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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

Top 10 risk and compliance management related news stories and world events that (for better or for worse) shaped the week's agenda, and what is next

Dear Member, This was a difficult week. We had significant amendments to the Basel iii liquidity rules. And we needed 206 pages for this weekly newsletter… Sorry, important things happen. 1. The LCR will be introduced as planned on 1 January 2015, but the minimum requirement will begin at 60%, rising in equal annual steps of 10 percentage points to reach 100% on 1 January 2019.

This graduated approach is designed to ensure that the LCR can be introduced without disruption to the orderly strengthening of banking systems or the ongoing financing of economic activity. 2. During periods of stress it would be entirely appropriate for banks to use their stock of high quality liquid assets (HQLA), thereby falling below the minimum.

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3.Banks will be able to count a much wider variety of liquid assets towards their buffers, including some equities and high-quality mortgage-backed securities.
4. European and American banking stocks surged because they will incur much reduced costs due to the implementation of the relaxed rules. 5.Banks in many other counties will have no benefit, as supervisors have already asked for strict liquidity rules, and they are not willing to take it back.

6.On the negative side, the main objective of Basel iii is to restore investor confidence. The Basel Committee has developed the new framework as a response to the crisis, and has explained (time and time again, every month since November 2010) the need for these strict rules.
Although it is true that Basel iii is an overreaction to the market crisis, it is way too late now to ―ease‖ the rules and make (clever) investors happy the same time. This is simply a red flag for many investors, leading to the conclusion that banks could not comply with the rules. I agree with the Liquidity Coverage ratio (LCR) Basel iii amendment, but I cannot agree with the way it was presented. Welcome to the Top 10 list.

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Basel I I I - Group of Governors and Heads of Supervision endorses revised liquidity standard for banks
The Group of Governors and H eads of Supervision (GHOS), the oversight body of the Basel Committee on Banking Supervision, met today to consider the Basel Committee's amendments to the Liquidity Coverage Ratio (LCR) as a minimum standard.

It unanimously endorsed them.

Commissioner Michel Barnier

The impact of the latest Basel Committee liquidity developments for Capital Requirements (CRD 4) in the EU
I n the light of the Group of Governors and Heads of Supervision meeting and the Basel Committee on Banking Supervision press release dated 6 January 2013

Basel I I I: The Liquidity Coverage Ratio and liquidity risk monitoring tools, January 2013

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Summary Responses To the Commissions‘ Green Paper on Shadow Banking
The European Commission's consultation on shadow banking attracted high interest from stakeholders. The comments provided cover a broad range of issues and responded to all the questions raised by the European Commission Green Paper. The Commission received in total 140 contributions, of which 24 from Public Authorities; 47 from registered organisations; and, 64 from individual organisations.

European Union: Financial Sector Assessment, Preliminary Conclusions by the IMF Staff
A Financial Sector Assessment Program (FSAP) team led by the Monetary and Capital Markets Department of the International Monetary Fund (IM F) visited the European Union (EU) during November 27–December 13, 2012, to conduct a first-ever overall EU-wide assessment of the soundness and stability of the EU‘s financial sector (EU FSAP).

European Cybercrime Centre (EC3) opens on 1 1 January
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As from 1 1 January the new European Cybercrime Centre (EC3) will be up and running to help protect European citizens and businesses from cyber-crime.
EU Commissioner for Home Affairs Cecilia Malmström will participate in the official opening of the Centre established at the European Police Office, Europol in the Hague (the Netherlands).

Sebastian von Dahlen and Goetz von Peter

Natural catastrophes and global reinsurance – exploring the linkages
Natural disasters resulting in significant losses have become more frequent in recent decades, with 2011 being the costliest year in history. This feature explores how risk is transferred within and beyond the global insurance sector and assesses the financial linkages that arise in the process.

