Risk and Compliance Management News May 2011

International Association of Risk and Compliance
Professionals (IARCP)
1200 G Street NW Suite 800 Washington, DC 20005-6705 USA
Tel: 202-449-9750 www.risk-compliance-association.com
Dear Member,
Understanding internal controls over financial reporting (ICFR) is very

important for the implementation of the new Dodd Frank Act.
And, who really understands internal controls?

Yes, Sarbanes Oxley professionals. Absolutely.
Today we will spend some time to understand the Dodd Frank Act, and
the new ICFR environment and requirements.
Some interesting developments:
According to the Sarbanes-Oxley Act, publicly traded companies cannot

punish employees that reveal suspected fraud.
Reveal to whom?
Can you reveal suspected fraud to the media?
Today we have a clear answer: No, you are not protected if you reveal
suspected fraud to the media.
According to the Ninth U.S. Circuit Court of Appeals, you are protected if
you speak to federal regulators, Congress or a workplace supervisor - to
those with "the capacity or authority to act effectively on the information"
as Judge Barry Silverman said in the court's ruling.
Leaks to the media are not protected.
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International Association of Risk and Compliance Professionals (IARCP)
www.risk-compliance-association.com
The ruling has to do with the well known case of two Boeing Co. auditors
who were fired in 2007, after telling a reporter that they were being
pressured to deliver favorable reports about the security of Boeing's
internal computer software.
According to the Boeing spokesman John Dern, the ruling supported

corporate policies that require employees to keep internal information
confidential.
Another interesting development:
James R. Doty has been appointed by the Securities and Exchange

Commission as the Chairman of the Public Company Accounting
Oversight Board.
From 1990 to 1992, Mr. Doty served as General Counsel of the SEC.
In that role, Mr. Doty advised the Commission on matters of law and
regulatory policy related to the Commission's oversight of U.S. securities
markets, including initiatives relating to the integrity of financial
reporting and disclosure standards in the context of the globalization of
capital markets, enforcement practices and policies in the wake of the
savings-and-loan crisis, international technical assistance and
coordination efforts, and adoption of the Remedies Act of 1990.
Prior to and following his SEC service, Mr. Doty was a partner at the law
firm of Baker Botts LLP, which he first joined in 1969.
At Baker Botts LLP, he practiced securities and corporate law and

counseled boards of directors and audit committees on regulatory and
compliance matters, including matters arising under the Sarbanes-Oxley
Act of 2002.
He also represented the PCAOB in obtaining a successful result in the

United States Supreme Court in the landmark challenge to its
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constitutionality, Free Enterprise Fund v. PCAOB.
Mr. Doty has earned a B.A. in History from Rice University and was a
Rhodes Scholar at Oxford University in England. He also received a M.A.
in History from Harvard University before getting an L.L.B from Yale
Law School.
It is time to discuss the Dodd Frank Act, Section 989G and the internal
controls over financial reporting (ICFR).
We start from the Dodd Frank Act:
SEC. 989G. EXEMPTION FOR NONACCELERATED FILERS.
(a) EXEMPTION.—Section 404 of the Sarbanes-Oxley Act of 2002 is

amended by adding at the end the following:
‗‗(c) EXEMPTION FOR SMALLER ISSUERS.—Subsection (b) shall

not apply with respect to any audit report prepared for an issuer that is
neither a ‗large accelerated filer‘ nor an ‗accelerated filer‘ as those terms
are defined in Rule 12b–2 of the Commission (17 C.F.R. 240.12b–2).‘‘.
(b) STUDY.—The Securities and Exchange Commission shall conduct a

study to determine how the Commission could reduce the burden of
complying with section 404(b) of the Sarbanes-Oxley Act of 2002 for
companies whose market capitalization is between $75,000,000 and
$250,000,000 for the relevant reporting period while maintaining investor
protections for such companies.
The study shall also consider whether any such methods of reducing the
compliance burden or a complete exemption for such companies from
compliance with such section would encourage companies to
list on exchanges in the United States in their initial public offerings.
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Not later than 9 months after the date of the enactment of this subtitle,
the Commission shall transmit a report of such study to Congress.
Study and Recommendations on Section 404(b) of the

Sarbanes-Oxley Act of 2002
For Issuers With Public Float Between $75 and $250 Million
As Required by Section 989G(b) of the Dodd-Frank Wall Street Reform
and Consumer Protection Act of 2010, April 2011
Section 989G(b) of the Dodd-Frank Act directed the SEC to conduct a

study with respect to the auditor attestation requirement under Section
404(b) for issuers whose market capitalization is between $75 and $250
million.
Specifically, the Dodd-Frank Act provides:
The Securities and Exchange Commission shall conduct a study to

determine how the Commission could reduce the burden of complying
with section 404(b) of the Sarbanes-Oxley Act of 2002 for companies
whose market capitalization is between $75,000,000 and $250,000,000 for
the relevant reporting period while maintaining investor protections for
such companies.
The study shall also consider whether any such methods of reducing the
compliance burden or a complete exemption for such companies from
compliance with such section would encourage companies to list on
exchanges in the United States in their initial public offerings.
Not later than 9 months after the date of the enactment of this subtitle,
the Commission shall transmit a report of such study to Congress.In
addition, Section 989G(a) of the Dodd-Frank Act amended the
Sarbanes-Oxley Act so that Section 404(b) does not apply with respect to
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any audit report prepared for an issuer that is neither a ―large accelerated
filer‖ nor an ―accelerated filer‖ as those terms are defined in Rule 12b-2 of
the Commission.
Pursuant to Section 989I of the Dodd-Frank Act, the Government

Accountability Office (GAO) is required to conduct a study on the impact
of the Section 404(b) amendments under the Dodd-Frank Act and to
submit a report not later than 3 years after the date of enactment of that
Act (July 2013).
The GAO study is to include an analysis of:
(1) whether issuers that are exempt from such section 404(b) have fewer or
more restatements of published accounting statements than issuers that
are required to comply with such section 404(b);
(2) the cost of capital for issuers that are exempt from such section 404(b)
compared to the cost of capital for issuers that are required to comply
with such section 404(b);
(3) whether there is any difference in the confidence of investors in the

integrity of financial statements of issuers that comply with such section
404(b) and issuers that are exempt from compliance with such section
404(b);
(4) whether issuers that do not receive the attestation for internal controls
required under such section 404(b) should be required to disclose the lack
of such attestation to investors; and
(5) the costs and benefits to issuers that are exempt from such section
404(b) that voluntarily have obtained the attestation of an independent
auditor.
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Approach to this Study
This study addresses the auditor attestation requirement with respect to

an issuer‘s ICFR pursuant to Section 404(b) as required by Section
989G(b) of the Dodd-Frank Act.
It does not address management‘s responsibilities pursuant to Section

404(a) of the Sarbanes-Oxley Act.
Under the Commission‘s rules prescribed pursuant to Section 404(a) of

the Sarbanes-Oxley Act, issuers, other than registered investment
companies, are required to include in their annual reports a report of
management on the issuer‘s ICFR that:
(1) States management‘s responsibility for establishing and maintaining

the internal control structure; and
(2) Includes management‘s assessment of the effectiveness of the ICFR.

Section 404(b) requires the auditor to attest to, and report on,
management‘s assessment.
In light of the interrelationship between the requirements in Section

404(a) and Section 404(b), and to be complete in our efforts to identify
potential methods of reducing the Section 404(b) compliance burden, the
Staff‘s research and analysis included consideration of certain existing
information about Section 404 compliance more broadly, particularly
where such information did not distinguish among the various
requirements in Section 404.
In order to fulfill the statutory mandate and produce this study, the Staff
has assigned meaning to certain terms as described below:
1. For purposes of this study, the Staff generally uses public float as the
measure of market capitalization.
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As the Commission described in its request for comment in connection
with this study:
The Dodd-Frank Act does not define market capitalization and it is not
defined in Commission rules.
For purposes of the study, we believe that public float is an appropriate

measure of market capitalization.
Public float, which is the aggregate worldwide market value of an issuer‘s

voting and non-voting common equity held by its non-affiliates, is the
measure used in Commission rules for determining accelerated filer and
large accelerated filer status.
The Commission has used public float historically in its actions to phase
issuers into Section 404 compliance, and Section 404(c) of the
Sarbanes-Oxley Act of 2002, as amended by Section 989G(a) of the
Dodd-Frank Act, provides that Section 404(b) shall not apply with respect
to issuers that are neither an accelerated filer nor a large accelerated filer
pursuant to Commission rules, which are generally issuers with a public
float below $75 million.
We therefore believe it would be consistent to use public float between

$75 million and $250 million to describe the group of issuers that are the
subject of the study.
2. Accelerated filer means an issuer after it first meets the following

conditions as of the end of its fiscal year:
(i) The issuer had an aggregate worldwide market value of the voting and
non-voting common equity held by its non-affiliates of $75-$700 million
as of the last business day of the issuer‘s most recently completed fiscal
quarter;
(ii) The issuer has been subject to the requirements of Section 13(a) or
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15(d) of the Exchange Act for at least twelve calendar months;
(iii) The issuer has filed at least one annual report pursuant to Section
13(a) or 15(d) of the Exchange Act; and
(iv) The issuer is not eligible to use the requirements for smaller reporting
companies in its annual and quarterly reports.
3. Large accelerated filer means an issuer that had an aggregate

worldwide market value of the voting and non-voting common equity
held by its non-affiliates of $700 million or more as of the last business day
of the issuer‘s most recently completed fiscal quarter and also meets the
requirements of (ii) – (iv) listed above in the definition of accelerated filer.
4. The study uses the term non-accelerated filer to refer to an issuer that
does not meet the definition of either an accelerated filer or a large
accelerated filer which principally are issuers with a public float of less
than $75 million.
5. The study uses the term illustrative population to refer to the group of
issuers identified for the analyses in Section II of this study.
Executive Summary
Under Section 989G(b) of the Dodd-Frank Wall Street Reform and
Consumer Protection Act (the Dodd-Frank Act), the Securities and
Exchange Commission (SEC or Commission) is required to conduct a
study to determine how the Commission could reduce the burden of
complying with Section 404(b) of the Sarbanes-Oxley Act of 2002 (Section
404(b)) for companies whose market capitalization is between $75 and
$250 million, while maintaining investor protections for such companies.
Section 989G(b) also provides that the study must consider whether any
methods of reducing the compliance burden or a complete exemption for
such companies from Section 404(b) compliance would encourage
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companies to list on exchanges in the United States in their initial public
offerings (IPOs).
This study addresses the auditor attestation requirement with respect to

an issuer‘s internal control over financial reporting (ICFR) pursuant to
Section 404(b) as required by Section 989G(b) of the Dodd-Frank Act.
It does not address management‘s responsibility for reporting on the

effectiveness of ICFR pursuant to Section 404(a) of the Sarbanes-Oxley
Act.
Although many of the academic and other studies surveyed relate to

Section 404 in general and to Section 404(b) for all issuers, the research
discussed in this study primarily focuses on findings related to
accelerated filers.
However, in conducting this study, the SEC Staff‘s research and analysis
considered certain existing information about Section 404 compliance
beyond the specific areas of the study requirements as provided in the
Dodd-Frank Act.
This approach was used to develop findings and recommendations

regarding Section 404(b) through the analysis of existing research, even
though the purpose of the existing research may have been broader than
the requirements of the current study.
Broadly, the Staff gathered information for this study through:
(1) a review of publicly-available information (including the 2009 SEC

