision-making.

III. Oversight 6. The Group of Governors and Heads of Supervision (GHOS)
The GHOS is the oversight body of the BCBS. The BCBS reports to the GHOS and seeks its endorsement for major decisions. In addition, the BCBS looks to the GHOS to: (a) Approve the BCBS Charter and any amendments to this document;
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(b) Provide general direction for the BCBS work programme (c) Appoint the BCBS Chairman from among its members. If the BCBS Chairman ceases to be a GHOS member before the end of his/her term, the GHOS will appoint a new Chairman. Until a new Chairman has been appointed, the Secretary General assumes the Chairman's functions.

IV. Organisation 7. Structure
The internal organisational structure of the BCBS comprises: (a) The Committee (b) Groups, working groups and task forces (c) The Chairman (d) The Secretariat

8. The Committee
The Committee is the ultimate decision-making body of the BCBS with responsibility for ensuring that its mandate is achieved.

8.1 Responsibilities
The Committee is responsible for: (a) Developing, guiding and monitoring the BCBS work programme within the general direction provided by GHOS; (b) Establishing and promoting BCBS standards, guidelines and sound practices;
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(c) Establishing and disbanding groups, working groups and task forces; approving and modifying their mandates; and monitoring their progress; (e) Recommending to the GHOS amendments to the BCBS Charter; and (f) Deciding on the organisational regulations governing its activities.

8.2 Number of Committee meetings
The Committee generally meets four times every year. However, the Chairman can decide to hold additional meetings as necessary.

8.3 Representation at Committee meetings
The Chairman presides over Committee meetings. All BCBS members and observers are entitled to appoint one representative to attend Committee meetings. BCBS representatives should be senior officials of their organisations and should have the authority to commit their institutions. Representation at Committee meetings is expected to be, for example, at the level of head of banking supervision, head of banking policy/regulation, central bank deputy governor, head of financial stability department or equivalent.

8.4 Decisions
Decisions by the Committee are taken by consensus among its members.

8.5 Communication of decisions
Committee decisions of public interest shall be communicated through the BCBS website.

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The Committee shall issue, when appropriate, press statements to communicate its decisions.

9. Groups, working groups and task forces
The BCBS's work is largely organised around groups, working groups and task forces. The Secretariat will make publicly available the list of BCBS groups and working groups.

9.1 Groups
BCBS groups report directly to the Committee. They are composed of senior staff from BCBS members that guide or undertake themselves major areas of Committee work. BCBS groups form part of the permanent internal structure of the BCBS and thus operate without a specific deliverable or end date.

9.2 Working groups
Working groups consist of experts from BCBS members that support the technical work of BCBS groups.

9.3 Task forces
Task forces are created to undertake specific tasks for a limited time. These are generally composed of technical experts from BCBS member institutions. However, when these groupings are created by the Committee, they consist of BCBS representatives and deal with specific issues that require prompt attention of the Committee. In such cases, they are called high-level task forces.

10. Chairman

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The Chairman directs the work of the Committee in accordance with the BCBS mandate.

10.1 Appointment
The Chairman is appointed by the GHOS for a term of three years that can be renewed once.

10.2 Responsibilities
The Chairman's main responsibilities are to: (a) Convene and chair Committee meetings. If the Chairman is unable to attend a Committee meeting, he or she can designate the Secretary General to chair the meeting on his/her behalf; (b) Monitor the progress of the BCBS work programme and provide operational guidance between meetings to carry forward the decisions and directions of the Committee; (c) Report to the GHOS when appropriate; and (d) Represent the BCBS externally and be the principal spokesperson for the BCBS.

11. The Secretariat
The Secretariat is provided by the Bank for International Settlements (BIS) and supports the work of the Committee, the Chairman and the groups around which the Committee organises its work. The Secretariat is staffed mainly by professional staff, mostly on temporary secondment from BCBS members.

11.1 Responsibilities
The Secretariat's main responsibilities are to:

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(a) Provide support and assistance to the Committee, the Chairman, groups, working groups and task forces; (b) Ensure timely and effective information flow to all BCBS members; (c) Facilitate coordination across groups, working groups and task forces; (d) Facilitate a close contact between BCBS members and non-member authorities; (e) Support the cooperation between the BCBS and other institutions; (f) Maintain the BCBS records, administer the BCBS website and deal with correspondence of the BCBS; and (g) Carry out all other functions that are assigned by the Committee and the Chairman.

11.2 Secretary General
The Secretary General reports to the Chairman and directs the work of the Secretariat. The Secretary General manages the financial, material and human resources allocated to the Secretariat. He/she also assists the Chairman in representing the Committee externally. The Secretary General is selected by the Chairman on recommendation of a selection panel comprising BCBS and/or GHOS members and a senior representative of the BIS. The term of appointment is typically three years with the potential to be extended.

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11.3 Deputy Secretaries General
Deputy Secretaries General report to and assist the Secretary General in discharging his/her duties. Deputy Secretaries General substitute for the Secretary General in case of absence, incapacity or as requested by the Secretary General. Deputy Secretaries General are selected by the Secretary General in conjunction with the Chairman.

11.4 Location of the Secretariat
The Secretariat is located at the BIS in Basel.

V. BCBS standards, guidelines and sound practices 12. Standards
The BCBS sets standards for the prudential regulation and supervision of banks. The BCBS expects full implementation of its standards by BCBS members and their internationally active banks. However, BCBS standards constitute minimum requirements and BCBS members may decide to go beyond them. The Committee expects standards to be incorporated into local legal frameworks through each jurisdiction's rule-making process within the pre-defined timeframe established by the Committee. If deviation from literal transposition into local legal frameworks is unavoidable, members should seek the greatest possible equivalence of standards and their outcome.

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13. Guidelines
Guidelines elaborate the standards in areas where they are considered desirable for the prudential regulation and supervision of banks, in particular international active banks. They generally supplement BCBS standards by providing additional guidance for the purpose of their implementation.

14. Sound practices
Sound practices generally describe actual observed practices, with the goal of promoting common understanding and improving supervisory or banking practices. BCBS members are encouraged to compare these practices with those applied by themselves and their supervised institutions to identify potential areas for improvement.

VI. Consultation with non-member authorities 15. Consultation with non-member authorities
Consistent with the activities described under section 2, the BCBS is committed to consulting widely on its activities with non-member authorities through the following structures and mechanisms:

15.1 The Basel Consultative Group (BCG)
The BCG provides a forum for deepening the Committee's engagement with supervisors around the world on banking supervisory issues. It facilitates broad supervisory dialogue with non-member authorities on new Committee initiatives early in the process by gathering senior representatives from various countries, international institutions and regional groups of banking supervisors that are not members of the Committee.

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15.2 The International Conferences of Banking Supervisors (ICBS)
The biennial ICBS provides a venue for supervisors around the world to discuss issues of common interest.

15.3 Participation in BCBS groups, working groups and task forces
By participating as observers in BCBS bodies, non-member authorities contribute to the Committee's policy development work.