Morten Bech, Todd Keister

On the liquidity coverage ratio and monetary policy implementation
Basel I I I introduces the first global framework for bank liquidity regulation. As monetary policy typically involves targeting the interest rate on interbank loans of the most liquid asset – central

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bank reserves – it is important to understand how this new requirement will impact the efficacy of current operational frameworks.

EIOPA – Risk Dashboard

Sovereign risk – a world without risk-free assets
Panel comments by Mr Patrick H onohan, Governor of the Central Bank of Ireland, at the BIS Conference on ―Sovereign risk – a world without risk-free assets‖, Basel, 8 January 2013. What‘s new about sovereign risk since the crisis began? Conceptually, not so much, I would suggest – and nothing that cannot be fully explained within standard models of finance.

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Basel I I I - Group of Governors and Heads of Supervision endorses revised liquidity standard for banks
6 January 2013 The Group of Governors and H eads of Supervision (GHOS), the oversight body of the Basel Committee on Banking Supervision, met today to consider the Basel Committee's amendments to the Liquidity Coverage Ratio (LCR) as a minimum standard. It unanimously endorsed them. Today's agreement is a clear commitment to ensure that banks hold sufficient liquid assets to prevent central banks becoming the "lender of first resort". The GHOS also endorsed a new Charter for the Committee, and discussed the Committee's medium-term work agenda. The GHOS reaffirmed the LCR as an essential component of the Basel I I I reforms. It endorsed a package of amendments to the formulation of the LCR announced in 2010. The package has four elements: 1.Revisions to the definition of high quality liquid assets (HQLA) and net cash outflows 2. A timetable for phase-in of the standard

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3.A reaffirmation of the usability of the stock of liquid assets in periods of stress, including during the transition period
4. An agreement for the Basel Committee to conduct further work on the interaction between the LCR and the provision of central bank facilities. A summary description of the agreed LCR is in Annex 1. The changes to the definition of the LCR, developed and agreed by the Basel Committee over the past two years, include an expansion in the range of assets eligible as HQLA and some refinements to the assumed inflow and outflow rates to better reflect actual experience in times of stress. These changes are set out in Annex 2. The GHOS agreed that the LCR should be subject to phase-in arrangements which align with those that apply to the Basel I I I capital adequacy requirements. Specifically, the LCR will be introduced as planned on 1 January 2015, but the minimum requirement will begin at 60%, rising in equal annual steps of 10 percentage points to reach 100% on 1 January 2019. This graduated approach is designed to ensure that the LCR can be introduced without disruption to the orderly strengthening of banking systems or the ongoing financing of economic activity. The GHOS agreed that, during periods of stress it would be entirely appropriate for banks to use their stock of HQLA, thereby falling below the minimum.

Moreover, it is the responsibility of bank supervisors to give guidance on usability according to circumstances.
The GHOS also agreed today that, since deposits with central banks are the most - indeed, in some cases, the only - reliable form of liquidity, the

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interaction between the LCR and the provision of central bank facilities is critically important.
The Committee will therefore continue to work on this issue over the next year. GHOS members endorsed two other areas of further analysis. First, the Committee will continue to develop disclosure requirements for bank liquidity and funding profiles.

Second, the Committee will continue to explore the use of market-based indicators of liquidity to supplement the existing measures based on asset classes and credit ratings.
The GHOS discussed and endorsed the Basel Committee's medium-term work agenda. Following the successful agreement of the LCR, the Committee will now press ahead with the review of the Net Stable Funding Ratio.

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

The new Charter sets out the Committee's objectives and key operating modalities, and is designed to improve understanding of the Committee's activities and decision-making processes.
Finally, the GHOS reiterated the importance of full, timely and consistent implementation of Basel I I I standards. Mervyn King, Chairman of the GH OS and Governor of the Bank of England, said,

"The Liquidity Coverage Ratio is a key component of the Basel I I I framework.
The agreement reached today is a very significant achievement. For the first time in regulatory history, we have a truly global minimum standard for bank liquidity. Importantly, introducing a phased timetable for the introduction of the LCR, and reaffirming that a bank's stock of liquid assets are usable in times of stress, will ensure that the new liquidity standard will in no way hinder the ability of the global banking system to finance a recovery." Stefan I ngves, Chairman of the Basel Committee and Governor of the Sveriges Riksbank, noted:

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"The amendments to the LCR are designed to ensure that it provides a sound minimum standard for bank liquidity - a standard that reflects actual experience during times of stress.
The completion of this work will allow the Basel Committee to turn its attention to refining the other component of the new global liquidity standards, the N et Stable Funding Ratio, which remains subject to an observation period ahead of its implementation in 2018."