Staff study on Section 404, discussed in Section III of this study), focusing
our data analysis on issuers that would be within the range called for by
the study;
(2) a review of prior academic and other research, including hundreds of

studies and research papers with respect to Section 404; and
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(3) a request for public comment which included 23 specific areas of
inquiry on how the Commission could reduce the burden of complying
with Section 404(b) for issuers with $75-$250 million in public float, while
maintaining investor protections for such issuers, and whether any
methods of reducing the compliance burden or a complete exemption for
such issuers from Section 404(b) would encourage issuers to list on U.S.
exchanges in their IPOs.
The purpose of using these sources was to:
(1) learn about the specific characteristics of the issuers in the range of the
study, how they compare to other issuers reporting as accelerated filers
and non-accelerated filers, and the benefits and current and historical
costs of compliance with Section 404(b) and current investor protections
relating to such issuers; and
(2) facilitate the development of potential new ideas for reducing the
compliance burden among such issuers, including the effects of such
compliance burden reduction or complete exemption from Section 404(b)
to encourage companies to list IPOs in the United States.
Consideration of Prior Action by the Commission and Others
In performing this study, the Staff first considered actions taken by the
Commission and others since the enactment of Section 404(b).
The Staff performed this analysis to consider the effects of the significant
steps that have already been taken to reduce the overall compliance
burden on the population that is the subject of this study.
Broadly, the timeline is as follows:
1. The Commission‘s initial implementing rule provided a phased-in

approach to compliance;
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2. In response to concerns from issuers (particularly non-accelerated
filers) about compliance costs and management‘s preparedness, the
Commission provided several extensions to the compliance dates;
3. The Commission provided that Section 404 compliance is not required

in an IPO and in the first annual report after an IPO;
4. In 2007, the Commission issued an interpretive release to provide

guidance for management regarding its evaluation of internal controls
and disclosure requirements;
5. At approximately the same time that the Commission‘s interpretive

release was issued, the Public Company Accounting Oversight Board (the
PCAOB or Board) adopted Auditing Standard No. 5, An Audit of Internal
Control Over Financial Reporting that is Integrated with an Audit of
Financial Statements (AS 5) to address feedback from constituents about
the costs of conducting an effective audit of internal controls, including
feedback received from roundtables and other activities with the
Commission; and
6. Additionally, in 2008 the Commission directed the Staff to conduct a

study on Section 404, which was released in 2009 and forms part of the
basis for the current study.
Analysis of the Issuers Subject to this Study
After considering prior actions taken to reduce the compliance burden on

all issuers subject to Section 404, the Staff analyzed the characteristics of
issuers that are the subject of this study.
The Staff performed this analysis to assist with the development of

potential recommendations specific to any unique circumstances rather
than to identify the exact listing of issuers as of any point in time that
could be affected by any future actions resulting from the implementation
of particular recommendations of the study.
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The characteristics analyzed included the following information about
the issuers:
(1) size in terms of assets and revenues;
(2) industries;
(3) locations;
(4) audit fees and scalability;
(5) restatement rates; and
(6) reported material weaknesses in ICFR.
The Staff also analyzed changes to the population of the issuers over time,
noting that issuers frequently enter and exit this band of public float, such
that the composition changes greatly from year to year.
The Staff identified an illustrative population of issuers as of December 31,

2009 as a proxy for those in the studied range.
The Staff observes that auditor attestation on ICFR has been required for
accelerated filers since 2004 for domestic issuers and 2007 for foreign
private issuers.
The Staff‘s analysis reveals that the illustrative population is, in many
important respects, significantly different from the population of all
non-accelerated filers (the group of issuers permanently exempted from
the requirements of Section 404(b) by the Dodd-Frank Act), particularly
in relation to size (by revenue and assets), audit fees relative to size,
restatement rates, and internal control issues discovered by management
and auditors.
Many of the characteristics point to similar financial reporting risks

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between the studied group of issuers and issuers with larger public float
that also must comply with Section 404(b).
The Staff recognizes, as would be the case with establishing any numeric
thresholds, that issuers at the lower end of the studied range within the
illustrative population could be more likely to have characteristics more
similar to non-accelerated filers (i.e., issuers that are just under or just
over the $75 million threshold are likely to have similar characteristics to
one another).
This analysis suggests that there generally are not unique characteristics
in the illustrative population that would suggest sufficient reasons for
differentiating these filers from accelerated filers taken as a whole,
including the requirement for an auditor attestation on ICFR pursuant to
Section 404(b).
To understand whether any possible recommendations may encourage

companies to list IPOs in the United States, the Staff analyzed the
characteristics of global IPOs with respect to those likely to be in the
range of issuers subject to this study.
Although the U.S. IPO market over time has recovered from the 2007
levels, it has not reached the 1999 levels (i.e., we reviewed IPO activity
over a range of years and noted that it was at a relatively low point during
the financial crisis and has since recovered, but not to the peak for the
range of years studied).
The Staff‘s analysis shows that the United States has not lost U.S.-based
companies filing IPOs to foreign markets for the range of issuers that
would likely be in the $75-$250 million public float range after the IPO
and that issuers filing IPOs in this range are not likely to remain in this
range for an extended period of time.
While U.S. markets‘ share of world-wide IPOs raising $75-$250 million

has declined over the past five years, there is no conclusive evidence from
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the study linking the requirements of Section 404(b) to IPO activity.
In addition, as noted above, the Commission has previously taken action

to reduce the compliance burden for new issuers by not requiring the
auditor attestation on ICFR for the IPO and the first annual report
thereafter.
Analysis of the 2009 SEC Staff Study on Section 404

Once the Staff understood the characteristics of the studied group of
issuers, it used the data from its 2009 Section 404 study to analyze the
effects of prior efforts to reduce the Section 404(b) compliance burden on
such issuers.
The Staff found that the 2007 reforms (broadly, the Commission‘s June
2007 interpretive release and the PCAOB‘s adoption of AS 5) had the
intended effect of reducing the compliance burden and improving the
implementation of Section 404, including the requirements of Section
404(b) for the studied group of issuers.
This information, in conjunction with the analysis of prior reforms and

general information about the characteristics of the studied group of
issuers, provided the Staff with a starting point to consider new public
input, existing academic research, and other information to determine
whether there are additional ways to further reduce the compliance
burden of Section 404(b) while maintaining investor protections for such
issuers.
Discussion of Public Comments

To assist the Staff in considering possible recommendations, the
Commission requested public input on 23 specific areas about how the
Commission could reduce the burden of complying with Section 404(b)
for the studied group of issuers, while maintaining investor protections
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for such issuers, and whether any methods of reducing the compliance
burden or a complete exemption for such issuers from Section 404(b)
would encourage issuers to list on U.S. exchanges in their IPOs.
There were few suggestions provided from the public input that
addressed techniques for further reducing the compliance burden while
maintaining investor protections without providing a complete
exemption.
For example, the three industry groups that advocated an exemption from
Section 404(b) for issuers in the studied market capitalization range did
not provide other recommendations for reducing the compliance burden.
The Staff considered this input as well as public input previously received
on the compliance burden of Section 404(b) from past Commission and
PCAOB actions, but generally did not believe that those suggestions,
beyond those previously implemented, were appropriate
recommendations for the issuer group the Staff was required to study
(e.g., forms of rotational or reduced testing and raising the threshold of
what constitutes a material weakness).
The Staff is also aware that there are continuing negative perceptions
attributed to the Sarbanes-Oxley Act, including Section 404.
However, the Staff does believe that certain other suggestions from the
public that involve Commission coordination and support for other
groups will likely take into account both the compliance costs and
effectiveness for all issuers, including those in the studied range.
First, certain commenters recommended that the PCAOB publish
additional observations about the implementation of the PCAOB‘s
auditing standards related to Section 404(b), including comparing such
implementation to the PCAOB‘s original intent.
These commenters believed that additional observations could assist

auditors in performing more efficient and effective audits.
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The Staff supports recommending to the PCAOB that it continuously
review inspection results and consider whether publishing observations is
warranted to improve the effective and efficient application of its auditing
standard.
If such observations were published, they may contribute to a reduction

in the compliance burden for issuers in the studied range and also provide
auditors, issuers, investors, and others with important information about
audit performance and quality.
Second, certain commenters recommended that the Commission actively

participate and monitor the Committee of Sponsoring Organizations of
the Treadway Commission (COSO) update to its internal control
framework.
COSO announced plans to update its framework, which was originally

released in 1992, in November of 2010.
The stated aims of the update to the 1992 framework do not explicitly
address the compliance burden on issuers that use the COSO framework
to evaluate ICFR, and it is not aimed at any particular size of issuer.
However, the update is designed to describe how to evaluate internal

controls in an environment that is more complex than it was when the
original framework was developed.
The Staff supports this recommendation, as the update may have

implications on the compliance burden on issuers, including those in the
studied range.
Summary of Prior Academic and Other Research on Section 404
Finally, the Staff considered existing research on Section 404 to
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understand the trends in compliance costs and the existing investor
protections provided by compliance with Section 404(b), as well as to
discern any additional ideas for reducing the compliance burden for
issuers in the studied range.
The research was useful to inform the Staff‘s broader consideration of

how and if the compliance burden could be reduced for such issuers by
examining, for example, compliance cost trends, listing trends, and
individuals‘ decision making in lending and investing activities.
The academic and other research on Section 404:
1. Indicates that the cost of compliance with Section 404(b), including

both total costs and audit fees, has declined since the 2007 reforms;
2. Does not provide conclusive evidence linking the enactment of Section

404(b) to decisions by issuers to exit the reporting requirements of the
SEC, including ICFR reporting;
3. Indicates that auditor involvement in ICFR is positively correlated with

more accurate and reliable disclosure of all ICFR deficiencies, and
restatement rates for issuers with the auditor attestation is lower than that
for issuers without this attestation; and
4. Indicates that disclosure of internal control weaknesses conveys

relevant information to investors.
The Staff also considered and does not recommend an approach detailed
in certain studies suggesting that the Commission allow an issuer to opt
out of Section 404(b) compliance.
Opt out approaches can provide a mechanism to allow an issuer options
regarding compliance rather than a strict requirement.
Under such an approach, so long as an investor was informed as to an

issuer‘s decision to opt out or comply, an investor could consider this
decision in allocating capital and otherwise making investment decisions.
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Although some suggest that allowing flexibility of this type could be
beneficial, in the context of Section 404(b) the Staff considered the
suggestion of an opt out to be too similar to providing a full exemption
given the Staff‘s view of the benefits of auditor involvement to reliable
ICFR disclosures and reliable financial reporting.
Academic literature also suggests it could incentivize insiders to exploit

the information asymmetry between themselves and other investors about
the incidence and severity of material weaknesses in ICFR.
Conclusion and Recommendations
The information compiled for the study provided the Staff with an
understanding that:
1. The costs of Section 404(b) have declined since the Commission first
implemented the requirements of Section 404, particularly in response to
the 2007 reforms;
2. Investors generally view the auditor‘s attestation on ICFR as beneficial;
3. Financial reporting is more reliable when the auditor is involved with

ICFR assessments; and
4. There is not conclusive evidence linking the requirements of Section

404(b) to listing decisions of the studied range of issuers.
The Staff also received public input suggesting certain means to reduce
the compliance burden that were previously considered by the
Commission or the PCAOB and they determined not to adopt.
The Staff considered this input but believes these suggestions would
possibly be detrimental to effectiveness of audits of ICFR and, therefore,
not maintain investor protections provided by Section 404(b).
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After considering the information gathered from internal and external
sources, the Staff concludes the study with the following two
recommendations:
1. Maintain existing investor protections of Section 404(b) for accelerated

filers, which have been in place since 2004 for domestic issuers and 2007
for foreign private issuers
The Staff believes that the existing investor protections for accelerated
filers to comply with the auditor attestation provisions of Section 404(b)
should be maintained (i.e., no new exemptions).
There is strong evidence that the auditor‘s role in auditing the

effectiveness of ICFR improves the reliability of internal control
disclosures and financial reporting overall and is useful to investors.
The Staff did not find any specific evidence that such potential savings
would justify the loss of investor protections and benefits to issuers
subject to the study, given the auditor‘s obligations to perform procedures
to evaluate internal controls even when the auditor is not performing an
integrated audit.
Also, while the research regarding the reasons for listing decisions is
inconclusive, the evidence does not suggest that granting an exemption
to issuers that would expect to have $75-$250 million in public float
following an IPO would, by itself, encourage companies in the United
States or abroad to list their IPOs in the United States.
The Staff acknowledges that the reasons a company may choose to
undertake an IPO are varied and complex.
The reasons are often specific to the company, with each company
making the decision as to whether and where to go public based on its
own situation and the market factors present at the time.
The costs associated with conducting an IPO and becoming a public