15.4 The Financial Stability Institute (FSI)
The FSI is a joint initiative of the BCBS and the BIS to assist supervisors around the world in implementing sound prudential standards. The BCBS supports FSI activities, including in particular the BCBS-FSI High Level Meetings. These are targeted at senior policymakers within central banks and supervisory authorities and provide a series of regional fora for distributing information on BCBS standards, keeping participants updated on Committee work, sharing supervisory practices and concerns, and establishing and maintaining strong contacts.

15.5 Regional groups of banking supervisors
The BCBS supports the work and activities of regional groups of banking supervisors worldwide. Secretariat staff may participate in meetings of such groups to exchange ideas and seek feedback on BCBS work.

VII. Relationship with other international financial bodies 16. International cooperation
The BCBS cooperates with other international financial standard setters and public sector bodies with the purpose of achieving an enhanced coordination of policy development and implementation.
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In carrying out their responsibilities to support this cooperation, the Chairman and the Secretariat will pay particular attention to the need to comply with the BCBS's due process and governance arrangements. Together with other international financial standard setters, the BCBS sponsors the Joint Forum, where issues of common concern to the standard setters can be addressed and recommendations for coordinated action can be developed. The BCBS is a member of the Financial Stability Board (FSB) and participates in the FSB's work to develop, coordinate and promote the implementation of effective regulatory, supervisory and other financial sector policies.

VIII. Public consultation process 17. Public consultation process of draft BCBS standards, guidelines and sound practices
In principle, the BCBS seeks input from all relevant stakeholders on policy proposals. The consultation process will include issuing a public invitation to interested parties to provide comments in writing to the Secretariat on policy proposals issued by the Committee, within a specified timeframe. The consultation period shall normally last 90 calendar days, but could exceptionally be shorter or longer. As a general rule, responses to public invitations for comments shall be published on the BCBS website, unless confidential treatment is requested by respondents. This process is compulsory for BCBS standards.

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Agenda 2013 – the next steps in completing EMU
Speech by Mr Jörg Asmussen, Member of the Executive Board of the European Central Bank, at the “Internationaler Club Frankfurter Wirtschaftsjournalisten”, Frankfurt am Main
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1. Introduction
Ladies and gentlemen, Thank you very much for inviting me to speak to you this evening. It is now almost one year since I started my term in the ECB Executive Board, and it is interesting to reflect on how Europe has changed in that time. When I joined the ECB in January, the situation looked bleak. The first 3 year LTRO had temporarily calmed the markets, but many informed commentators were predicting a very difficult year ahead. Putting probabilities on a euro break-up had become a cottage industry. Today, we have grounds to be cautiously optimistic. The fear of catastrophic tail risks has lessened. This is in part due to actions taken by the ECB to ensure monetary policy transmission, notably through our OMT programme. But it is also due to very important changes that have taken place in euro area governance.
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Of these, the most significant is the recognition by the euro area Member States that EMU is an incomplete project – and that it urgently needs completing. For this reason, the topic of my address will be that process of achieving a genuine EMU, focusing in particular the conclusions of the European Council last week. I will say upfront that this outcome is not the definitive vision for EMU. It necessarily balances the views of European policy makers, reflecting what is realistic in the current political circumstances, while – I hope – remaining sufficiently ambitious to give citizens and investors a sense of direction of where the euro area is heading. Accordingly, we need to think about the process of completing EMU in two phases: those elements that can be implemented quickly and can make a real difference to the euro area already in 2013; and those elements where more progress needs to be made in the mediumterm as the integration process evolves. Let me begin by focusing on the first phase: the key elements for the year ahead.

2. Key elements for 2013 a) Completing financial market union
Perhaps the most important element of agreed by the European Council is the commitment to construct a real financial market union in the euro area. This will be critical in 2013 for three reasons.

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First, a stable and healthy banking system is necessary to restore normal monetary policy transmission across the euro area, and hence to ensure that the ECB’s low rates are duly passed on to all parts of the euro area. Second, restoring confidence in the financial sector – of which the banking system is the bedrock – is the only way to re-integrate the single financial market and therefore disentangle banks from their sovereigns. Third, putting in place a less risky banking system and fixing the credit channel are key contributions to restarting growth across the euro area during 2013.

Towards a Single Resolution Mechanism
The agreement on a Single Supervisory Mechanism (SSM) by the EU Finance Ministers is an important first step towards a real financial market union. But it is only one component. A financial market union has to involve a Single Supervisory Mechanism and a Single Resolution Mechanism (SRM). This is the only way to ensure that taxpayers do not end up paying for the mistakes of the private sector. Let me explain why. Banks that are “too big” or “too interconnected” to fail at the national level – making bailout the preferred strategy – would not benefit from this status at the European level. The SRM would have the legal and financial capacity, as well as independence, to ensure that viable banks survive and non-viable banks are closed down.

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Moreover, banks that are “too complex” to resolve via cross-border cooperation – making early action impossible – could be dealt with more effectively at the European level. The SRM would create an authority that could concentrate decisions on resolution and act pre-emptively and quickly, helping to preserve the value of the banks and save money for taxpayers.

Principles for European public support

However, a strong resolution mechanism cannot remove risks for taxpayers entirely. Certainly, any costs incurred from resolution should first and foremost be covered by the private sector, through establishing a European Resolution Fund raised by levies on the banking sector. But a real financial market union must also contain a public sector dimension at the European level. In this context, the European Council called for the operational framework for direct bank recapitalisation by the ESM to be ready by the first semester of 2013. I am aware that the prospect of ESM direct bank recapitalisation raises serious concerns: that European taxpayers will end up paying for the bad assets accumulated over the past decade; that mutualisation will become standard practice for dealing with banking sector problems. But let me reassure you that these concerns can be contained with what I would see as the three key principles for European support. First, European support has to be accompanied by European control, meaning public funds can only be used after the SSM has effectively assumed its duties and on the basis of strong conditionality.

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Second, European support should only be granted to banks that are systemically relevant, or pose a serious threat to European financial stability, and therefore affect the common good. Third, European support must come at the end of a sequential process, involving the following steps: • One, the beneficiary banks must undergo a thorough and independent economic evaluation of their assets to ascertain their real capital needs and reveal any legacy problems; • Two, those banks must be assessed to have a viable business model and so be deserving of additional capital, otherwise they should wound down; • Three, if the banks are to be kept going, private sector sources should be exhausted first – meaning bailing-in of shareholders and bondholders, and if needed, use of the bank-funded resolution financing; • Four, if there are still capital shortfalls, the financial resources of the beneficiary Member States should be drawn on; • Only in the very last step, would European public funds be used. This pecking order underscores that, the stronger the European resolution framework, the lower the eventual costs for European taxpayers. The more the financial sector can be bailed- in, the less it has to be bailedout. We see in the US how this can work: the FDIC closed down more than 400 banks during the crisis, without any cost for taxpayers. This is the standard we should be aiming for in Europe – and a real financial market union is the only way to achieve it.