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

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

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

Liquidity Coverage Ratio
The standard requires that, absent a situation of financial stress, the value of the ratio be no lower than 100% (ie the stock of HQLA should at least equal total net cash outflows). Banks are expected to meet this requirement continuously and hold a stock of unencumbered HQLA as a defence against the potential onset of liquidity stress.

During a period of financial stress, however, banks may use their stock of HQLA, thereby falling below 100%.
Important - The 100% threshold is the minimum requirement absent a period of financial stress, and after the phase-in arrangements are complete.
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References to 100% may be adjusted for any phase-in arrangements in force at a particular time.

Annex 2
Complete set of agreed changes to the Liquidity Coverage Ratio

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

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

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

Operational requirements
- Refine and clarify the operational requirements for H QLA

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

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Alternative liquid asset (ALA) framework
-Develop the alternative treatments and include a fourth option for sharia-compliant banks

Central bank reserves
-Clarify language to confirm that supervisors have national discretion to include or exclude required central bank reserves (as well as overnight and certain term deposits) as H QLA as they consider appropriate

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

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

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

Committed but unfunded inter-financial liquidity and credit facilities
-Distinguish between interbank and inter-financial credit and liquidity facilities and reduce the outflow rate on the former from 100% to 40% Derivatives
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-Additional derivatives risks included in the LCR with a 100% outflow (relates to collateral substitution, and excess collateral that the bank is contractually obligated to return/ provide if required by a counterparty)
-Introduce a standardised approach for liquidity risk related to market value changes in derivatives positions -Assume net outflow of 0% for derivatives (and commitments) that are contractually secured/ collateralised by HQLA

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

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

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

OTHER
Rules text clarifications
-Clearer guidance on the usability of H QLA, and the appropriate supervisory response, has been developed to ensure that the stock of liquid assets is available to be used when needed -A number of clarifications to the rules text to promote consistent application and reduce arbitrage opportunities (eg operational deposits from wholesale clients, derivatives cash flows, open maturity loans). Also incorporation of previously agreed FAQ
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Internationally agreed phase-in of the LCR
- The minimum LCR in 2015 would be 60% and increase by 10 percentage points per year to reach 100% in 2019

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

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

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standards, guidelines and sound practices beyond BCBS member countries; and
(g) Coordinating and cooperating with other financial sector standard setters and international bodies, particularly those involved in promoting financial stability.

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

I I . Membership 4. BCBS members
BCBS members include organisations with direct banking supervisory authority and central banks. After consulting the Committee, the BCBS Chairman may invite other organisations to become BCBS observers. BCBS membership and observer status will be reviewed periodically. In accepting new members, due regard will be given to the importance of their national banking sectors to international financial stability. The Committee will make recommendations to its oversight body, the Group of Governors and H eads of Supervision, for changes in BCBS membership. The Secretariat will publish the list of BCBS members and observers on its website.

5. BCBS members' responsibilities
BCBS members are committed to:
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(a)Work together to achieve the mandate of the BCBS;
(b) Promote financial stability; (c)Continuously enhance their quality of banking regulation and supervision; (d)Actively contribute to the development of BCBS standards, guidelines and sound practices; ( e ) I mplement and apply BCBS standards in their domestic jurisdictions 2 within the pre-defined timeframe established by the Committee; (f)Undergo and participate in BCBS reviews to assess the consistency and effectiveness of domestic rules and supervisory practices in relation to BCBS standards; and (g)Promote the interests of global financial stability and not solely national interests, while participating in BCBS work and decision-making.