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company no doubt factor into the decisions and may be particularly
challenging for smaller companies.
The Staff appreciates that the costs and benefits of the regulatory actions
that the Commission takes – and does not take – certainly can impact
these decisions.
At Chairman Schapiro‘s request, the Staff is taking a fresh look at several

of the Commission‘s rules, beyond those related to Section 404(b), to
develop ideas for the Commission about ways to reduce regulatory
burdens on small business capital formation in a manner consistent with
investor protection.
However, the Dodd-Frank Act already exempted approximately 60% of

reporting issuers from Section 404(b), and the Staff does not recommend
further extending this exemption.
2. Encourage activities that have potential to further improve both

effectiveness and efficiency of Section 404(b) implementation
The Staff recommends that the PCAOB monitor its inspection results and
consider publishing observations, beyond the observations previously
published in September 2009, on the performance of audits conducted in
accordance with AS 5.
These observations could assist auditors in performing top-down, risk

based audits of ICFR.
These communications could include the lessons that can be learned
from internal control deficiencies identified through PCAOB inspections.
The Staff is observing COSO‘s project to review and update its internal
control framework, which is the most common framework used by
management and the auditor alike in performing assessments of ICFR.
The Staff believes that this project can contribute to effective and efficient
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audits by providing management and auditors with improved internal
control guidance that reflects today‘s operating and regulatory
environment and by allowing constituent groups to share information on
improvements that can be made that enhance the ability to design,
implement, and assess internal controls.
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Basel III News
Dear Members,
According to Otto von Bismarck, laws are like sausages, it is better not to
see them being made.
But this is not an option for us. Basel II / III professionals must try hard
to understand both, the letter and the spirit of the law.
Banks continue to lobby for revisions of the key factors that are included
in the Basel III liquidity ratios, in an effort to minimize the consequences
and... increase shareholder value (and of course pay dividends).
Citigroup and Goldman Sachs for example, try to persuade that the NSFR
should be substantially re-calibrated.
Are you ready for the bad news? According to Moody‘s senior vice
president Alain Laurin: ―While directionally positive, Basel 3 does not
cure the structural challenges banks continue to face from a credit
perspective, such as illiquidity and high leverage, nor does it alleviate the
tension between profit-maximizing equity holders and bank managers in
contrast to risk-averse bondholders.‖
This month we had another opportunity to see that Basel III is a

minimum standard:
The finance commission members in Switserland voted in favor of the

government's proposal, which would make the UBS and Credit Suisse
hold equity Tier 1 capital of at least 10 percent, 3 percentage points more
than required by new Basel III rules.
Credit Suisse puts on a brave face and considers the proposal "tough but
doable".
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UBS, more practical, calls for a year's delay to allow more clarity on
international regulation.
Today we will study one of the new papers that explain the Basel III
framework.
Conference on Basel III, Financial Stability Institute, 6 April 2011

Basel III: Stronger Banks and a More Resilient Financial System
Stefan Walter, Secretary General, Basel Committee on Banking
Supervision
I. Introduction
Thank you for the opportunity to speak to you this morning about Basel
III.
It is has now been three and a half years since the global financial crisis
began.
The banking sector and financial system have now been stabilised.
But this required unprecedented public sector interventions.
Despite the severity of the crisis, we are already seeing signs that its
lessons are beginning to fade.
At the same time, there are still significant risks on the horizons, while
key reforms still need to be carried through if we are to achieve a truly
stable banking and financial system.
I would like to begin this morning by recalling the damaging effects of

the crisis and why the Basel III reforms are central to promoting financial
stability.
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I will then briefly outline the key reforms that comprise Basel III.
Finally, I will focus on what still needs to be done to ensure longer-term
stability.
In particular, I will discuss the need for global and consistent

implementation of the Basel III reform package and the ongoing work to
address the risks of systemic banking institutions.
II. Motivation for Basel III reforms
A. Damaging effects of banking crises
There is a wide body of evidence that the most severe economic crises are
associated with banking sector distress.
While there is variation in findings across studies, the Basel Committee‘s

long-term economic impact study found that the central estimate in the
economics literature is that banking crises result in losses in economic
output equal to about 60% of pre-crisis GDP.
Why are banking crises so damaging?
Banks are highly leveraged institutions and are at the centre of the credit
intermediation process.
In addition, credit and maturity transformation functions are vulnerable

to liquidity runs and loss of confidence.
A destabilised banking system affects the provision of credit and liquidity

to the broader economy and ultimately leads to lost economic output.
[see Table 1]
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In the most recent phase of the crisis there has also been significant
spillover of risk between the banking sector and sovereigns.
Governments in a number of industrialised countries had to increase their

debt in order to stabilise their banking systems and economies.
As a result, debt-to-GDP ratios in a number of economies increased by as

much as 10-25 percentage points.
It therefore is clear that the economic benefits of raising the resilience of

the banking sector to shocks are immense.
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B. Frequency of banking crises
The costs of banking crises are extremely high but, unfortunately, the
frequency has been as well.
Since 1985, there have been over 30 banking crises in Basel

Committee-member countries.
Roughly, this corresponds to a 5% probability of a Basel Committee

member country facing a crisis in any given year – a one in 20 chance,
which is unacceptably high.
[See Table 2]
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Many countries may not have been the cause of the current crisis, but
they have been affected by the global fall out.
Moreover, history has shown that banking crises have occurred in all
regions of the world, affecting all major business lines and asset classes.
Moreover, there tend to be a common set of features that seem to repeat

themselves in various combinations from banking crisis to banking crisis.
These include:
1. Excess liquidity chasing yields
2. Too much credit and weak underwriting standards
3. Underpricing of risk, and
4. Excess leverage
In the current crisis, these recurring trends were magnified by:
1. Weak bank governance practices, including in the area of

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

products
3. Risk management and supervision focused on individual institutions

instead of also at the system level
4. Procyclicality of financial markets propagated through a variety of

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

institutions.
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C. Benefits of tighter regulation through Basel III exceed the
costs
The objective of the Basel III reforms is to reduce the probability and
severity of future crises.
This will involve some costs arising from stronger regulatory capital and
liquidity requirements and more intense and intrusive supervision.
But our analysis and that of many others has found the benefits to society
well exceed the costs to individual institutions.
The Committee‘s long-term economic impact analysis found that capital

and liquidity requirements could be increased – well above current
minimum levels – while still achieving positive net economic benefits.
[see Table 3]
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These findings are not surprising.
It is widely accepted that prudent fiscal and monetary policies are the
cornerstones of financial stability and sustainable economic growth.
Indeed, maintaining conservative fiscal and inflation policies involve a

cost – they result in potentially lower short-term economic growth, which
is offset by more sustainable long-term growth.
Increasing stability of the banking and financial system involves a similar

trade-off, where the costs are more than offset by the long-term gain.
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In particular, it is difficult to imagine a country that can maintain
sustainable growth on the foundation of a weak banking system
III. Key features of the Basel III reform package

The Basel III framework is the cornerstone of the G20 regulatory reform
agenda and the final Basel Committee rules were issued at the end of last
year.
This development is the result of an unprecedented process of

coordination across 27 countries.
Compared to Basel II, it was also achieved in record time, less than two
years.
The next step, which is just as critical as the policy development, is

implementation.
The full potential of Basel III will only be achieved if all

Committee-member countries and regions work within the global
process, and fully implement the minimum standards.
Some countries may choose to implement higher standards to address

risks particular to their national contexts.
This has always been an option under Basel I and II, and it will remain
the case under Basel III.
Why is Basel III fundamentally different from Basel I and Basel II?
First, it is more comprehensive in its scope and, second, it combines

micro- and macro-prudential reforms to address both institution and
system level risks.
On the microprudential side, these reforms mean:

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1. A significant increase in risk coverage, with a focus on areas that were
most problematic during the crisis, that is trading book exposures,
counterparty credit risk, and securitisation activities;
2. A fundamental tightening of the definition of capital, with a strong

focus on common equity.
At the same time, this represents a move away from complex hybrid
instruments, which did not prove to be loss absorbing in periods of stress.
We also introduced requirements that all capital instruments must absorb

losses at the point of non-viability, which was not the case in the crisis;
3. The introduction of a leverage ratio to serve as a backstop to the

risk-based framework;
4. The introduction of global liquidity standards to address short-term

and long-term liquidity mismatches; and
5. Enhancements to Pillar 2‘s supervisory review process and Pillar 3‘s

market discipline, particularly for trading and securitisation activities.
In addition, a unique feature of Basel III is the introduction of

macroprudential elements into the capital framework.
This includes:
1. Standards that promote the build-up of capital buffers in good times

that can be drawn down in periods of stress, as well as clear capital
conservation requirements to prevent the inappropriate distribution of
capital;
2. The leverage ratio also has system-wide benefits by preventing the

excessive build-up of debt across the banking system during boom times.
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To minimise the transition costs, the Basel III requirements will be
phased in gradually as of 1 January 2013.
I would now like to say a few words in particular about two of the newer
elements of the regulatory framework, namely the liquidity standards and
the leverage ratio. As mentioned, excess leverage and weak liquidity
profiles of banks were at the core of the crisis, and they therefore
represent a critical part of the Basel III framework going forward.
A. The Liquidity Framework
There is broad support for the liquidity framework introduced by the

Committee.
Banks and other market participants already use methods similar to the
Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio
(NSFR).
Many of the issues that have been raised pertaining to these requirements
revolve around the calibration of the ratios, rather than the conceptual
basis of the framework.
It is important to emphasise the Committee‘s goal in establishing the

liquidity framework: to require banks to withstand more severe shocks
than they had been able to in the past, thus reducing the need for such
massive public sector liquidity support in future episodes of stress.
The success of the framework should not be measured in terms of

whether it will have zero cost.
Instead, the better measure of success is whether the framework corrects

pre-crisis extremes at acceptable costs.
Banks that take on excessive liquidity risk should be penalised under the
new framework, while sound business models should continue to thrive.
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With these objectives in mind, the Committee will use the observation
period to review the implications of the standards for individual banks,
the banking sector, and financial markets, addressing any unintended
consequences as necessary.
In this regard, the Committee‘s focus is now on ensuring that the

calibration of the framework is appropriate.
Certain aspects of the calibration will be examined and this will involve
regular data collection from banks.
Any adjustments should be based on additional information and rigorous

analyses.
Moreover, relying just on banks‘ experiences from the crisis is not

sufficient, as it embeds a high level of government support of banks and
markets.
Hence, the analysis will need to include both quantitative bank

experience and additional qualitative judgement.
It is worth emphasising that a number of effects of the framework are

indeed intended.
For example, with regard to the pool of liquid assets, the rules are meant
to promote changes in behaviour.
Contrary to popular perception, they are not about promoting the

hoarding of government debt, but about creating incentives to reduce
risky liquidity profiles.
This can be achieved, for example, by pushing out the average term of
funding or increasing the share of stable funds.
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In other cases, banks did not price liquidity appropriately throughout the
firm, and correcting risk management deficiencies will in turn improve
liquidity profiles.
In fact, the initial response we have observed in some countries that have
already implemented comparable liquidity ratios suggest that these are
the types of strategies that are being pursued.
Also contrary to what many have claimed, the new standards should help
promote greater diversification of the pool of liquid assets held by banks.
Bank holdings of liquid assets continue to be dominated by exposures to

sovereigns, central banks and zero percent risk-weighted public sector
entities.
These assets comprised 85% of banks‘ liquid assets according to the

Committee‘s most recent quantitative impact study.
By recognising high quality corporate and covered bonds – subject to a

limit – the liquidity framework will help promote a further diversification
of the liquid asset pool.
B. The Leverage Ratio