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Let me make a final point regarding the institutional set-up of the SRM and Resolution Fund, which is my own personal view: the ESM would be well-suited to perform the tasks of the SRM and to house the European Resolution Fund raised from the banking sector.

b. Building economic union
The second key outcome of the European Council is the aim to strengthen economic union – particularly by ensuring that national economies can remain competitive and hence prosper within a single currency area. The importance of this issue for 2013 cannot be overstated, as it is critical to ignite growth and lower unemployment. We can see before our eyes a series of cases where quick implementation of targeted reforms could have a strong impact, even in the near-term. For instance, despite the recession in Italy, unit labour costs have adjusted by only 0.1% relative to the euro area average since 2008. This is because many sectors of the economy are sheltered and wages do not respond to weak productivity. It needs product market reforms to increase competition and reinvigorate its external competitiveness. In Spain, employment is struggling to rebound, and the burden on unemployment falling disproportionately on the young, because its two-tier labour market protects insiders. It needs labour market reforms to bring in outsiders and improve incentives to hire. The Conclusions propose to kick-start this much-needed process of reform through three avenues.
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First, a renewed effort to complete the Single Market, in particular by opening up services and increasing labour mobility. Second, a thorough assessment, carried out in all euro areas countries, of the compatibility of their labour and product markets with membership of EMU. And third, for the issues identified in this assessment to be addressed through the new concept of “Reform Contracts”. Let me elaborate some more on this last point. The idea behind the “Reform Contracts” is that countries would commit to specific structural reforms that have a direct positive impact on competitiveness, with those commitments formalised in a legally binding contract. The contract would be multi-annual and, to foster national ownership, initiated by the national government and approved by the national parliament. If the terms of the contract were met, financial support would be provided, targeted at the transitional costs arising from structural reforms – for instance, re-training programmes for displaced workers.

What are the benefits of this approach compared to the status quo?
In my view there are three, although they depend very much on how the concept is eventually implemented. First, the contracts could be entered into as part of a concerted national reform effort, rather than being seen as an imposition from “Brussels” in the context of the EU procedures like the European Semester.

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Second, reform commitments could potentially be more precise, measurable and binding in the contracts than under those existing procedures. However, this effect would quickly be lost if it simply becomes another bureaucratic procedure. Third, and perhaps most importantly, because the contracts are multi-annual they could allow for deeper reforms than are possible under existing procedures. There have been a series of recent studies that suggest that competitiveness is not only about flexibility, but also strongly connected to governance. We see clear correlations between countries’ economic performance and their rankings in governance indices published by, among others, the World Economic Forum and Transparency International. The contracts provide an opportunity, if used properly, to “go deep” and address these more fundamental barriers to competitiveness. Building a stronger economic union along these lines is necessary to correct what might be called an “original sin” of EMU: the fact that the convergence criteria did not include any structural benchmarks for joining the euro, and hence structural policies remained mainly within the national remit.

3. Areas for further progress in the future
What about those areas that were not outcomes of the European Council and where there is room for further progress in the future? The most important is greater sharing of sovereignty.

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The importance of credible governance has been starkly demonstrated during the crisis. Countries without credible policies have been forced by markets to consolidate more rapidly than others in the downturn. This is because markets have not trusted that they can run sufficient surpluses in good times, or achieve sufficient growth, to lower debt levels and ensure long-term sustainability. Paradoxically, the lack of strong external constraints on fiscal and economic policies has led to countries losing substantive sovereignty in these areas. By the same token, countries now need to share more sovereignty in order to regain their sovereignty. By sharing decision-making with the European level, they can restore their policy credibility with investors, while at the same time having a voice over where they are heading. This will mean going beyond the Maastricht logic of national responsibility for fiscal and structural policies, and committing to governance arrangements that are actually enforceable – for instance, allowing for intervention rights by the center to prevent unsound national budgets. Sharing sovereignty implies a number of other changes to euro area governance. First, there have to be strong institutions in order to exercise that sovereignty effectively. This will require a stronger Eurogroup.

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Second, those European institutions have to be properly democratically legitimated. This requires changes in the way the citizens participate in the European political process, in particular via the European Parliament. Let me stress: while I would have liked the outcome of the European Council to be more ambitious, these ideas are not intended as criticism of it. They are orientations to advance further which will need to be properly fleshed out in the years ahead as the integration process evolves. This will require a Treaty change in the medium-term in order to complete EMU in a comprehensive way.

4. Conclusion
One year ago, the euro area was facing an uncertain future. But those painted a dark picture at that time have been proven wrong. One year later, Europe has proven its ability to act and we have begun to set the euro area on a more convincing path. It is now critical that, over the next year, we continue down this path and provide EMU with institutions it needs to advance. Putting in place a genuine financial union and a stronger economic union must be our key priorities for 2013. It is essential that the appearance of calm on financial markets does not distract from the urgent need to address the euro area’s fundamental challenges.

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Moreover, we should also not row back on what has already been achieved. Implementing the Fiscal Compact and adopting the “Two Pack” of legislation in 2013 are essential to strengthen the fiscal framework. We should not undermine this by re-opening discussions on what constitutes “good” or “bad” deficits by arguing for exemptions for public investment. All deficits have to be financed on financial markets and increase public debt stocks – and this is the opposite of what we need next year. However, this focus on 2013 does not mean we should lose sight of the big picture. It is instructive to notice how little markets are reacting to the “fiscal cliff” debate in the US, while they are jolted by the prospect of earlier than planned elections in Italy. Our long-term goal is a situation where the essential functioning of the euro area is unaffected by events in individual countries, because sovereignty is shared and exercised in strong common institutions – and those institutions have a longer time horizon than politics. This is what Jean Monnet understood when he said: “Rien n’est possible sans les hommes, rien n’est durable sans les institutions”.

“Nothing is possible without men, but nothing is lasting without institutions”.
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These words have never been more true than today. Thank you for your attention.

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The Qatar Central Bank, QFC Regulatory Authority and Qatar Financial Markets Authority

New law regulating financial institutions
Doha, Qatar: The Qatar Central Bank (QCB), the QFC Regulatory Authority (QFCRA) and the Qatar Financial Markets Authority (QFMA) have welcomed the enactment of The Law of the Qatar Central Bank and the Regulation of Financial Institutions, which was enacted by H.H. The Emir. The new Law is an important step in advancing the framework for financial regulation and supervision in the State of Qatar, promoting financial stability and expanding the ambit of regulation and supervision to cover areas requiring new and enhanced financial regulation within the State. It also lays the foundation for increased co-operation between the regulatory and supervisory bodies in Qatar as they develop and apply regulatory and supervisory policy and implement international standards and best practices to deliver the objectives of the Qatar National Vision 2030 and Qatar National Development Strategy 2011-2016. The QCB, the QFCRA and the QFMA have issued a summary of some of the important provisions of the new Law and detail on the objectives for the Financial Stability and Risk Committee established under the new Law. His Excellency Sheikh Abdullah Saoud Al Thani, Governor of the Qatar Central Bank and Chairman of QFCRA and QFMA said: “The new Law is an important step in continuing to build a resilient financial sector for the State of Qatar that operates to the highest international standards of regulation and supervision and best practices.
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Importantly, the new Law also formalises, through the Financial Stability and Risk Committee, the excellent level of co-ordination and collaboration that exists between the Central Bank, the QFCRA and the QFMA.”