I I I . Oversight 6. The Group of Governors and H eads of Supervision (GHOS)
The GHOS is the oversight body of the BCBS. The BCBS reports to the GH OS and seeks its endorsement for major decisions. In addition, the BCBS looks to the GHOS to: (a) Approve the BCBS Charter and any amendments to this document; (b) Provide general direction for the BCBS work programme (c) Appoint the BCBS Chairman from among its members.

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If the BCBS Chairman ceases to be a GHOS member before the end of his/ her term, the GHOS will appoint a new Chairman.
Until a new Chairman has been appointed, the Secretary General assumes the Chairman's functions.

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

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

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

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(f) Deciding on the organisational regulations governing its activities.

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

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

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

5. Communication of decisions
Committee decisions of public interest shall be communicated through the BCBS website. The Committee shall issue, when appropriate, press statements to communicate its decisions.

9. Groups, working groups and task forces
The BCBS's work is largely organised around groups, working groups and task forces.

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The Secretariat will make publicly available the list of BCBS groups and working groups.

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

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

3. Task forces
Task forces are created to undertake specific tasks for a limited time. These are generally composed of technical experts from BCBS member institutions.

However, when these groupings are created by the Committee, they consist of BCBS representatives and deal with specific issues that require prompt attention of the Committee. In such cases, they are called high-level task forces.

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

1.

Appointment

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

2.

Responsibilities

The Chairman's main responsibilities are to:

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

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

1 1.1 Responsibilities
The Secretariat's main responsibilities are to: (a)Provide support and assistance to the Committee, the Chairman, groups, working groups and task forces; (b) Ensure timely and effective information flow to all BCBS members; (c) Facilitate coordination across groups, working groups and task forces; (d)Facilitate a close contact between BCBS members and non-member authorities; (e) Support the cooperation between the BCBS and other institutions;

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(f)Maintain the BCBS records, administer the BCBS website and deal with correspondence of the BCBS; and
(g)Carry out all other functions that are assigned by the Committee and the Chairman.

2.

Secretary General

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

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

4. Location of the Secretariat
The Secretariat is located at the BI S in Basel.

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

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

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

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

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

2.

The I nternational Conferences of Banking Supervisors (I CBS)

The biennial ICBS provides a venue for supervisors around the world to discuss issues of common interest.

3.

Participation in BCBS groups, working groups and task forces

By participating as observers in BCBS bodies, non-member authorities contribute to the Committee's policy development work.

4.

The Financial Stability I nstitute (FSI )

The FSI is a joint initiative of the BCBS and the BIS to assist supervisors around the world in implementing sound prudential standards. The BCBS supports FSI activities, including in particular the BCBS-FSI High Level Meetings. These are targeted at senior policymakers within central banks and supervisory authorities and provide a series of regional fora for distributing information on BCBS standards, keeping participants updated on Committee work, sharing supervisory practices and concerns, and establishing and maintaining strong contacts.
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15.5 Regional groups of banking supervisors
The BCBS supports the work and activities of regional groups of banking supervisors worldwide. Secretariat staff may participate in meetings of such groups to exchange ideas and seek feedback on BCBS work.

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

VI I I . Public consultation process 17. Public consultation process of draft BCBS standards, guidelines and sound practices
In principle, the BCBS seeks input from all relevant stakeholders on policy proposals.

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The consultation process will include issuing a public invitation to interested parties to provide comments in writing to the Secretariat on policy proposals issued by the Committee, within a specified timeframe.
The consultation period shall normally last 90 calendar days, but could exceptionally be shorter or longer. As a general rule, responses to public invitations for comments shall be published on the BCBS website, unless confidential treatment is requested by respondents.

This process is compulsory for BCBS standards.