Many banks entered the crisis with excessive leverage.
This increased the probability of bank failures.
It also exacerbated the effects of the crisis on broader financial markets as

many banks rushed to de-leverage once the crisis hit.
The objective of the leverage ratio is to serve as a back-stop to the

risk-based measure.
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The Committee‘s calibration work shows that bank leverage was a highly
statistically significant discriminator between banks that ultimately failed
or required government capital injections during the crisis and those that
did not.
Moreover, at the height of the crisis, the market gravitated towards simple
leverage based measures to compare banks. [see Table 4]
The leverage ratio also serves a macroprudential purpose.
We have seen during this and prior crises the cyclical movement of
leverage at the system-wide level.
Leverage, which tends to build up prior to crisis periods, is subsequently

unwound when a crisis occurs.
This cyclical aspect exacerbates both the upswing phase and the
downturn.
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In addition, what can appear to be very low risk assets at the institution
level can ultimately create incentives for the build-up of risks at the
broader system level.
The leverage ratio serves to limit excessive concentrations in such asset

classes.
[see Table 5]
As with the liquidity framework, the Committee has a process in place to

assess the impact of the leverage ratio on business models.
It will take actions if necessary to make sure that the design of the
leverage ratio will achieve its objectives.
As I stressed earlier, it is important that all countries and regions continue

to work within this global process.
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IV. What still needs to be done to ensure longer-term banking
sector and economic stability?
Over the past three years, much has been achieved by the global
regulatory community to respond to the crisis.
This policy work is now substantially complete.
But to ensure longer-term banking sector and economic stability,

consistent and timely global implementation of Basel III is critical.
In addition, a key remaining area of policy development work is focused

on dealing with systemically important banks (SIBs).
Finally, we will also need to stay attuned to bank-like risks that emerge in
the shadow banking sector.
V. Implementation of Basel III

The Committee has put in place mechanisms to help ensure more
consistent implementation of its standards.
This applies not only to Basel III but to other global standards agreed by
the Committee.
The efforts of the Committee are reinforced through additional

institutional arrangements introduced at the level of the Financial
Stability Board (FSB) and the G20.
Going forward, the Committee‘s Standards Implementation Group will

play a critical role in conducting thematic peer reviews of member
countries‘ implementation of standards and sound practices.
Implementation involves not only introduction of the standards in legal

form, but also rigorous and robust review and validation by supervisors.
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We therefore are also introducing processes to ensure the integrity of key
elements of the framework.
An example of this is the review of banks‘ risk weightings, which should

include the use of test portfolio exercises.
As we have painfully learned from the recent crisis, the failure to

implement Basel III in a globally consistent way will again lead to a
competitive race to the bottom and increase the risk of another crisis
down the road.
VI. Addressing the Too-Big-To-Fail (TBTF) problem
During the crisis, the failure or impairment of certain banks sent shocks
through the financial system.
This had an adverse knock-on effect on the real economy.
Supervisors and relevant authorities had limited options to prevent or

contain problems effecting individual firms and this led to wider financial
instability.
As a consequence, public sector intervention to restore financial stability

during the crisis was necessary, as was the massive scale of these
responses.
The fallout from the crisis underscores the need to put in place additional
measures to reduce the likelihood and severity of problems emerging at
systemic banking institutions.
The Committee, in close cooperation with the FSB is working to address

the financial system externalities created by Systemically Important
Banks (SIBs).
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To achieve this broad objective, policy tools are being designed to:
1. Reduce the probability as well as the impact of an SIB failure;
2. Reduce the cost to the public sector should a decision be made to

intervene; and
3. Level the playing field by reducing too-big-to-fail competitive

advantages in funding markets.
The Committee has developed a methodology that embodies the key

components of systemic importance.
These are size, interconnectedness, substitutability, global activity and

complexity.
The methodology can serve as a basis for the differentiated treatment of

systemic institutions without needing to specify a fixed list of such
institutions.
Common equity is the key when it comes to going concern capital as it is

available to absorb losses with certainty, thus reducing the probability of
failure.
The Committee also continues to study the role that going-concern

contingent capital could play in its framework for SIBs.
Strong resolution and recovery frameworks play a critical role in reducing

the impact of failure by facilitating the orderly wind-down of a global
bank.
In this context, the Committee is reviewing the role that bail-in debt
could play in complementing Tier 2 capital to provide additional
resources that can mitigate the systemic impact of banks at the point of
non-viability.
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The Committee‘s work on systemically important banks is part of the
broader effort of the Financial Stability Board (FSB) to address the risks
posed by SIFIs.
The Committee is working closely with the FSB through this process, and
expects to consult on proposals to address the risks of globally systemic
banks around the middle of the year.
VII. Shadow Banking
The final area where further work is needed is shadow banking.
Shadow banking was a key mechanism through which the crisis was
propagated.
SIVs, money market mutual funds, the securitisation process, and bank
liquidity lines to off-balance-sheet exposures all served to amplify the
impact of the crisis on banks.
While it is clearly important to address issues in the shadow banking

sector, its existence should not detract from the fundamental need to
strengthen the resilience of the banking system itself.
The banking sector remains at the centre of the credit and liquidity
This is true even in economies that are more reliant on capital markets.
Moreover, significant parts of shadow banking were created, sponsored

or financed by the banking sector and these include SIVs, ABCP
conduits, MMMFs, certain securitisation structures, and hedge funds.
Finally, much of the shadow banking sector depends on the financing

and liquidity support of the banking sector.
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Basel III goes a long way to closing the gaps in exposure to shadow
banking. It does this in several ways:
1. By addressing the capital treatment for liquidity lines to SIVs and other
types of off-balance sheet conduits;
2. By addressing counterparty credit risk;
3. By including off-balance sheet exposures in the Basel III leverage ratio;

and
4. By incorporating a range of contractual and reputational risks arising

from the shadow banking sector into the liquidity regulatory and
supervisory standards.
Thus, stronger, consolidated banking regulation and supervision will go a

significant way towards containing the risks of the shadow banking
sector.
In addition, to the extent that bank-like risks emerge in the shadow

banking sector, they should also be addressed directly.
Supervisors should take a system-wide perspective on the credit

To the extent that bank-like functions are carried out in the shadow
banking sector and pose broader systemic risks, they should be subject to
appropriate regulation, supervision, and disclosure.
In particularly this is the case where activities combine credit

intermediation, maturity or liquidity transformation, and leverage.
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The FSB, the Basel Committee and the Joint Forum of Banking,
Securities, and Insurance Supervisors will monitor developments closely
and promote appropriate responses as circumstances dictate.
VIII. Other Basel Committee initiatives

The Committee is also conducting a fundamental review of the trading
book.
It is fundamental in the sense that it will help inform basic questions such
as how to address the line between the banking and the trading book and
how to improve upon the current VAR based framework for measuring
trading risks.
We will consult on this issue as the work progresses, which I expect will
be around the end of this year
Other issues on the Committee‘s agenda include further work on

cross-border bank resolution issues and updating of large exposure
standards, as well as a revision of the Core Principles for Effective
Banking Supervision.
It is critical that we incorporate the lessons of the crisis into a revised set
of Core Principles, which will serve as the basis for enhanced country
level reviews through the IMF and World Bank.
IX. Conclusion
The policy work for developing the Basel III framework has for the most
part been completed.
The reforms are significant and bring together micro and macro lessons
of the crisis.
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The Committee has now moved to the next phase: implementation.
One of the regulatory lessons of the crisis is that it is critical that all
countries and regions now follow the global implementation process.
By definition, it will be hard to predict the cause of the next crisis.

Many risks are still looming on the horizon, and all countries need to
continue the process of building their capacity to absorb shocks –
whatever the source.
The banking sector‘s shock absorbing capacity must be much stronger

than it has been in the past, and the implementation of our standards
must be more globally consistent and robust.
Speech by Jean-Claude Trichet, President of the ECB,

Madrid, 13 May 2011
Introduction
We are nearly four years on from the first tremors in the world‘s financial
system that started in the summer of 2007, and in a few months we will
approach three years since the dramatic intensification of the crisis in the
early autumn of 2008.
As you are all well aware, the euro area, the world‘s second largest and
most open economy, was immediately and strongly affected.
And as guardians of what is generally considered the world‘s second most

important currency, the European Central Bank (ECB) was profoundly
involved in the response to the crisis.
Our consistent aim in the crisis has been to protect as far as possible the
real economy from the financial distress in the system.
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Over the past few years, our toolkit has featured the standard monetary
policy measures of setting interest rates, as well as a range of
non-standard monetary policy measures.
The latter have included temporary measures such as full allotment of
liquidity, expanded eligibility for collateral, longer-term refinancing
operations and interventions in bond markets.
The ECB has also been involved in actions focused on the long term to try
to ensure that the financial sector cannot pose such a danger to the real
economy again.
The financial turmoil that emerged from the US housing market and
which sent shockwaves across the world economy revealed deep flaws in
the way the financial system in advanced economies operates and in the
way that system is supervised and regulated.
Tackling those systemic flaws through financial reform is what I would

like to discuss today.
The ECB‘s involvement in financial reform takes place through our role
in the institutional framework of the European Union as well as the
institutional framework of the global economy – the G20, the Basel
Committee and other fora of international cooperation.
Last year several important decisions were taken on the pillars of the new
supervisory and regulatory framework.
First, the adoption of Basel III.
Second, reforms of market infrastructure.
And third the establishment of macro-prudential oversight institutions,

including the European Systemic Risk Board (ESRB).
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Key areas where work is still in progress include the treatment of
systemically important financial institutions, crisis management and
resolution, oversight of the shadow banking system, and – very
importantly – the regulation and oversight of financial markets and their
functioning.
***
Today I would like to lay out what I believe are the three main building
blocks of the financial reconstruction that is currently in progress – to
outline what has been achieved and what remains to be done.
The first building block is banking regulation. Here, the global

community has made the right diagnosis and, in the Basel III framework,
drawn the appropriate lessons.
The second building block is regulation of the financial markets.
Here, reform must create greater transparency for the various market
segments and products, ensure sufficient competition in all markets, and
attenuate as far as possible the pro-cyclicality from structural features
such as ratings and market phenomena such as herding.
The third building block is macro-prudential oversight.
This new discipline focuses on the interactions between the various parts
of the financial system and between the financial sector and the real
economy.
New institutions, including the ESRB, will pursue the task of identifying
sources of systemic risk, issuing early warnings and recommending
remedial action.
The birth date of macro-prudential oversight in Europe will probably be

identified as the start of this year but it was originally conceived in 2009
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through the work of the Committee presided over by Jacques de
Larosière.
The fact that it took little more than a year and a half from policy design
to institutional establishment was made possible by thorough
groundwork by the European Commission and very rapid decisions by
the European Parliament and the European Council.
I feel very honoured to chair this new body, the ESRB, together with
Mervyn King and Andrea Enria.
Let me discuss each of these three building blocks, focusing on both

progress to date and the challenges that lie ahead.
1. Banking regulation and Basel III
First, banking regulation, where the Basel III framework represents the
cornerstone of the newly revised international regulatory architecture.
This framework envisages higher minimum capital requirements, better

risk capture, stricter definition of eligible capital elements and more
transparency.
It introduces entirely new concepts, such as non-risk-based leverage

ratios and mandatory liquidity requirements.
Beyond the micro-prudential dimension of regulation – typically

represented by institution-specific solvency requirements – Basel III also
introduces macro-prudential elements, most prominently the capital
buffer regime based on aggregate credit growth.
From both a macroeconomic and financial stability perspective, the

implementation of Basel III should bring substantial long-term benefits.
As painfully experienced in recent years, financial crises impose

enormous costs on society.
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The main benefit of the reform will stem from the reduced frequency of
future crises.
The new standards aim at improving banks‘ capital base and the sector‘s
resilience to a crisis.
Financially sounder banks will, in turn, help foster financial stability as

well as mitigating systemic risk.
The prevention and mitigation of downside tail risks for the economy
implies a sizeable reduction in the expected output losses associated with
systemic events, contributing to more sustainable growth.
Although the net benefits from Basel III are difficult to quantify precisely,
the Committee‘s analysis indicates that the potentially negative impact of
the new framework on long-term output is considerably lower than the
growth benefits associated with the reduced frequency of crises.
Additional benefits include lower funding costs for banks and a decline in
risk premia.
At the same time, it is acknowledged that implementation of the new