JOINT STATEMENT BY Qatar Central Bank Qatar Financial Markets Authority QFC Regulatory Authority regarding The Law of the Qatar Central Bank and the Regulation of Financial Institutions (Law No. 13 of 2012)
1. The Qatar Central Bank (“QCB”), the Qatar Financial Markets Authority (“QFMA”) and the QFC Regulatory Authority (“Regulatory Authority”) welcome the enactment of The Law of the Qatar Central Bank and the Regulation of Financial Institutions (Law No. 13 of 2012). The purpose of this statement is to provide a summary of some of the important provisions of the new Law and to explain the objectives for the Financial Stability and Risk Control Committee (the “Financial Stability Committee”) established under the new Law. More detailed explanations and guidance will be provided in due course on other aspects of the Law by the relevant authorities. 2. The Law is an important step in: (i) Advancing the framework for financial regulation in the State of Qatar, (ii) Promoting financial stability and (iii) Expanding the ambit of regulation to cover areas requiring new and enhanced financial regulation within the State. It also lays the foundation for increased co-operation between the regulatory bodies in Qatar as they develop and apply regulatory policy and implement international standards and best practices to deliver the
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objectives of the Qatar National Vision 2030 and Qatar National Development Strategy 2011-2016. 3. In addition to its existing responsibilities for the supervision of banking and financial services institutions, the QCB acquires responsibility for the licensing and supervision of insurance companies, reinsurance companies and insurance intermediaries that were previously licensed by The Ministry of Business and Trade. The Law repeals Decree Law No. 1 of 1966 on the Supervision and Control of Insurance Firms and Agents. The QCB will, in due course, publish further details regarding the new regulatory framework for the insurance sector in the State. 4. The Law also introduces important new provisions dealing with consumer protection, client confidentiality, protection of credit information, regulation of Islamic financial institutions, merger and acquisition of Financial Institutions, and settlement of disputes. Additional details on these matters will also be provided in due course. The Law also makes clear that the conduct of financial services in the State requires that a license be obtained from the competent authority and provides sanctions for persons who conduct such activities without the required license. 5. In line with its responsibilities for financial stability, the Law mandates the QCB to act as the competent supreme authority in framing the policies for the regulation and supervision of all financial services and markets in the State. The Financial Stability Committee is the mechanism established under the Law to help deliver this objective by providing recommendations to the Board of Directors of the QCB.

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The Financial Stability Committee provides a formal structure for co-ordination among the regulatory bodies and it will advance the objective of creating a consistent and co-operative regulatory and supervisory environment within the State. 6. The Financial Stability Committee will be chaired by H.E., The Governor of the QCB and its membership will include H.E., The Deputy Governor (Vice-Chairman) and the Chief Executive Officers of the QFMA and the Regulatory Authority. Under the new Law, the Financial Stability Committee is charged with the following critical functions: • Identifying and assessing risks to the financial sector and markets and recommending solutions to manage and mitigate such risks; • Co-ordinating the work of the financial regulatory authorities in the State with a view to enhancing co-operation and information exchange in order to establish a consistent and co-operative regulatory and supervisory environment; and • Proposing policies related to regulation, control and supervision of financial services businesses and markets. 7. Where recommendations made by the Financial Stability Committee are approved by the Board of Directors of the QCB, the Boards of the QCB, the Regulatory Authority and the QFMA will consider what action they may need to take to implement the recommendations, taking into account their legal and regulatory mandates under their respective laws. 8.The QFMA and the Regulatory Authority remain independent regulators under the management and direction of their respective Boards of Directors in accordance with the Law regarding the Qatar Financial Market Authority (Law No.8 of 2012) (“QFMA Law”) and the Qatar Financial Centre Law (Law No.7 of 2005) (“QFC Law”).

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The QFMA is responsible for the regulation and supervision of financial markets in Qatar (including the Qatar Exchange) in accordance with the QFMA Law and the Regulations and Rules made under that law. Authorized firms in the QFC will continue to be subject to authorization and supervision by the Regulatory Authority in accordance with the QFC Law, the Financial Services Regulations and the Regulatory Authority’s Rules. 9.The QCB, the QFMA and the Regulatory Authority look forward to continuing their co-operation in working together to implement the Law and to develop international standards of regulation across the spectrum of banking and financial activities in Qatar that will create the conditions in which the banking and financial sectors in Qatar can fulfill their potential.

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WIBC 2012 - Inaugural Keynote Address by H.E. Rasheed M. Al-Maraj, Governor, Central Bank of Bahrain, Manama, Bahrain
Your Excellencies, Distinguished Guests, Ladies and Gentlemen: It is a great honour and a privilege to deliver this keynote address, and I take this opportunity to welcome all of you to the Kingdom of Bahrain. I wish you an enjoyable stay and hope this will be a fruitful and successful conference. We are privileged to have a range of speakers over the next two days who represent a broad spectrum of the financial industry, and their insights into how Islamic finance can be further developed will undoubtedly provide significant food for thought amongst the delegates. In common with the financial industry in general, the Islamic financial industry continues to undergo significant change. This is partly due to the continuing developments required in the industry as it comes to terms with rebuilding customer confidence, which was so badly damaged by the global financial crisis. In addition, the industry needs to come to terms with the need to make significant changes to the traditional business model, which has primarily been based on investment in real estate. But the Islamic financial industry does not require change - it requires both a transformation and a new mindset.

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I would like to spend the next few minutes discussing three crucial issues: 1. The new and evolving global financial standards; 2. The current and emerging challenges which face Islamic finance; and 3. Some of the necessary improvements to strengthen the foundations required to ensure the Islamic financial industry is recognized and respected as a major global player.

The New Standards
Perhaps the most important subject in the global financial industry at present is the proposed implementation of Basel III. Although it is impossible to discuss all of the changes in the time available to me, you know the primary intention is to mitigate the risks of a repeat of the current financial crisis. The detail has yet to be finalised, but there is no doubt that it will have a huge influence on the fundamentals of the global banking industry and the wider economic environment. One of the major changes arising from Basel III is the definition of eligible Tier 1 capital. Going forward this will primarily consist of common shares and retained earnings. Critically the quality and quantity of Tier 1 capital will be significantly increased. The ultimate result will be a higher Capital Adequacy Ratio.