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Commissioner Michel Barnier

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

Context
The Basel Committee on Banking Supervision (BCBS) has agreed a package of LCR (liquidity coverage ratio) revisions unanimously as well as its 2013 work plan. The LCR revisions include an expansion of eligible assets, a less severe calibration for certain cash flows and a phasing-in arrangement from January 2015 to 2019.

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The current Commission approach to liquidity in the CRD4 negotiations, namely first a reporting period followed by comprehensive European Banking Authority (EBA) Reports and subsequently a delegated act by the Commission to define the detailed ratio remains fully valid.

Background information
The Commission's approach to liquidity in CRD 4 still remains valid in the light of the latest Basel Committee approval of the revision of a number of parameters and calibrations on liquidity (GHOS meeting of 6 January).

In the Basel Committee, the European Central Bank, the European Commission and various countries including from the EU had argued for such a revision.
At the level of the Basel Committee, the final package of LCR revisions will now be subject to an observation period with a Quantitative I mpact Study (QIS) that will take place in 2013 together with some other important work that still needs to be completed in the coming year. The EU needs to take full benefit of this observation period and learn from it, as this is the first time in history that regulators are defining globally harmonized, quantitative liquidity standards. The EBA will make reports on the results of the observation period for EU banks before the end of 2013. Based on the evaluation of this work, the Commission will propose defining the detailed LCR through a delegated act (i.e. legislation adopted by the Commission provided no objections are raised by the EP and the Council). Nevertheless, important work still remains to be completed at the global and European levels. This includes the determination of alternative, market-based indicators for the definition of High Quality Liquid Assets (HQLA); the treatment of Central Bank facilities which could impact upon the definition of HQLA and related cash flows; and the treatment of market valuation changes on derivative cash flows.

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In this light, the best course continues to be rapid adoption of the CRD 4 package while leaving the necessary flexibility to implement the final detailed LCR standard through a delegated act, taking into account the on-going work by Basel and the comprehensive EBA reports.
Subject to this approach, the texts on the table now of the European Parliament and Council should be adopted shortly, hopefully in the coming weeks.

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Basel I I I: The Liquidity Coverage Ratio and liquidity risk monitoring tools, January 2013
Introduction
1.This document presents one of the Basel Committee‘s key reforms to develop a more resilient banking sector: the Liquidity Coverage Ratio (LCR). The objective of the LCR is to promote the short-term resilience of the liquidity risk profile of banks. It does this by ensuring that banks have an adequate stock of unencumbered high-quality liquid assets (HQLA) that can be converted easily and immediately in private markets into cash to meet their liquidity needs for a 30 calendar day liquidity stress scenario. The LCR will improve the banking sector‘s ability to absorb shocks arising from financial and economic stress, whatever the source, thus reducing the risk of spillover from the financial sector to the real economy. This document sets out the LCR standard and timelines for its implementation. 2.During the early ―liquidity phase‖ of the financial crisis that began in 2007, many banks – despite adequate capital levels – still experienced difficulties because they did not manage their liquidity in a prudent manner. The crisis drove home the importance of liquidity to the proper functioning of financial markets and the banking sector.

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Prior to the crisis, asset markets were buoyant and funding was readily available at low cost.
The rapid reversal in market conditions illustrated how quickly liquidity can evaporate, and that illiquidity can last for an extended period of time. The banking system came under severe stress, which necessitated central bank action to support both the functioning of money markets and, in some cases, individual institutions. 3.The difficulties experienced by some banks were due to lapses in basic principles of liquidity risk management. In response, as the foundation of its liquidity framework, the Committee in 2008 published Principles for Sound Liquidity Risk Management and Supervision (―Sound Principles‖). The Sound Principles provide detailed guidance on the risk management and supervision of funding liquidity risk and should help promote better risk management in this critical area, but only if there is full implementation by banks and supervisors. As such, the Committee will continue to monitor the implementation by supervisors to ensure that banks adhere to these fundamental principles. 4.To complement these principles, the Committee has further strengthened its liquidity framework by developing two minimum standards for funding liquidity. These standards have been developed to achieve two separate but complementary objectives.