framework will impose some transitional costs on the sector as banks
need to meet the more stringent regulatory requirements.
Banks can adjust their capital ratios through a combination of several

measures, for example, by raising capital or reducing dividends for some
time.
The length of the implementation period matters crucially for the

transition costs.
The Basel Committee has designed relatively long phase-in arrangements

to mitigate adjustment costs.
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If the new framework had been implemented hastily, banks would have
needed to reorganise their balance sheet structure quickly, which could
have had adverse impacts on credit intermediation in the short term.
Implementation over the time frame 2013-2019 has been agreed to provide
the sector sufficient time to adjust to the new requirements.
The gradual implementation should prevent disruptions in credit flows

and bring enough clarity and scope for banks to absorb the necessary
adjustments smoothly over time.
Looking forward, the introduction of the new standards presents the

international regulatory and supervisory community with two major
challenges.
The first is to ensure proper implementation of Basel III at the global

level.
In line with the G-20 recommendations, all national authorities should

honour their commitment to implement the framework without any
undue postponement.
The second challenge relates to thorough assessment of the new

regulatory concepts and measures.
Some of the new concepts, such as liquidity standards and leverage ratios,
have sparked controversy and delayed final agreement.
To alleviate concerns about potential unintended consequences, an

observation period has been agreed to serve as a basis for the final design
and calibration.
Work in progress on systemically important financial institutions, crisis

resolution and shadow banking
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Let me turn to some issues of banking regulation on which it is important
that work continues.
The first is systemically important financial institutions, which the G20

and the Group of Governors and Heads of Supervision have stated should
satisfy additional solvency requirements beyond the levels agreed in Basel
III.
The main goal here is to reduce the externalities related to the financial
distress of such institutions, and ultimately avoid a repetition of the crisis.
The Financial Stability Board (FSB) has been working on identifying

systemically important financial institutions and evaluating the desirable
magnitude of additional capital with which they should comply.
Its recommendations will be delivered to the G20 summit in November.
The FSB‘s work is a fundamental step towards an international

framework that fully reflects the greater risks posed by these large
institutions.
Looking forward, it is crucial that effective peer reviews of final

implementation are set up, ensuring consistency across jurisdictions.
Enforcing a level global playing field remains a priority for the regulatory
agenda, to prevent regulatory arbitrage to parts of the financial sector
with less supervision and weaker regulation.
In parallel with higher solvency requirements for systemically important

financial institutions, important initiatives are underway – both in Europe
and globally – to improve the capacity of authorities to resolve financial
institutions, especially in a cross-border context.
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An effective resolution regime should consist of a comprehensive toolkit
of gradually increasing powers, complemented by credible financing
arrangements that reduce the reliance on government budgets.
It is essential to make significant progress in the coming years to ensure

that all systemically important financial institutions can be resolved in an
orderly manner and without taxpayers‘ support.
The FSB is identifying the key elements of effective resolution regimes.
At the same time, the reform of national (or in the case of the EU,
supra-national) resolution frameworks is already underway in the major
jurisdictions, including the Dodd Frank Act in the United States.
Here, the European Commission has published a public consultation

document on the planned EU framework, for which legislative proposals
are expected in June.
Let me briefly mention shadow banking.
The introduction of more stringent capital requirements for credit

institutions may provide further incentives for banks to shift part of their
activities outside the regulatory perimeter.
Against this background, the FSB is developing recommendations to

strengthen oversight of the shadow banking system in collaboration with
other international standard setting bodies.
Work on the shadow banking system should aim to develop a better

understanding of the interconnections between regulated banks and
unregulated entities that are conducting credit intermediation, either
directly or as part of a complex chain of intermediation activity, as well as
the channels for possible contagion.
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In this context, it is crucial to understand the functioning of the repo
market. It is also vital to identify entities or activities within the shadow
banking system that may be sources of systemic risk.
2. Market regulation
Let me turn to the second building block, namely regulation of financial

markets.
One of the key lessons from the crisis is that the risks to market returns
did not come mainly from shocks to the real economy.
The risks came from the financial sector itself.
The financial structures that we thought were in place to assess, absorb

and neutralise risk were either dysfunctional or worked to magnify
volatility.
Key factors in creating this risk were opaque financial structures and
pro-cyclicality in financial markets.
The lack of transparency in many financial instruments meant that some

market players could exploit – for their own, private benefit – information
that was not generally available.
Pro-cyclicality acts as a formidable accelerator of financial trends.
Two important factors that drive such amplification are distorted

incentives and herd behaviour.
The role of distortions in economic incentives is widely understood, but

herd behaviour as a driver of pro-cyclical patterns in financial markets still
needs a thorough explanation.
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One explanation lies in the significance of market players‘ evaluation of
their performance relative to the rest of the market.
This is reminiscent of Keynes‘ famous beauty contest analogy.
To be successful in this environment, individual participants do not form

their own opinions, but follow the general mood.
Everybody seeks to ride the wave, hoping to step off before the mood
turns.
A second complementary explanation is that global markets are in fact

less atomistic than we think. Derivatives activity in the US banking
system, for example, is dominated by a small group of large institutions.
And, of course, the market for credit ratings is famously dominated by

three signatures, which act as standard-setters for an enormous volume of
transactions.
Many regulatory initiatives are underway to remedy these issues,

including work on OTC derivatives, which comprise 80% of traded
derivatives.
The near-collapse of Bear Stearns in March 2008, the default of Lehman

Brothers in September 2008 and the bail-out of AIG the same month
highlighted shortcomings in the functioning of the OTC derivatives
market, and underlined the need for appropriate action to increase
transparency and address concerns about financial stability.
To this end, there is now a regulation underway in Europe aimed at

bringing more safety and more transparency to the derivatives market.
According to the draft regulation, information on OTC derivative

contracts should be reported to trade repositories and be accessible to
supervisory authorities.
_____________________________________________________________
Furthermore, standard OTC derivative contracts should be cleared
through central counterparties, thus reducing the risk that one party to
the contract defaults.
Any possible concentration risk involved in the set-up of the CCPs could
be assessed at the macro-prudential level.
Of course, financial market infrastructures can only help to foster the

stability of markets to the extent that they are safe and sound.
To this end, the Committee on Payment and Settlement Systems and the
Technical Committee of the International Organization of Securities
Commission are reviewing the relevant regulatory and oversight
standards.
A consultative report published in March 2011 outlines principles that will

provide greater consistency in the oversight of financial market
infrastructures worldwide.
3. Macro-prudential supervision and the ESRB
Let me come to the final building block: macro-prudential oversight.
As my earlier remarks suggested, the financial crisis has been revealing in

many respects.
It has revealed the fallout from the failure of large financial institutions.
It has revealed the fragility of the financial system to features and trends
that cut across institutions, markets and infrastructures.
And it has illustrated the amplitude of the consequences of the adverse

feedback loop between the financial system and the real economy.
_____________________________________________________________
All these three elements are key features of systemic risk: first, contagion;
second, the build-up of financial imbalances and unsustainable trends
within and across the financial system; and third, the close links with the
real economy and the potential for strong feedback effects.
The strengthening of macro-prudential oversight – with the

establishment of institutions devoted to that task such as the ESRB, the
US Financial Stability Oversight Council and the UK‘s Financial Policy
Committee – should enhance our ability to identify and address systemic
risk.
How can these new bodies reach their full potential?
The first precondition is that they have an adequate infrastructure to

identify and analyse systemic risks.
This demands a state-of-the-art analytical toolkit, which can provide a

solid basis for systemic risk analysis and the ensuing formulation of
policy responses.
In the field of systemic risk assessment, great attention is currently

devoted to macro stress testing as a tool to evaluate the impact of shocks
on the financial sector and the real economy.
This complements micro stress tests relating to individual financial

institutions.
A key challenge is modelling feedback effects between the financial

system and the real economy.
Another promising area relates to network analysis, which aims to

identify systemic inter-linkages across firms, sectors and countries.
This type of analysis, which is well established in other domains, is still at

its infancy for the financial sector.
_____________________________________________________________
A key point in this context is that the effectiveness of the analytical toolkit
is strongly dependent on the availability and quality of data.
There are several data gaps, which make it difficult to assess the sources
and magnitude of systemic risks and the very complex network of
inter-linkages in the financial system.
The second precondition for the success of the new bodies is a coherent
framework for macro-prudential oversight and policy development.
In this context, it is important to note that the institutions do not have

direct control over policy tools.
In the case of the ESRB it may issue risk warnings and recommendations
to other authorities, which should comply with them or give reasons for
non-compliance.
Since existing policy tools that can be used for macro-prudential purposes
fall in other policy domains (e.g. micro-financial supervision, monetary
policy or fiscal policy), it is essential that effective coordination
mechanisms should be developed between the responsible authorities.
In particular, close cooperation between macro- and micro-supervisory

authorities is essential as most of the macro-prudential tools are
micro-prudential in nature.
It is therefore of utmost importance that the mandate of macro-prudential

authorities as well as the role of supervisory authorities in
macro-prudential surveillance are clearly defined.
Conclusion
Let me conclude. I believe we are now about halfway through the

comprehensive financial reforms that the crisis has demanded.
_____________________________________________________________
We have achieved a blueprint of more stringent bank regulations that
includes more loss-absorbing capital, better risk coverage and limitations
for undue leverage. The oversight of financial institutions as well as
markets and market infrastructure are being strengthened.
And the organisational structure of financial supervision is being

overhauled.
But much remains to be done.
The key aspect is implementation of the reforms.
Moreover, the issue of systemically important financial institutions

requires further reflection.
And oversight of the proper functioning of financial markets in a way that

avoids undue volatility, excessive influence of dominant players and
oligopolistic market structures, while reinforcing transparency, needs to
be addressed resolutely.
Thanks, in particular, to prompt and resolute action by central banks and

by governments, the international community avoided a great depression,
after the intensification of the crisis in mid-September 2008.
With the global recovery being confirmed, numerous voices in the

financial sector are arguing that we are now back to business as usual.
Achieving an ambitious programme of reforms of rules, regulations and
oversight of the financial sector is considered by some as unnecessary and
counterproductive.
I do not at all share those views. It is an absolute obligation, for all of us,
to do all what is necessary to reinforce the resilience of the financial
system and ensure its sustainable contribution to growth.
_____________________________________________________________
We must be sure that the excessive fragility that was revealed in 2008 and
2009 is eliminated.
Not only because the costs of financial crises in terms of growth is always
considerable but, even more, because it is extremely likely that our
democracies would not be ready to provide once again the financial
commitments to avoid a great depression in case of a new crisis of the
same nature.
Our people would not permit, for a second time, that governments
mobilize 27% of GDP of tax payer risk, on both sides of the Atlantic, to
avoid the collapse of the financial sector.
For these reasons public authorities must pursue and implement their
G20 programme with inflexible determination, and it is essential that the
private sector fully implements this programme.
_____________________________________________________________
Solvency II News
Dear Members,
The new EIOPA (the European Insurance and Occupational Pensions

Authority) has a better sense of humor. Below is one interesting slide –
from the official thoughts on the impact of Solvency II:
The same time, companies try hard to find ―fit and proper‖ risk
managers, compliance officers and auditors. Fortunately, most actuaries
are qualified.
Risk managers experience a massive increase in their take-home pay as a
result of the Solvency II projects.
Below is an interesting job description.