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Further substantial improvements to the risk management frameworks of banks will be required. The methodology underpinning value-at-risk calculations will be strengthened, and the output from these calculations will be scrutinized in far more detail by a wide stakeholder audience. Regulators will be required to improve their supervisory review processes, and in so doing these will become increasingly stringent. Whereas in the past jurisdictional judgement has played a prominent role in the implementation of regulation, this will be largely replaced by reforms which will be consistent in the manner in which they aim to strengthen regulation, and raise the resilience of individual banking institutions to periods of stress. These reforms will also have a macro-prudential focus, and will address system-wide risks that can build up across the banking sector, thereby ultimately amplifying these risks over time. In tandem with Basel III, accounting rules are changing. Moreover, the way in which banks can remunerate staff, and the level of remuneration they can provide, will be subject to increasing regulation. The CBB has already published papers detailing what policies and practices will be considered as acceptable. The public and other stakeholders have spoken clearly on this subject, and their opinions that the current levels of remuneration are extreme reflect the view that they are also unsustainable. All of this will change the way banks do business. Islamic banks must prepare now for these changes, or risk being left behind.
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Let me move now to discuss the challenges and some ways they can be met.

The Challenges, and Strengthening the Foundations
The headline challenges arising from Basel III are not new, but they are becoming increasingly time-critical at various levels. At the foundation level, there are simply too many small to medium sized Islamic financial institutions. The risks inherent in that scenario are clear - Islamic banks cannot play with the big boys. Smaller banks will find it very difficult to combine the increased capital requirements with the ability to participate in the market. The larger and often more lucrative deals are even now frequently beyond the reach of Islamic banks, and without major changes this will become more acute. Leaving aside the debate about the quality of assets, the importance of holding a larger amount of liquid assets cannot be ignored, and small banks will find this almost impossible. There are a number of steps which need to be taken to achieve this. The first is to build a range of Islamic institutions which are well capitalized, continuously highly profitable, and which have a balance sheet size which places them within the top ten in their sphere in the world. There are various options which can be implemented to achieve this aim, and by way of example I outline two below.

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Acquisitions and mergers have been discussed many times, but this has been a slow and cumbersome path. It is no longer appropriate to have only small, local, financial institutions which are fundamentally and practically restricted in terms of the markets in which they can compete and the deals they can underwrite. Personal interest and a local or regional mindset must be replaced with a 'big picture' mentality; a mentality which emphasizes and works towards the global contribution Islamic institutions can make for the benefit of all. However, institutions are impotent if they do not have the correct leadership supported by appropriate numbers of well-trained, experienced, and respected individuals. A first-class corporate governance framework is essential, and it must be continuously implemented in practice. Inspirational leaders are absolutely essential. Each leader must exude credibility with the stakeholders and wider community. They need to act responsibly at all times. A further challenge is that the business model has to change. I have spoken before about the over-reliance on a model built on real estate. A business model has to adapt to the changing environment in which it operates. If the Islamic financial industry is to be successful at each stage of any economic cycle, the model needs to implement and demonstrate diversity in the asset portfolio.
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This in turn needs to be coupled with investment in a much wider range of economic sectors. Moreover, the range of available products must be increased in line with Shari'a principles. They must be competitively priced, and marketed such that they appeal to the broadest possible community of clients. All of the above must be underpinned by a risk management framework which recognizes that to properly service the demands of the client base the institution has to have an appropriate risk appetite. The risk appetite should also reflect the discrete elements of the client base, taking account of the needs of the retail customer as well as the various requirements of the investors and other stakeholders.

Many will ask - what has Bahrain done to turn these desires into reality?
Firstly, the CBB has successfully worked with many stakeholders to encourage and facilitate mergers. This year, one of our Islamic banks successfully completed the acquisition of a conventional bank. Moreover, within the next few weeks three of our Islamic banks will merge to become one. Shortly after that we anticipate the merger of two other banks. We continuously work quietly and effectively behind the scenes to influence, persuade, and guide licensees to grow and develop. This is only the beginning of what we consider to be an essential ingredient in the transformation of Islamic finance.

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On a parallel front, the CBB works closely with a plethora of industry stakeholders with the aim of developing and expanding the range of products and services which can be made available. We reach out to licensees; industry bodies; standard setters; and of course Shari'a Boards through consultation papers and face-to-face meetings. We encourage and facilitate constructive dialogue aimed at transforming the industry. We are tireless in our pursuit of improving regulatory standards. The Rulebooks are continuously refined to reflect market and other changes. We actively participate with other financial regulators and such bodies as the IIFM, AAOIFI, IFSB, and the Basle Committee for Banking Supervision. I recognize the challenge in the ideas I have put forward here today. Some may consider them to be controversial, and I understand that there are many different ways of addressing a situation. My aim has been to provoke thought and action which is designed to encourage the growth of this important part of the financial industry. This is a time of great opportunity, I urge you to embrace the challenges. Your Excellencies, Distinguished Guests, Ladies and Gentlemen, I hope my words will encourage an increase in prompt and practical actions which will transform the Islamic financial industry from a growing, developing aspect of the world economy into a world leader in its spheres of influence in the very near future. Thank you for your attention.
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Finance and the real economy – fostering sustainability
Speech by Dr Zeti Akhtar Aziz, Governor of the Central Bank of Malaysia At the Islamic Development Bank (IDB) Regional Lecture Series on Islamic economics, finance and banking: “Finance and the real economy – fostering sustainability”, Jakarta.
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I am most honoured to be invited to deliver this inaugural lecture of the Islamic Development Bank Regional Lecture Series. I am also most delighted to be back here in Jakarta. I would like to thank the Islamic Development Bank for the invitation, and Bank Indonesia for kindly hosting this event. For more than three decades now, the Islamic Development Bank has had an important role in promoting economic growth and development in so many parts of the world, and associated with this, has been its role in fostering the development of Islamic finance. It has supported the building of key international financial infrastructure that has been important for the orderly global development of Islamic finance and for safeguarding financial stability. The Islamic Development Bank has also supported research and education efforts in this area, while its strategic interests in financial
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institutions in different jurisdictions have been an important catalyst for their establishment and expansion. In the current more uncertain environment, in the aftermath of the recent global financial crisis, the role of the Islamic Development Bank will continue to be important, given that the goal of sustainable growth and development in the world economy has now become even more challenging. As the conventional financial system currently confronts what is perhaps its most defining period, several important lessons can be drawn for our collective efforts to build more resilient financial systems. Important considerations need to be accorded to the issues that have emerged, and on the policy directions affecting growth and stability. My address today will discuss several of these issues, and discuss how Islamic finance, given its nature and inherent features, can contribute to the process of enhancing the discipline that contributes to ensuring growth and financial stability. At the core, the financial system needs to serve the real economy. The purpose of the financial system is intermediation – that is, to match savings and investments for the purpose of generating economic growth. Yet, in recent decades, a number of factors have contributed to the weakening of the link between financial intermediation and productive economic activity. Deregulation opened up new opportunities for financial institutions to enhance performance and expand the scope of their activities. Greater competition, reinforced by significant advances in technology, intensified the pace of innovation.