The first objective is to promote short-term resilience of a bank‘s liquidity risk profile by ensuring that it has sufficient H QLA to survive a significant stress scenario lasting for one month.
The Committee developed the LCR to achieve this objective.

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The second objective is to promote resilience over a longer time horizon by creating additional incentives for banks to fund their activities with more stable sources of funding on an ongoing basis.
The Net Stable Funding Ratio (NSFR), which is not covered by this document, supplements the LCR and has a time horizon of one year. It has been developed to provide a sustainable maturity structure of assets and liabilities. 5.These two standards are comprised mainly of specific parameters which are internationally ―harmonised‖ with prescribed values. Certain parameters, however, contain elements of national discretion to reflect jurisdiction-specific conditions. In these cases, the parameters should be transparent and clearly outlined in the regulations of each jurisdiction to provide clarity both within the jurisdiction and internationally. 6.It should be stressed that the LCR standard establishes a minimum level of liquidity for internationally active banks. Banks are expected to meet this standard as well as adhere to the Sound Principles. Consistent with the Committee‘s capital adequacy standards, national authorities may require higher minimum levels of liquidity. In particular, supervisors should be mindful that the assumptions within the LCR may not capture all market conditions or all periods of stress.

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

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11.The Committee also reaffirms its view that, during periods of stress, it would be entirely appropriate for banks to use their stock of H QLA, thereby falling below the minimum.
Supervisors will subsequently assess this situation and will give guidance on usability according to circumstances. Furthermore, individual countries that are receiving financial support for macroeconomic and structural reform purposes may choose a different implementation schedule for their national banking systems, consistent with the design of their broader economic restructuring programme. 12.The Committee is currently reviewing the N SFR, which continues to be subject to an observation period and remains subject to review to address any unintended consequences. It remains the Committee‘s intention that the N SFR, including any revisions, will become a minimum standard by 1 January 2018. 13.This document is organised as follows: - Part 1 defines the LCR for internationally active banks and deals with application issues. - Part 2 presents a set of monitoring tools to be used by banks and supervisors in their monitoring of liquidity risks.

Part 1: The Liquidity Coverage Ratio
14.The Committee has developed the LCR to promote the short-term resilience of the liquidity risk profile of banks by ensuring that they have sufficient H QLA to survive a significant stress scenario lasting 30 calendar days. 15.The LCR should be a key component of the supervisory approach to liquidity risk, but must be supplemented by detailed supervisory assessments of other aspects of the bank‘s liquidity risk management

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framework in line with the Sound Principles, the use of the monitoring tools included in Part 2, and, in due course, the NSFR.
In addition, supervisors may require an individual bank to adopt more stringent standards or parameters to reflect its liquidity risk profile and the supervisor‘s assessment of its compliance with the Sound Principles.

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

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

Banks may use their stock of H QLA in both idiosyncratic and systemic stress events, although the supervisory response may differ between the two.
(i) At a minimum, a bank should present an assessment of its liquidity position, including the factors that contributed to its LCR falling below
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100%, the measures that have been and will be taken and the expectations on the potential length of the situation.
Enhanced reporting to supervisors should be commensurate with the duration of the shortfall. (ii)If appropriate, supervisors could also require actions by a bank to reduce its exposure to liquidity risk, strengthen its overall liquidity risk management, or improve its contingency funding plan. ( i i i ) H owever, in a situation of sufficiently severe system-wide stress, effects on the entire financial system should be considered. Potential measures to restore liquidity levels should be discussed, and should be executed over a period of time considered appropriate to prevent additional stress on the bank and on the financial system as a whole. (e) Supervisors‘ responses should be consistent with the overall approach to the prudential framework.