Risk Manager is needed, that will:
1. Provide specialist support to the Risk Team in the delivery of agreed

Solvency II development and implementation plans,
_____________________________________________________________
2. Embed new or enhanced risk processes and be accountable for
assigned project plan deliverables relating to Solvency II processes.
3. Design and execute the risk oversight framework for the Internal Model
and supporting processes, including the drafting of oversight reports.
Interesting
Firms continue to lobby, to influence the final implementation of the

directive.
Below there is an interesting example:
Lloyd's lobbying
Overview of Lloyd's Solvency II lobbying activities
―We want Solvency II to recognise Lloyd's unique structure and
operations.
We don‘t want Solvency II to put the market at a competitive

disadvantage.
For this reason, Lloyd‘s has been and is highly engaged in activity to
influence the development of Solvency II legislation in Europe, alongside
organisations such as the CEA in Brussels and the ABI and the IUA in
London.
It is important for Lloyd's to retain an independent voice in the debate on

Solvency II as well as influencing the input of bodies such as the CEA.
Although its positions are closely aligned with those of other insurers,
there can be subtle, yet important, differences in emphasis and
prioritisation.
‗Lloyd‘s focus is on the regime‘s impact on non-life insurers whereas

some other major insurers in the UK and Europe are more concerned
_____________________________________________________________
about proposals for the treatment of annuities and other issues primarily
of interest to life insurers.
Lloyd‘s also aims to ensure that policymakers in the UK are aware of its
views.
Lloyd‘s is represented at high-level meetings with the FSA and at

ministerial level to address key industry concerns regarding Solvency II.
On 5 January 2011, Sean McGovern, Lloyd's Director, sent a letter to

Managing Agents' CEOs and FDs with a view to providing an update on
the Lloyd's lobbying approach for the development of Solvency II.
Lloyd's aims
To ensure that:
• The Market‘s unique structure including regulatory recognition as a

unitary organisation is preserved.
• The standard formula does not impose excessive capital requirements

on undertakings.
• Internal model tests, standards and approval processes are reasonable

and proportionate.
• The types of asset commonly held in the market are appropriately

recognised.
• Additional administrative burdens on insurers are minimised.
• The competitiveness of the European industry is enhanced, not

diminished.
Also interesting
_____________________________________________________________
Many countries continue to work hard to become Solvency II equivalent.
Other counties do exactly the opposite. They try to advertise that they will
never become equivalent.
Guernsey, for example, the largest captive insurance domicile in Europe,

has decided not to seek equivalence under Solvency II.
According to Peter Niven, Chief Executive of Guernsey Finance: ―The

decision not to seek equivalence under Solvency II is based on the fact
that under the current proposals, we would need to adopt measures that
might undermine the competitive nature of our captive insurance
industry".
News - Specifications for the 2011 EU-wide stress test in the

insurance sector
In the second-half of 2009 CEIOPS coordinated an EU wide stress-test
which involved 28 major European insurance groups, including three
larger Swiss insurers.
The scope of the exercise was based on the List of 30 which had been
previously agreed by CEIOPS Members.
The stress test was conducted in accordance with the mandate received
from the EFC-FSC with the aim of testing the resilience of the largest and
important insurance groups to adverse capital market developments.
The exercise was launched in November 2009 and aggregated results

were reported by the national regulators to the CEIOPS Secretariat in
January 2010.
Aggregated EU-wide results were reported back to EFC-FSC in March

2010 and high-level outcomes were disclosed to the public in the same
month.
_____________________________________________________________
For future stress tests the EFC-FSC encouraged CEIOPS and CEBS in
2010 to coordinate the timing between the European banking and
insurance stress tests.
The aim of this exercise is to receive information on the current

vulnerability of the EU insurance sector to adverse developments.
At this juncture, priority is given to learning about the economic effects

over implementing a supervisory tool.
This is why the cornerstones of this exercise are most current information
(i.e. year end 2010 data), market valuation, distinct scenarios with rather
different and also contradictory economic developments, and no
reference to the current supervisory regime of Solvency I.
Although not part of the current supervisory toolkit, the insights gained
through this stress test will be an input into the supervisory dialogue
between colleges of supervisors/national supervisory authorities and
participants, insofar as individual vulnerabilities appear too severe to
tolerate.
As the stress test is not a test of the current regulatory requirements

(Solvency I), but uses prospective measures in Solvency II and as much as
possible uses specifications laid out for the last available impact study,
any results, even when published on an aggregate level, need to be
interpreted with this qualification.
As the stress test is not another QIS5 or a capital requirement and, at the
same time, is based on a yet to be finalised future Solvency II regulation,
the stress test will be conducted on a best effort basis and undertakings
are able to use reasonable approximations, and proxies, where necessary.
In developing the stress scenarios due consideration was given to

aligning the macro-economic assumptions with those applied to the
stress test in the banking sector.
_____________________________________________________________
However, the specificities of the insurance business needed to be
reflected in the design of the EIOPA stress test.
EIOPA Regulation Requirements

The new EIOPA regulation which came into force on 1 January 2011
enables EIOPA to ―initiate and coordinate Union-wide stress tests in
accordance with Article 32 to assess the resilience of financial
institutions, in particular the systemic risk posed by financial
institutions as referred to in Article 23, to adverse market
developments, and evaluate the potential for systemic risk to increase
in situations of stress, ensuring that a consistent methodology is
applied at the national level to such tests and, where appropriate,
address a recommendation to the competent authority to correct issues
identified in the stress test.‖ (Article 21 b)
Furthermore Article 23 stipulates that ―the Authority shall, in
consultation with the ESRB, develop criteria for the identification and
measurement of systemic risk and an adequate stress testing regime
which includes an evaluation of the potential for systemic risk that may
be posed by financial institutions to increase in situations of stress.
The Authority shall develop an adequate stress testing regime to help

identify those financial institutions that may pose a systemic risk.
These institutions shall be subject to strengthened supervision, and

where necessary, to the recovery and resolution procedures referred to
in Article 25.‖
In addition, Article 32 (2) states that ―the Authority shall, in cooperation

with the ESRB, initiate and coordinate Union-wide assessments of the
resilience of financial institutions to adverse market developments.
To that end, it shall develop the following, for application by the

competent authorities:
_____________________________________________________________
a) Common methodologies for assessing the effect of economic scenarios
on an institution‘s financial position;
b) Common approaches to communication on the outcomes of these

assessments of the resilience of financial institutions;‖
Objective of the 2011 exercise

Building on the experience of the 2009/10 exercise and taking into
account new EU regulatory requirements, the aim of this exercise is to
test whether the insurance sector in the European Union will be able to
meet the minimum capital requirement even after applying well defined
stress scenarios.
The Solvency II capital requirements already are based on a certain level

of prudence for similar risks.
For example, groups and undertakings will be required to hold capital at a
level so that they can absorb a significant decline in equity prices - based,
as much as possible, on the QIS5-Technical Specifications, although
reasonable approximations and proxies may be used, where necessary.
In addition to these asset-related stresses, this exercise includes

insurance-related shock scenarios in order to test the resilience of the
sector to catastrophic or severe insurance events.
This exercise should also be seen as a precursor for the development of a

future comprehensive stress test framework in accordance with the
EIOPA regulation.
Scope of the exercise

The aim of this exercise is to reach a market coverage rate of at least 50%
based on statutory gross written premiums per country in EU/EEA
member states, split between life and non-life.
_____________________________________________________________
Similar to the previous stress test, the Swiss Financial Market Authority
(Finma) has decided to join the Europe wide stress test.
Whilst the market coverage was calculated based on gross written

premiums by solo undertakings, there is not necessarily a need for each
undertaking identified by the national supervisors to carry out a separate
stress test.
The exercise should be conducted on the highest level of insurance

consolidation within the European Union or EEA.
This means that for the purpose of this exercise if these solo undertakings
are part of groups which are participating in the stress test exercise, they
do not have to submit individual stress test results
The stress test will thus include more than 200 insurers, including the
largest European insurance groups.
Data collection and analysis
A best-effort principle applies to the 2011 stress test.
This principle has been employed for all QIS exercises or any other
ad-hoc data request from EIOPA.
However, given the significantly shorter time-frame set out for this stress
test exercise compared to a full QIS exercise, a reasonable use of
approximations and proxies is envisaged under this stress test.
In order to ensure consistency and a level playing field, EIOPA offers the
possibility to address open issues in a Q&A procedure.
_____________________________________________________________
All participants should register to the related mailing list in order to
receive updates on such Q&As.
All questions and answers will be published on EIOPA‘s website.
The (lead) supervisors of the respective insurance groups and

undertakings will be responsible for co-ordinating the exercise on all
participating companies/groups subject to their supervision.
EIOPA Members should ensure that results are submitted by the

groups/undertakings in a timely manner and they should also validate
individual results, in particular whether these are consistent with the
previous assessments by national supervisors.
Following the collection of data the lead supervisor/national authority is

then expected to submit the anonymised data to EIOPA for processing
the results.
An example of data to be submitted to EIOPA is shown in Annex 1.

EIOPA will provide the lead supervisor/national authority with a basic
Excel IT tool to facilitate the delivery of the data.
The information submitted from the lead supervisors/national authority

to EIOPA should also include a qualitative assessment following the
validation process.
Main data to be delivered to EIOPA:
(a) Change and ratio of own funds compared with the MCR per individual
group/undertaking.
(b) Change in own funds per individual group/undertaking.
(c) Percentage contribution of the individual shocks to the change in own

funds per individual group/undertaking.
_____________________________________________________________
(d) It is assumed that the political bodies FSC and EFC will receive
indicative and aggregated information at a European level, without any
reference to individual Member States, insurance groups or undertakings.
National supervisors should report aggregated results split between

groups and solo undertakings.
The calculation of the MCR (derived from the SCR) should also be
performed on a best-effort basis, i.e. both SCR and MCR. In order to
derive the MCR on a best effort basis participants may, in close
co-ordination with their relevant supervisor, include information based on
QIS5, if appropriate.
Publication of results
EIOPA will publish the preliminary aggregated results of this exercise in
early July. Due consideration will be given to the Solvency II-framework
of this exercise, which will make interpretation of results an essential part
of the analytical output.
This is why EIOPA sees no positive value in a possible publication of

highly complex individual information, all the more so as the reference
base – Solvency II specifications as in QIS5 – in itself might undergo
changes while this exercise is performed and has indeed already been
discussed in the preparation for the Solvency II implementing measures.
This being said, EIOPA expects valuable insights into the risk position of
participants for the market in aggregate and for the individual supervisor
to be obtained, as this information is based on fair valuation.
Further, this minimises possibly distorting effects of the Solvency I

framework.
_____________________________________________________________
Timeline
March 2011
• 23 March: Launch of exercise
• 28 March: Workshop with participating groups/undertakings
May 2011
• 31 May: Results to be reported to national/lead supervisors
• Validation of results by national/lead supervisors
June 2011
• 14 June: Results to be reported by national supervisors to EIOPA
• Analysis of results and preparation of aggregate report
• 30 June: Briefing to EIOPA Board of Supervisors and Communication
July 2011
• Presentation of results to EFC
• Presentation of results to ESRB
• Public presentation of aggregated results
Reference date
The reference date for all scenarios is 31 December 2010.
Participating groups and undertakings should update the QIS5 results,

which were previously submitted to national supervisors, for year-end
2010 financials on a best effort basis.
This includes updated discount rate curves to 2010 (both pre and post
stress) following a methodology as much as possible similar to the one
used under QIS5, but for simplicity for this exercise assuming no change
in the liquidity premiums used, even though the illiquidity premium
would in practice be expected to move in line with the market.
_____________________________________________________________
A table is provided by EIOPA as a supplement to this specification.
Participating groups from Switzerland should follow full Swiss regulatory

requirements (i.e. Swiss Solvency Test).
This stress test model assumes that in the baseline and adverse scenarios
the capital market stresses occur instantaneously and simultaneously on
the reference date.
All other factors or assumptions remain unchanged in relation to the

reference date.
EIOPA‘s instant stress test model analyzes three ―what-if-situations‖ or

scenarios focusing on development on ―market prices‖ on bonds, shares
and technical provisions.
An instant model just compares a ―what-if-situation‖ with the present

situation.
This what-if-situation / instant model does not have an explicit time

horizon.
The scenarios assume a simultaneous occurrence of the shocks for each

capital market risk factor, so the risk correlation matrix for market and
credit risks is assumed to be 1.
There will be only one set of insurance related stresses for life and non-life
across the baseline, adverse and inflation scenarios.
However, a correlation adjustment should be made with other risks

following overall Solvency II factors.
_____________________________________________________________
Consolidation
A world-wide consolidation for participating groups at the highest level of

relevance for the group (including a holding company, if economically
relevant) is required.
Insurance groups should follow the consolidation principles as set out in

the QIS5 Technical Specifications.
For participating solo undertakings, their scope would encompass their

activities as described below for groups and solo entities.
For simplicity reasons, only insurance activities and other non-banking

participations are mandatory for inclusion in the exercise.
Consequently, banking activities are to be excluded from the scope of

consolidation. If the banking activities are non-material to the group they
can be included for simplicity.
In case of exclusion from the scope of consolidation, the book value of

banking participations should be deducted from the available capital.
The value of non-controlled shareholdings in a non-insurance,

non-banking subsidiary which is not subject to supervision or capital
requirements should be included in the equity stress calculation.
For the purpose of this stress test exercise the QIS5 option of applying
local rules for third countries should be included when assessing MCR
and available own funds.
Valuation Approach
The previous stress test exercise was based on Insurance Group Directive
(IGD)/Solvency I valuation requirements.
_____________________________________________________________
The limitations of this approach, in particular the non-comparable
differences in valuation standards across Member states, were
highlighted in the stress test results report to the EFC in March 2010.
In order to achieve better comparability and more realistic results, the