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And, the extended period of low inflation and low interest rates incentivised greater risk-taking. Cumulatively, these developments contributed to a dangerous build-up of financial imbalances. This has prompted a rethinking of the issues related to the financial business and its models, and wide-ranging regulatory reforms by the international community. Related to these issues is the question on the “appropriate” size of the financial sector. As economies develop, the size of financial sector assets and, correspondingly, the value-added contribution of the financial sector, is expected to increase. However, while there is a fundamental relationship between the growth of the financial sector and the real economy, the relationship is not well understood or captured in current macroeconomic models. This creates a potential challenge for policymakers to determine the point at which growth of the financial sector may be outstripping the demands and the potential of the real economy. This issue has become even more pronounced with greater regional and global financial integration, and in countries that are also international financial centres. To the extent that corporate and personal income growth is driven by financial transactions rather than by an increase in production or employment growth, economies become potentially more vulnerable to the consequences of financial system stress. The recent global financial crisis provides a distinct example of how excessive leverage and exponential growth in financial activities that are
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detached from the growth trajectory of the real economy can become a source of instability. Leverage increased sharply in the years leading to the crisis, buoyed by years of strong economic growth. In the advanced economies, bank balance sheets exploded, growing to multiples of annual GDP. For example, in the case of Iceland, the three largest banks that were nationalised in early October 2008 had seen their total assets expand from 100 percent of GDP in 2004, to more than 900 percent of GDP as at end-2007. Similarly in Ireland, assets in their financial institutions with substantial domestic businesses were more than 400 percent of GDP by 2008, while in the United Kingdom, bank assets were more than 500 percent of GDP prior to the global financial crisis. The sheer size, complexity and leverage in the banking system increased the fragility of financial institutions and limited their ability to absorb even small losses, thereby resulting in widespread and deep economic dislocations. This expansion of financial activities was also in part due to the activities in the shadow banking system, which in the United States, grew to be even larger than the traditional banking sector in gross terms. At the height of the crisis, the size of gross amounts outstanding of over-the-counter (OTC) derivatives globally was estimated at over 614 trillion US dollars1, more than ten times global GDP. Despite its size, the over-the-counter market was opaque and inadequately regulated, making it more difficult to quantify the risk that had been assumed by the financial institutions.

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A further issue relates to financial innovation and for policy interventions not to stifle those innovations that are beneficial to society, while reining in those that are harmful. The current debate on the international financial reforms continues to reveal that this is a challenging task. While there is wide support for a return to basic banking, it is also acknowledged that financial innovations have been instrumental in improving financial access levels, by enabling financial institutions to manage risks in ways that have allowed for higher-risk economic activities to be undertaken. Contrary evidence, however, also exists. In the run-up to the crisis, derivatives were extensively used to arbitrage regulatory requirements and to extract excessive profits through opaque and complex transactions that resulted in the fundamental mispricing of risk. Current reform efforts are therefore confronted with the need to strike a balance between constraining harmful practices, without restricting innovation that is key to a progressive financial system. Another issue relates to the prospect for aligning the expectations of capital providers with the imperatives of sustainable banking. In the years preceding the crisis, the growth of the financial system substantially exceeded that of the overall economy. Published data indicates that the balance sheet of the world’s largest 1000 banks increased by about 150 percent between 2001 and 2009. At its peak, the scale of the assets of the financial sector far exceeded those in other sectors, with record profits reported from year to year.

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In the current environment, banks continue to remain under considerable pressure to support activities that generate the kind of rates of return that capital providers have come to expect from the industry. This runs counter to expectations for banking to be returned to its fundamental role of supporting real economic activity. The extent to which these conflicting imperatives can be reconciled in a sustainable manner remains unclear. A focal point of the reforms has been to protect retail banking from the vagaries of investment banking that often has involved higher risk-taking activities. In the United States, the Volcker Rule prohibits banks from carrying out certain types of investment banking activities if they wished to continue to rely on deposit funding. In a similar vein, in the United Kingdom, the adoption of the recommendations by the Independent Commission on Banking mandates banking groups to establish a separate subsidiary for their retail activities, and it prohibits the subsidiary from undertaking other businesses and risks. Solutions to these challenges are far from straightforward. While these and other reforms by the Basel Committee and the Financial Stability Board are expected to have far reaching implications for the landscape of the financial system as we know it today, they have yet to provide answers to many of the key questions that policymakers and the financial industry need to address in the pursuit of effective functioning and sound financial systems as we progress forward into the future. Since the global financial crisis, significant attention has been directed at evolving an effective macro-prudential policy framework, which can serve

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to rein in excesses and strengthen the nexus between finance and the real economy. The concept of macroprudential policies is hardly new and can be traced back to as early as the late 1970s, in reference to the macroeconomic and financial stability implications from the rapid pace of lending to developing economies. Some emerging markets, including Asia, have, since the 1990s, deployed macro-prudential policy instruments to manage imbalances in the financial system and capital flows. Following the recent global financial crisis, greater attention is now being focused on the role, scope, instruments and governance arrangements for macro-prudential policy to preserve financial stability. New or strengthened mandates for macro-prudential policies are being established in a growing number of jurisdictions, supported by wide ranging changes to the legislative framework and institutional structures. Used effectively in combination with other policy tools, including micro-prudential measures and monetary and fiscal policy tools, macro -prudential policies have been demonstrated to significantly improve financial stability outcomes. Effectively operationalising macro-prudential policy frameworks, however, remains a key challenge. By design, macro-prudential policies are intended to reduce the probability and severity of a future crisis. While further research will deepen our understanding of leading indicators and transmission channels, judgments will continue to have a key role.

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History has shown that political economic considerations have, at times, had an effect on the willingness of policymakers to act. Despite the high costs of crisis on the financial system on the economy and on the society, there is still an inherent bias towards inaction. This underscores the need for a stronger focus on creating an environment in which policymakers will have the confidence to act. This requires a strong mandate, sufficient policy instruments, and clear accountability structures. While macro-prudential policy has a clear and important role in contributing towards financial stability moving forward, it does not however diminish the important role of micro-prudential supervision. Indeed, the notion that more developed macro-prudential policy frameworks can, over time, provide a credible alternative to the close supervision of systemic financial institutions – for example, through the development of better predictive macro indicators, or through reliance on recovery and resolution plans alone – is misplaced. There can be no substitute for the effective ongoing supervision of financial institutions, which relies on supervisory assessments and judgments, and enhances the understanding of firm behaviours in a manner that models and plans, no matter how sophisticated, will never be able to fully achieve. Efforts should therefore also be accorded towards further strengthening the conduct of micro-prudential supervision and promoting the complementarities between micro- and macro-prudential policies. Let me now turn my remarks to the growing role and relevance of Islamic finance in contributing to the global agenda of fostering sustainable growth that is firmly anchored to the real economy.