I I . Definition of the LCR
19. The scenario for this standard entails a combined idiosyncratic and market-wide shock that would result in: (a)The run-off of a proportion of retail deposits; (b) A partial loss of unsecured wholesale funding capacity; (c)A partial loss of secured, short-term financing with certain collateral and counterparties; (d)Additional contractual outflows that would arise from a downgrade in the bank‘s public credit rating by up to and including three notches, including collateral posting requirements;

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( e ) I ncreases in market volatilities that impact the quality of collateral or potential future exposure of derivative positions and thus require larger collateral haircuts or additional collateral, or lead to other liquidity needs;
(f)Unscheduled draws on committed but unused credit and liquidity facilities that the bank has provided to its clients; and (g)The potential need for the bank to buy back debt or honour non-contractual obligations in the interest of mitigating reputational risk. 20.In summary, the stress scenario specified incorporates many of the shocks experienced during the crisis that started in 2007 into one significant stress scenario for which a bank would need sufficient liquidity on hand to survive for up to 30 calendar days. 21.This stress test should be viewed as a minimum supervisory requirement for banks. Banks are expected to conduct their own stress tests to assess the level of liquidity they should hold beyond this minimum, and construct their own scenarios that could cause difficulties for their specific business activities. Such internal stress tests should incorporate longer time horizons than the one mandated by this standard. Banks are expected to share the results of these additional stress tests with supervisors. 22.The LCR has two components: (a)Value of the stock of HQLA in stressed conditions; and

(b)Total net cash outflows, calculated according to the scenario parameters outlined below.

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A. Stock of HQLA
23. The numerator of the LCR is the ―stock of H QLA‖. Under the standard, banks must hold a stock of unencumbered HQLA to cover the total net cash outflows (as defined below) over a 30-day period under the prescribed stress scenario. In order to qualify as ―HQL A‖, assets should be liquid in markets during a time of stress and, ideally, be central bank eligible. The following sets out the characteristics that such assets should generally possess and the operational requirements that they should satisfy.

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

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(i) Fundamental characteristics
- Low risk: assets that are less risky tend to have higher liquidity. High credit standing of the issuer and a low degree of subordination increase an asset‘s liquidity. Low duration, low legal risk, low inflation risk and denomination in a convertible currency with low foreign exchange risk all enhance an asset‘s liquidity. - Ease and certainty of valuation: an asset‘s liquidity increases if market participants are more likely to agree on its valuation. Assets with more standardised, homogenous and simple structures tend to be more fungible, promoting liquidity. The pricing formula of a high-quality liquid asset must be easy to calculate and not depend on strong assumptions. The inputs into the pricing formula must also be publicly available.

In practice, this should rule out the inclusion of most structured or exotic products.
- Low correlation with risky assets: the stock of H QLA should not be subject to wrong-way (highly correlated) risk. For example, assets issued by financial institutions are more likely to be illiquid in times of liquidity stress in the banking sector. - Listed on a developed and recognised exchange: being listed increases an asset‘s transparency.

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

- There should be robust market infrastructure in place.
- The presence of multiple committed market makers increases liquidity as quotes will most likely be available for buying or selling HQLA. - Low volatility: Assets whose prices remain relatively stable and are less prone to sharp price declines over time will have a lower probability of triggering forced sales to meet liquidity requirements.

Volatility of traded prices and spreads are simple proxy measures of market volatility.
There should be historical evidence of relative stability of market terms (eg prices and haircuts) and volumes during stressed periods. - Flight to quality: historically, the market has shown tendencies to move into these types of assets in a systemic crisis. The correlation between proxies of market liquidity and banking system stress is one simple measure that could be used. 25. As outlined by these characteristics, the test of whether liquid assets are of ―high quality‖ is that, by way of sale or repo, their liquidity generating capacity is assumed to remain intact even in periods of severe idiosyncratic and market stress.

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Lower quality assets typically fail to meet that test.
An attempt by a bank to raise liquidity from lower quality assets under conditions of severe market stress would entail acceptance of a large fire-sale discount or haircut to compensate for high market risk. That may not only erode the market‘s confidence in the bank, but would also generate mark-to-market losses for banks holding similar instruments and add to the pressure on their liquidity position, thus encouraging further fire sales and declines in prices and market liquidity.