2011 stress test exercise will be based on future Solvency II principles.
EIOPA acknowledges that there are shortcomings by referring to a
framework which is seen as a testing environment and which is bound to
change even whilst conducting this exercise.
However, for the purpose of gaining realistic and consistent information,

EIOPA considers QIS5 specifications as being the closest proxy to the
framework that should be the background for a stress test.
Although the QIS5 – Technical Specifications do not represent the final

Solvency II requirements, the application, as much as possible of the
most recent Quantitative Impact Study valuation and calculation
guidelines overcomes some of the shortcomings of the first exercise.
Conducting a stress test based as much as possible on QIS5 rules will

better reflect the risk profile of insurance groups and insurance
undertakings thus allowing for better comparability and understanding of
outcomes.
However, a reasonable use of approximations and proxies is expected,

given the significantly shorter time-frame envisaged for this exercise
compared to a QIS exercise.
In order to ensure consistency and a level playing field, the principle of
such shortcuts should be addressed within the public Q&A procedure.
Participating groups and undertakings should therefore as default and,
on a best efforts basis, follow the valuation approach as set out in the
QIS5 – Technical Specifications and the QIS5 Q&A document and which
formed the basis for the EIOPA Report on the fifth Quantitative Impact
Study (QIS5) for Solvency II.
_____________________________________________________________
Swiss insurers should follow valuation requirements in accordance with
the Swiss Solvency Test.
Stress Test Output

The aim of the stress test is to assess either the group solvency position or
the solvency position of an individual undertaking, focusing on the level
of own funds (i.e. available capital) before and after the stress test
compared with the Minimum Capital Requirement (MCR) as a Solvency
II measure.
Swiss groups will be assessed based on Swiss Solvency Test

requirements.
The direct output of the stress test will be the reduction in available own
funds after stress test shocks (scenarios), i.e. own funds as of end-2010
minus the change in own funds after the scenario.
This will be compared to the MCR.
Participants may recalculate the MCR level after the shock in each
scenario, as this would more appropriately represent their solvency
position.
However, for simplicity reasons, the pre-stress MCR will be the default
numerator (i.e. in line with the best effort basis participants can opt for
leaving the MCR unchanged post stress).
The output shall include some information on the contribution of the

different shocks/risks to the change in own funds.
The Solvency II - MCR is used as a benchmark which is consistent with

the aim of the stress test as it is deemed to be the ultimate intervention
threshold for regulatory purposes whereas a breach of the SCR allows for
a more flexible approach.
_____________________________________________________________
Swiss insurance groups should calculate their equivalent of the MCR (e.g.
Threshold 3 in Circular 2008/44 SST).
EIOPA provides a stress test template in Excel format, comparable to

QIS exercises, which will help to minimise misinterpretation of the
framework and will produce the expected outcome in a way easily
controllable by participants.
Loss-absorbing capacity
The loss-absorbing capacity of technical provisions and deferred taxes

can be taken into account in line with the QIS5 – Technical Specifications
(i.e. that participants exploit the means at their hands only within the
current legal boundaries. See management actions in section 16)
For further details please see Section SCR 2 of the QIS5 Technical
Specifications.
The loss absorbing capacity should be calculated on a best effort basis

using one of the options outlined in the QIS5 Technical Specifications,
but taking into account any legal requirements or restrictions regarding
profit sharing and taxes.
Unit-linked business
In respect of unit-linked business, groups/undertakings should follow

the approach as per the QIS5-Technical Specifications.
Indirect investments
The look through principle as set out in the QIS5-Technical Specification

applies to indirect investments.
_____________________________________________________________
Hedging
Any existing hedging or other risk mitigations (e.g. derivatives and

reinsurance) can be included in the stress testing, but only insofar as the
hedging instruments have been in place at the reference date or if there is
a contractual agreement with a counterparty that guarantees a downward
protection if predefined capital market scenarios occur.
This also includes dynamic hedging where appropriate.
Where possible, groups/undertakings should report the impact of the

hedging on the individual stress test results.
For the inclusion of potential management actions see section 16.
Management actions (post-stress)

In principle, stress test results should be calculated without taking into
account risk mitigating actions (such as closing for new business).
However, groups or undertakings have the option to calculate stress test

results without the impact of management actions (gross) and including
the impact of management actions (net).
If this option is exercised, both gross and net outcomes would need to be
reported to the national supervisors.
National supervisors will have to verify these management actions and

provide an opinion whether the proposed actions are realistic.
For the purpose of considering management actions it is assumed that

negative events occur six months prior to the reference date, so that
groups and undertakings have time to initiate realistic actions.
_____________________________________________________________
However, they should have due regard to the fact that during a period of
crisis not all proposed initiatives would be successful (such as a fire sale
of assets or the implementation of a new hedging programme).
Stress Test Scenarios
This stress test framework comprises the following scenarios and

modules:
For capital market and spread risks there are baseline and adverse
scenarios.
There is also an inflation scenario which assumes an increase in inflation

and which forces central banks to rapidly increase interest rates.
In developing the scenarios due consideration was given to aligning the

macroeconomic assumptions with those applied to the stress test in the
banking sector, in particular the assumptions underlying the
macroeconomic adverse scenario provided by ECB.
The stress test also contains a set of insurance-specific stresses which are
to be applied across the baseline, adverse and inflation scenarios.
All these stresses should be regarded as instantaneous shocks i.e.

occurring on the reference date.
Further to these stresses two satellite scenarios on long term low interest
rates and sovereign risk are to be conducted.
_____________________________________________________________
Interest rate, equity, property, spread risk parameters
Interest rate risk
The ECB macro economic assumptions for market risks in respect of the
development of interest rates reflect an upward trend in the adverse
scenario.
However, insurers are typically more affected by a decline in interest rates

either because of embedded guarantees in life insurance contracts or
because of lower investment returns in non-life.
Consequently, the upward stress applied to banks will be used for the
inflation scenario and the magnitude of this trend will be converted into a
decline in the adverse scenario.
The floor of interest rate levels post the scenarios is zero.
Equity Risk
The ECB equity market assumptions in respect of the adverse scenario

are very granular within the European Union.
In line with the current proposals under Solvency II and in order to

facilitate the calculation of this stress module, a flat 15% decline for all
equities in the adverse and 7.5% for the baseline scenario will be assumed
by EIOPA.
Property risk
Residential property
In respect of property risk parameters the ECB has provided house price
assumptions for 2011 and 2012 as a percentage deviation from the baseline
scenario.
_____________________________________________________________
EIOPA has used the average percentage deviation for the two years
2011-2012 for the adverse scenario and the 2011 percentage deviation for
the baseline scenario. It follows:
- Baseline scenario: 3.8%
- Adverse scenario: 11.6%
The stresses apply to all residential property world-wide.
Commercial property
Commercial property plays a significant role for insurers? investment

strategy.
Based on the information available3 the following stresses apply:
- For all commercial property portfolios the decline in property prices

during 2008 should be considered for the adverse scenario. Based on this,
it assumes a 25% decline for the adverse scenario and a 12.5% decline in
the baseline scenario (See table 1 in annex 2).
The stresses apply to all commercial property world-wide.
Spread risk
A 31.4% shock for investment grade bonds and a 38.3% shock for high
yield bonds have been assumed.
This has been converted from actual option adjusted spreads (based on
Merrill Lynch Bond indices as of 31 December 2010) applying an
additional increase to actual spreads for investment grade.
_____________________________________________________________
News
The UK FSA's approach to the implementation of Solvency II
18 April 2011 - Speech by Julian Adams, Director of Insurance, the FSA

FSA Solvency II Conference
I want to update you today on some steps we are taking to make sure we
can deliver our obligations under Solvency II.
Hector has just spoken about the context in which we are implementing
the Directive and the drivers for change in our delivery approach.
Later on, Paul will outline some of the main uncertainties and challenges
in the policy space.
Here, I want to tell you more about what all of this means for you as firms,
provide you with a greater degree of clarity as to what you will see and
hear from us between now and the implementation date, and outline what
we will be expecting of you in the coming months.
We are today making a number of announcements about our delivery

approach – particularly in the area of internal model approval – which we
believe, taken together, will provide us with the confidence that we need
to have that our programme of work can be delivered in the time available
to us, without compromising the standard of what we do.
We need this confidence, because we have to be sure that we are

discharging the obligations placed upon us by the Directive in a way that
is appropriate and proportionate.
In the same way, I would expect all of you to review your programmes of
work regularly to ensure that the delivery risk associated with them is
appropriately managed, and that the timescales can be met.
_____________________________________________________________
The EU policymaking process remains fluid, and the lack of clarity
around the final policy position – and associated transitionals – means
that we still do not have full clarity on what has to be in place for day one.
We have made some assumptions, and we keep the position under review.
What I will be saying to you today is based on our current view of the
world, particularly that there will be full implementation on 1 January
2013.
If this should change – although I should stress that we have no

information at present that it will – we will naturally review our plans and
may look again at our implementation approach.
We would clearly expect firms to do the same.
Our current plans recognise Solvency II as a significant challenge, but

one which both we and the UK industry are in a good position to meet.
This is because we view Solvency II as an evolution of the regime which

we have had in place here in the UK for a number of years, and we have
fought very hard in Europe to ensure that many of the principles which
underpin the current UK approach are present in the Solvency II regime.
We also have a long-standing knowledge base of the firms we supervise,

and we recognise that we are not starting from scratch when we come to
review many aspects of firms‘ activities.
Nonetheless, there are significant changes which both we and firms need
to make to ensure that implementation is a success.
The Directive brings about entirely new areas of responsibility for us, not
least a significantly enhanced group supervision regime, and provision for
model approval.
_____________________________________________________________
These new responsibilities, along with the changes we need to make to
other parts of what we do, mean that implementation of Solvency II is the
largest programme of its type ever undertaken by the FSA.
This is partly because Solvency II is not only a new Directive which we

have to implement, but is also something which will influence
significantly the shape of, and approach to, insurance supervision in the
Prudential Regulation Authority (PRA) when it is created.
The PRA is due to assume its statutory responsibilities in early 2013, at

around the same time as the implementation of Solvency II, and – as we
build the new regulator – we will be embedding Solvency II in all that it
does, whilst preserving the best of the FSA‘s existing approach.
One of the main reasons for our programme of work being so substantial
is that we have a large and vibrant insurance market here in the UK, with
a greater number of firms than in many other Member States.
On top of this, firms have shown a very significant level of appetite for the
use of internal models, possibly driven by the UK industry‘s prior
experience of modelling under the ICAS regime, but also probably driven
by two specific aspects of the UK market.
Here in the UK, firms write significantly higher levels of with-profits

business than elsewhere in Europe, and this lends itself much more to an
internal model approach.
The same is true of the international catastrophe and specialist business