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The core proposition of Islamic finance draws from its inherent features and the values that it brings to the economy, and the tremendous potential that it offers in supporting sustainable economic growth and in safeguarding financial stability. These core propositions are derived from the Shariah, which dictates that Islamic financial transactions must be supported by underlying productive activities. This Shariah ruling ensures a close link between financial transactions and the real economy. Innovation and intermediation in Islamic finance are thus aligned to generating productive economic activities. There is also strong discouragement against excessive risk undertakings and a prohibition against speculative elements. These rulings also serve to insulate the Islamic financial system from excessive leverage, which in turn contributes towards promoting financial stability and its long-term sustainability. These fundamental elements resonate with the call for banking to focus on its core function of providing financial services that add value to the real economy. This recent decade has also witnessed a dramatic transformation of the Islamic financial landscape. It has been marked by sustained rapid growth and the widening of its geographical reach, resulting in more diverse Islamic financial institutions and the generation of a wide spectrum of innovative products, particularly in the high-growth segment of the sukuk market. In this decade, Islamic finance has also evolved from being domestic centric to become increasingly internationalised.
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In this dynamic environment, the scope of the Islamic finance business has expanded from simple retail and trade financing to include private equity, project finance, sukuk origination and issuance, as well as fund and wealth management products. Today, the total global size of the Islamic financial assets has surpassed more than 1 trillion US dollars. There are now more than 600 Islamic financial institutions operating in 75 countries. The vision for the Islamic financial system in Malaysia was articulated in our first Financial Sector Masterplan that was launched in the year 2001, in which the plans for building the foundations for the Islamic financial system were outlined. This included strengthening and diversifying the financial intermediaries in the financial system, building and developing the financial markets, and enhancing the regulatory supervisory, Shariah and legal framework. Ten years later, in 2011, a new Financial Sector Blueprint was launched, charting the path for Islamic finance to transition to become increasingly internationalised, and thus to become more integrated into the mainstream of the global financial system. Whilst Islamic finance has all the ingredients and the potential to meet the needs of the global economy, the channelling of funds to productive activities in Islamic finance today is still largely being carried out through non-participatory contracts, that includes the mark-up sale (Murabahah) and the lease-based (ijarah) structures, which continue to remain essential to cater for financing trade and the purchase of assets. Such contracts are similar to lending instruments which expose the Islamic financial institutions mostly to credit risk elements.

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Whilst non-risk-sharing contracts will continue to contribute to the future growth of Islamic finance, the wider use of risk-sharing transactions and undertakings under participatory finance models have significant scope in evolving a broader representation of Islamic financial products that will spur the next phase of industry growth and development. This includes participatory or equity-based contracts such as Mudarabah and Musharakah that support ventures involving entrepreneurship endeavours. Greater use of equity-based models in Islamic financial solutions has been observed in the more recent period. This has been most evident in the sukuk segment, with Shariah structures evolving from predominantly ijarah and murabahah structures to musharakah partnerships as well as convertible and exchangeable trusts. The further development of participatory Islamic finance contracts on a broader scale offers particular potential in efforts to reinforce links between finance and the real economy. Several elements of risk- and profit-sharing participatory contracts support this. As profitsharing and loss-bearing are clearly identified and agreed based on the contractual agreements between the financier and the entrepreneur, strong emphasis is placed on the value creation and economic viability of productive efforts that create new wealth. In equity based contracts, the financial intermediation is thus also directed towards promoting entrepreneurship, in that the clearly defined risk - and profit - sharing characteristics of the Islamic financial transaction provides strong incentives for both parties to contribute to the success of the investment.

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This also provides the foundation for a long-term trust-based relationship, and a clear interest for the financial institutions to undertake the appropriate due diligence to ensure that the returns are commensurate with the risks being assumed. Aspects of governance and risk management thus strongly underpin these contracts. In particular, such contracts demand higher standards of disclosure and transparency to be observed, which in turn act to strengthen market discipline. The legal, regulatory and supervisory framework will need to be adjusted to accord greater clarity to the appropriate legal and regulatory treatment in order to foster the sound and orderly growth of risk-sharing structures and activities, both in terms of the funding and the assets-side of Islamic banks. In Malaysia, steps are currently being taken to provide a conducive enabling environment for this next phase of development that will spur more risksharing transactions though the formulation of new legislation for Islamic banking and takaful. This legislation is now at the final stages of the process of its enactment. This new law for the industry is aimed at promoting certainty to the legal and regulatory treatment of Islamic financial transactions by providing legal recognition to the contractual requirements in accordance with the Shariah. This provides a comprehensive legal environment under which effective risk and profit sharing activities can take place, encompassing all aspects of Islamic financial transactions, from its prudential and business conduct requirements to the legal treatment of Islamic banking assets upon its resolution, to be fully consistent with the distinctive elements of the respective Shariah contracts employed in these transactions.
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This legal framework will also further enhance the capacity of the regulatory and supervisory framework for the Malaysian Islamic finance industry to evolve in greater alignment with the international regulatory and the supervisory standards and best practices issued by the Islamic Financial Services Board (IFSB) to govern the specificities of Islamic financial transactions. To complement the efforts to strengthen the regulatory law for Islamic finance, Malaysia has also established the Law Harmonisation Committee in 2010 to undertake objective reviews on other relevant laws and recommend legislative changes to ensure that the laws in the country would allow for Islamic financial transactions to take place effectively and efficiently. Another important dimension in fostering the further development of risk and profit sharing instruments is the need to ensure the institutional soundness of the Islamic financial institutions and their enhanced ability to assess risks in the real sector. This underscores the imperative of robust risk management capabilities to manage new risks peculiar to risk and profit sharing contracts and the adoption of strong governance, transparency and disclosure practices within the Islamic financial institutions to meet the due diligence requirements for determining the viability of business and investment proposals. Business risks of equity positions and ownership risks of underlying assets are, for example, embedded in these arrangements arising from the contractual relationships between the investors and entrepreneurs as well as the Islamic banking institutions as the intermediary of funds. Further in-depth applied research is also needed to develop more innovative financial products using risk and profit sharing structures with the corresponding development of risk management techniques.

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This also needs to be reinforced by enhanced consumer protection and education initiatives to deepen the understanding and awareness of consumers on the associated risks and rewards in the Islamic financial contracts, in particular for equity-based instruments. Equally important in ensuring the institutional soundness of Islamic financial institutions is the need for robust liquidity management. Today, Islamic financial institutions operating in the different jurisdictions are still confronted with the challenge of managing their liquidity positions effectively, given the limited supply of high quality Shariah-compliant liquid instruments being the reason most commonly cited. The lack of high quality liquidity instruments for Islamic finance is not only constraining effective liquidity management, but it is also affecting the efficient cross-border diversification of financial flows. It is therefore our hope that through the mandate of the International Islamic Liquidity Management Corporation (IILM) in issuing high quality liquid sukuks, it will contribute to promoting more efficient crossborder liquidity management by Islamic financial institutions whilst facilitating Islamic financial institutions in meeting the international requirements on liquidity. Let me conclude my remarks. Whilst the evolution of the global financial landscape is currently being shaped by the need to return finance to its basic functions of serving the real economy, several critical questions remain, the answers to which will continue to have an important bearing on the global agenda to build sound and resilient financial systems that promote sustainable growth. In particular, determining the appropriate size of a financial sector relative to its economy before it becomes a risk to overall financial system and economic stability; promoting conditions that ensure that financial
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innovation is beneficial to the economy; and enhancing prospects for aligning expectations of capital providers with more sustainable banking strategies present significant policy challenges that will continue to occupy the attention of policymakers going forward. The global community has made some important strides, but more work remains to achieve an appropriate balance between preserving safety and soundness of the financial system and allowing financial institutions and markets to perform their intended functions. We are not without policy options. The role of macro-prudential policy and the developments in Islamic finance have gained greater prominence in terms of their potential to improve financial stability outcomes, and most notably by the vital contribution that they make towards restoring the foundations for finance that supports sustainable economic growth, and bringing with it immense benefits to the real economy and to the well-being of society.

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The Liikanen Report takes a holistic approach
Interview with BaFin's Chief Executive Director Raimund Röseler For some time, considerable efforts have been made at global, European and national level towards better equipping banking systems to deal with a crisis. Attention is currently focused primarily on the Liikanen Report and the G20 decision to require global systemically important banks to develop recovery plans.

“How should the European banking sector be structured in future?”
That was the Commission's question to an expert group chaired by the governor of the Bank of Finland, Erkki Liikanen. The most important proposal is that retail banking activities should be segregated from trading activities within universal banks. BaFin's Chief Executive Director Raimund Röseler gives his perspective in this interview.

Mr Röseler, how do you see the Liikanen Report's proposals currently being discussed at EU level and in the member states?
The report of the group of experts chaired by Mr Liikanen is a thorough and in-depth study of key aspects of financial market regulation and the “too big to fail” problem.

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The “too big to fail” problem has still not been solved despite all the work regarding recovery and resolution plans. Instead, both the size of the banking sector and concentration within it has grown since the start of the crisis. The proposals by the Liikanen group of experts are an important contribution to tackling this problem. It is well worth considering the proposals in detail and without any bias. Difficult questions need to be answered before we can set about implementing the proposal. But that doesn't mean that we shouldn't look for answers to these questions. The report centres on the proposal of segregating trading activities from traditional banking operations without breaking up universal banks. Does that go far enough to mitigate the risks? I don't think that we can eliminate the interconnectedness in the banking sector just by implementing this proposal. The risks won't automatically disappear just because we segregate individual business activities. That's why the proposals also want to ban credit relationships with certain financial market players such as hedge funds. However, the segregation of trading activities from the retail banking business could contribute to reducing the complexity of large banks. Incentives for the banks to improve the transparency of their structures could also be created.

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This makes the Liikanen proposals an attractive alternative – particularly as the report takes a holistic approach.

What do you mean by that?
The proposals don’t stop at a segregation of trading activities from the rest of a bank's operations. This measure is only a supplementary element, which is closely linked to higher capital requirements and improved corporate governance, and also to the future resolution regime. The supervisory authorities would have to prepare efficient and credible resolution plans and they would get considerable ex-ante powers of intervention – up to and including economic and organisational separation of critical business activities. The recovery plans which systemically important banks will soon have to submit will help us here.

The G20 has only required global systemically important banks to do this. Why does BaFin want domestic systemically important institutions to submit recovery plans too?
We view recovery planning as a type of extended risk management which better equips banks against crises. If credit institutions and supervisory bodies consider ahead of time what will need to be done in an emergency, they can then act more quickly and effectively. That's why it's important for all the major German banks to submit recovery plans for our critical review. Together with the Bundesbank, BaFinhas drafted a circular that will help the institutions to develop their recovery plans.
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Market participants were invited to comment on a draft in November.

The Liikanen Report contains not only the approaches mentioned above, but also a proposal on remuneration requirements. What do you think about that?
The proposal is largely within the scope of what CRD III requires and what is also currently being discussed for CRD IV. This is true, for example, of linking variable remuneration to fixed remuneration. As soon as the European requirements, in particular those of CRD IV, have been finalised, they will be fully transposed into German legislation. One element is new: the expert group's proposal to pay a fixed, mandatory component of variable remuneration in the form of bail-in instruments. This should put a stop to “gambling for resurrection,” i.e. institutions close to insolvency using high-risk strategies in a last-ditch effort for recovery. In addition, such remuneration in instruments could provide incentives to employees that are more like those of an owner with a long-term interest in the businesses’ sustainable development. This is a welcome step. However it's important that the incentives should be carefully calibrated, particularly as the bail-in instrument has not yet been finally decided.

The proposals are on the table – what is the next step?
The wealth of good ideas should now be implemented with a view to what we want to achieve. The goal must be to make the system more secure.
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From my point of view, it is right that the report focuses on the large institutions and the firms with a high proportion of trading activities. The stricter requirements will thus only apply to institutions which are so large and interlinked that they could present a danger to financial market stability. Most medium-sized and smaller institutions, on the other hand, will not be impacted.

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Is a bank required to calculate the CVA capital charge daily?
Banks should discuss the frequency with which the CVA capital charge needs to be computed with their national supervisor. To receive regulatory approval to use the advanced CVA approach, banks are generally expected to have the systems capability to calculate the CVA capital charge on a daily basis, but would not be expected or required to calculate it on a daily basis. Instead, banks are required to calculate the CVA capital charge at least on a monthly basis in which expected exposure is also required to be calculated. In this case, banks are to calculate VaR and stress VaR by taking the average over a quarter. Another interesting answer:

Is an intercompany transaction with a zero risk weight subject to a CVA charge?
As per the group consolidated reporting, no regulatory capital charge (including a CVA charge) applies to intercompany transactions. This should include the relevant CVA hedge that is only with an internal desk; internal hedges are not recognised for regulatory capital purposes because they are eliminated in consolidation.

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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 (2,389 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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Presentations only (not the full program)
1. CBiiPro www.basel-ii-association.com/Distance_Learning_Online_Certification_CBiiPro_Pr esentations.htm 2. CP2E www.basel-ii-association.com/Distance_Learning_Online_Certification_CP2E_Pres entations.htm 3. CP3E www.basel-ii-association.com/Distance_Learning_Online_Certification_CP3E_Pres entations.htm

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351 4. CSTE www.basel-ii-association.com/Distance_Learning_Online_Certification_CSTE_Pres entations.htm 5. CBiiiPro www.basel-ii-association.com/Distance_Learning_Online_Certification_CBiiiPro_P resentations.htm 6. All 4 Basel ii Programs CBiiPro, CP2E, CP3E, CSTE Presentations (all 4 programs) www.basel-ii-association.com/Distance_Learning_Online_Certification_CBiiPro_C P2E_CP3E_CSTE_Presentations.htm 7. All 5 (Basel ii and Basel iii) programs CBiiPro, CP2E, CP3E, CSTE, CBiiiPro Presentations (all 5 programs) www.basel-ii-association.com/Distance_Learning_Online_Certification_CBiiPro_C P2E_CP3E_CSTE_CBiiiPro_Presentations.htm

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