written in the London market.
All of these features mean that we have seen a large number of firms
entering our pre-application process.
_____________________________________________________________
I want to be clear here that we do not necessarily regard developing a full
model as being the only acceptable choice; nor do we necessarily regard
use of the standard formula as being in some way second best.
Whatever its deficiencies in some areas, the standard formula produces
for some firms perfectly acceptable results, and we would expect firms to
consider use of the standard formula for some risk modules, or some parts
of their business.
Nevertheless, the number of firms developing an internal model is

significant, and I therefore propose to spend some time in a moment
talking about our internal model approvals process – generally known as
IMAP.
Before I do so, I want to touch first on some other aspects of Solvency II

which have received a little less airtime so far, but are just as important
and not optional – reporting and ORSA.
First of all, Solvency II will bring about very significant changes to the
reporting regime for all firms, whether they are using a model or not.
From a regulatory perspective this is a considerable enhancement in the

quality of the data we will receive, and in the way it is submitted to us and
shared amongst supervisors across Europe.
For the first time, all European supervisors will be receiving data from
firms on a consistent, comparable and shareable basis.
For firms, the new reporting regime will require changes to systems, and
we will be requiring all firms to submit quarterly reports during 2013, and
annual reports in respect of their 2013 year end.
The UK-specific aspects of the reporting regime will be covered in our

consultation process, and firms should engage fully with it both at that
time and before via the Association of British Insurers (ABI) and our
industry groups.
_____________________________________________________________
Solvency II also requires all firms to have sound governance, good
internal controls and effective risk management across the whole of the
business, not just the financial areas.
All firms are subject also to the requirement to have in place an Own Risk
and Solvency Assessment process – the ORSA.
This is the principal means by which Solvency II draws together risk

management, governance, controls and capital into a single picture which
is squarely the responsibility of firms‘ senior management and which
must be used in decision making.
Firms should ensure that all of these aspects of their business are
compatible with Solvency II requirements, and that they have in place the
processes to ensure that they can manage the ORSA successfully.
So, Solvency II is not just about capital requirements, and is not just
about internal models.
Nonetheless, our IMAP approach is something that I want to turn to now.
As responsible custodians of funds which we raise from you, the industry,

we have to be sure that, when organising such a large programme of
work, we are in a position to deliver it safely and ensure that those funds
are properly deployed to the best effect.
This is the approach we adopt in all of our work, and you will be familiar
with the risk-based approach we have always taken to the allocation of
our resources.
Given all of the constraints I have already talked about, we have looked
again at our ability to deliver the IMAP process, along with everything
else we are preparing to do before day one.
We have considered the level of resources we are able to devote to firms

going through the pre-application phase of IMAP, and have decided to
_____________________________________________________________
concentrate these on a smaller population of firms – those firms
representing a significant market share, and being those which we have
always regarded as having the highest potential impact on our objectives.
These firms will continue to receive the greatest intensity of review

throughout the pre-application phase, with detailed reviews of various
aspects of their model in accordance with a work plan which we will agree
over the course of the coming weeks.
Specifically, these firms comprise the following sets: major UK life and
non-life firms – broadly the UK top ten; firms which have operations in
the Lloyd‘s market; and firms which are subsidiaries of major European
groups where we will be obliged to participate in a college of supervisors.
Other firms who are in pre-application will receive a reduced level of

engagement.
This will comprise a small degree of interaction with our actuaries and
other risk specialists, supplemented as always by interactions with
supervisors to ensure that firms remain on-track with their plans.
We are proposing to develop various tools to facilitate our review.
We think a number of these will assist firms in ensuring that their model
development continues in the right direction and will help bridge the gap
created by the reduced specialist input.
The following are some examples of the kind of tools we are developing:
1. Stress testing for general insurance firms;
2. Reference portfolios to test model treatment of certain types of asset or

business;
3. Industry standards on catastrophe models; and

_____________________________________________________________
4. Specified models for certain esoteric types of firm.
More details on how these will work and the kind of firms to which we‘ll
be applying them will follow at a later date.
We will be working with the ABI and others to ensure that we achieve a
solution which meets our needs whilst not imposing undue additional
burdens on industry.
At the same time, we will be introducing elements of external review into

our approach, whereby we will allow firms to submit to us independent
reports on some aspects of their model and how it works.
The advantage of this approach is that firms get to see up front the areas
in which we are particularly interested, and the FSA will receive
independent reviews in a consistent format, which will help us to take
decisions quickly and efficiently.
We will be piloting this approach in the area of data very soon, and more
details will follow later in the summer.
This lower level of specific specialist interaction for some firms should
not be taken to mean that those firms will in some ways be held to lower
standards than others.
The Directive is clear that the same standards apply to all firms, and that
is how we will implement it.
We are merely being proportionate here in how we apply our internal

resources to our investigations as to whether those standards are being
met; and being proportionate in the level of engagement we are able to
give to firms in the run-up to implementation.
I should also make it clear at this point that pre-application is now closed.
_____________________________________________________________
This means that no more firms will be able to enter the pre-application
process, which in turn means that firms which are currently not in
pre-application should not expect to receive a pre-day one decision on an
internal model, and they should therefore plan accordingly if they are not
already doing so.
Supervisors are aware of the approach which is being taken for individual
firms, and will be able to let you know soon what the work plan for your
firm will look like, and the level of interaction you are likely to receive.
It would be useful also to highlight what this approach means and does
not mean.
First, being in pre-application does not guarantee a firm day-one approval

of its model; it simply means that we are striving to be in a position to
make a decision on that internal model application prior to day one.
We cannot guarantee to be in a position to make a decision, as in part that

depends on the quality and completeness of the application we receive.
Second, the reduced level of attention devoted to some firms which I

mentioned a few moments ago does not necessarily imply that those firms
are less likely to have a decision prior to day one.
By and large, the firms where we are applying our resources are the
largest and most complex, and therefore those for whom the challenge of
building and implementing a model will be the greatest.
It is also important to stress that the FSA cannot make decisions about
group internal model applications in isolation, as our ability to make a
decision will rely on other supervisors‘ agreement and engagement
through pre-application and beyond, which is outside our control.
_____________________________________________________________
We have also reviewed and streamlined our processes to ensure that we
make maximum use of the knowledge our supervisors already have about
the firms that they supervise, and to ensure that we focus on the key
judgements of maximum impact, making sure we get the most ‗bang for
our buck‘.
Firms will begin to see the benefits of this approach as we agree work
plans and move into the next stage of pre-application.
Whatever approach is taken to pre-application, the objective is for a firm

to reach a point where it is able to submit a full application to us for model
approval.
Exactly what we look at after receiving this application will depend on the
level of interaction we have had so far, and the extent to which firms have
responded to the feedback we have given them previously, so the
approach will be an individual one for each firm.
What I can tell you today is that we will be open to receive those
applications from 30 March 2012.
This is later than we had originally envisaged, and reflects the

dependency we all have on the EU policymaking process, and our need to
be sure that we have as much clarity as we can on the policy position and
the requirements which we are expected to meet, both in our own
operations and in the firms which we supervise.
We currently envisage remaining open to receive formal applications for

two months, meaning that any firm currently planning to submit a formal
application later than the end of May next year is unlikely to receive a
decision before day one.
Firms should be aware that our processes will be designed with regular
review points, both during pre-application and after formal applications
are received.
_____________________________________________________________
If at any of these points we feel that a firm is likely not to be able to meet
the required standards in time, we will be inviting firms to leave the
process and invoke their contingency plans at these checkpoints along
the way.
As well as ensuring transparency and fairness for the firms involved, this
will allow us to conserve our resources and focus them on those firms
which have the best prospects of achieving model approval.
There are three possible outcomes of the model approval process:
1. Firms may have their models fully approved;
2. They may have them partially approved; or, in a small number of cases,
3. They may be rejected altogether, either because the application is

incomplete, or because our review work continues to point to significant
weaknesses.
Two out of these three outcomes will require firms to have a contingency
plan to fall back on, and I have alluded to this a number of times already.
This therefore seems an appropriate time to spell out in a little more detail
what those contingency plans might be.
Firms will be aware that non-approval of a model application means that

they revert to the default position under the Directive, which is to use the
standard formula.
This would apply either to the firm‘s whole business (in the case of a
complete rejection of the model) or to those parts not covered by the
approved elements of a partial model.
_____________________________________________________________
That is not quite as simple as it sounds because, where firms are using the
standard formula, they have a responsibility to assess its suitability, and to
be confident that it properly reflects the risks inherent in their business –
this should be reflected in their ORSA.
All firms – whether they are planning to use the standard formula, or
because the standard formula is part of their contingency planning –
should therefore take account – at the very least – of the extent to which
this is the case, and the areas in which firms would need to make use of
undertaking specific parameters, or other adjustments to the basic
standard formula.
Firms should also give consideration to the extent to which use of the
standard formula would imply a much higher regulatory capital
requirement than their own model, and explain to us what their approach
would be to meeting those additional capital requirements, given that our
decision on whether or not to approve their model would potentially come
much later in the day.
I have attempted here to set out some of the immediate, major changes to
our approach which will become visible to you in the coming weeks and
months.
_____________________________________________________________

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International Association of Risk and Compliance

Understanding internal controls over financial reporting (ICFR) is very

And, who really understands internal controls?

Some interesting developments:

According to the Sarbanes-Oxley Act, publicly traded companies cannot

Leaks to the media are not protected.

According to the Boeing spokesman John Dern, the ruling supported

Another interesting development:

James R. Doty has been appointed by the Securities and Exchange

At Baker Botts LLP, he practiced securities and corporate law and

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

We start from the Dodd Frank Act:

SEC. 989G. EXEMPTION FOR NONACCELERATED FILERS.

(a) EXEMPTION.—Section 404 of the Sarbanes-Oxley Act of 2002 is

‗‗(c) EXEMPTION FOR SMALLER ISSUERS.—Subsection (b) shall

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

Study and Recommendations on Section 404(b) of the

Section 989G(b) of the Dodd-Frank Act directed the SEC to conduct a

Specifically, the Dodd-Frank Act provides:

The Securities and Exchange Commission shall conduct a study to

Pursuant to Section 989I of the Dodd-Frank Act, the Government

The GAO study is to include an analysis of:

(3) whether there is any difference in the confidence of investors in the

This study addresses the auditor attestation requirement with respect to

It does not address management‘s responsibilities pursuant to Section

Under the Commission‘s rules prescribed pursuant to Section 404(a) of

(1) States management‘s responsibility for establishing and maintaining

(2) Includes management‘s assessment of the effectiveness of the ICFR.

In light of the interrelationship between the requirements in Section

For purposes of the study, we believe that public float is an appropriate

Public float, which is the aggregate worldwide market value of an issuer‘s

We therefore believe it would be consistent to use public float between

2. Accelerated filer means an issuer after it first meets the following

3. Large accelerated filer means an issuer that had an aggregate

This study addresses the auditor attestation requirement with respect to

It does not address management‘s responsibility for reporting on the

Although many of the academic and other studies surveyed relate to

This approach was used to develop findings and recommendations

Broadly, the Staff gathered information for this study through:

(1) a review of publicly-available information (including the 2009 SEC

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

The purpose of using these sources was to:

Consideration of Prior Action by the Commission and Others

Broadly, the timeline is as follows:

1. The Commission‘s initial implementing rule provided a phased-in

3. The Commission provided that Section 404 compliance is not required

4. In 2007, the Commission issued an interpretive release to provide

5. At approximately the same time that the Commission‘s interpretive

6. Additionally, in 2008 the Commission directed the Staff to conduct a

Analysis of the Issuers Subject to this Study

After considering prior actions taken to reduce the compliance burden on

The Staff performed this analysis to assist with the development of

(1) size in terms of assets and revenues;

(4) audit fees and scalability;

(5) restatement rates; and

(6) reported material weaknesses in ICFR.

The Staff identified an illustrative population of issuers as of December 31,

Many of the characteristics point to similar financial reporting risks

To understand whether any possible recommendations may encourage

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

In addition, as noted above, the Commission has previously taken action

Analysis of the 2009 SEC Staff Study on Section 404

This information, in conjunction with the analysis of prior reforms and

Discussion of Public Comments