In these circumstances, private market liquidity for such instruments is likely to disappear quickly.
26.HQLA (except Level 2B assets as defined below) should ideally be eligible at central banks for intraday liquidity needs and overnight liquidity facilities. In the past, central banks have provided a further backstop to the supply of banking system liquidity under conditions of severe stress.

Central bank eligibility should thus provide additional confidence that banks are holding assets that could be used in events of severe stress without damaging the broader financial system.
That in turn would raise confidence in the safety and soundness of liquidity risk management in the banking system. 27.It should be noted however, that central bank eligibility does not by itself constitute the basis for the categorisation of an asset as H QLA.

2. Operational requirements
28. All assets in the stock of H QLA are subject to the following operational requirements. The purpose of the operational requirements is to recognise that not all assets outlined in paragraphs 49-54 that meet the asset class,
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risk-weighting and credit-rating criteria should be eligible for the stock as there are other operational restrictions on the availability of H QLA that can prevent timely monetisation during a stress period.
29.These operational requirements are designed to ensure that the stock of HQLA is managed in such a way that the bank can, and is able to demonstrate that it can, immediately use the stock of assets as a source of contingent funds that is available for the bank to convert into cash through outright sale or repo, to fill funding gaps between cash inflows and outflows at any time during the 30-day stress period, with no restriction on the use of the liquidity generated. 30.A bank should periodically monetise a representative proportion of the assets in the stock through repo or outright sale, in order to test its access to the market, the effectiveness of its processes for monetisation, the availability of the assets, and to minimise the risk of negative signalling during a period of actual stress. 31. All assets in the stock should be unencumbered. ―Unencumbered‖ means free of legal, regulatory, contractual or other restrictions on the ability of the bank to liquidate, sell, transfer, or assign the asset. An asset in the stock should not be pledged (either explicitly or implicitly) to secure, collateralise or credit-enhance any transaction, nor be designated to cover operational costs (such as rents and salaries). Assets received in reverse repo and securities financing transactions that are held at the bank, have not been rehypothecated, and are legally and contractually available for the bank's use can be considered as part of the stock of H QLA. In addition, assets which qualify for the stock of H QLA that have been pre-positioned or deposited with, or pledged to, the central bank or a public sector entity (PSE) but have not been used to generate liquidity may be included in the stock.

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32.A bank should exclude from the stock those assets that, although meeting the definition of ―unencumbered‖ specified in paragraph 31, the bank would not have the operational capability to monetise to meet outflows during the stress period.
Operational capability to monetise assets requires having procedures and appropriate systems in place, including providing the function identified in paragraph 33 with access to all necessary information to execute monetisation of any asset at any time. Monetisation of the asset must be executable, from an operational perspective, in the standard settlement period for the asset class in the relevant jurisdiction. 33.The stock should be under the control of the function charged with managing the liquidity of the bank (eg the treasurer), meaning the function has the continuous authority, and legal and operational capability, to monetise any asset in the stock. Control must be evidenced either by maintaining assets in a separate pool managed by the function with the sole intent for use as a source of contingent funds, or by demonstrating that the function can monetise the asset at any point in the 30-day stress period and that the proceeds of doing so are available to the function throughout the 30-day stress period without directly conflicting with a stated business or risk management strategy. For example, an asset should not be included in the stock if the sale of that asset, without replacement throughout the 30-day period, would remove a hedge that would create an open risk position in excess of internal limits.

34.A bank is permitted to hedge the market risk associated with ownership of the stock of HQLA and still include the assets in the stock.
If it chooses to hedge the market risk, the bank should take into account (in the market value applied to each asset) the cash outflow that would

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arise if the hedge were to be closed out early (in the event of the asset being sold).
35.In accordance with Principle 9 of the Sound Principles a bank ―should monitor the legal entity and physical location where collateral is held and how it may be mobilised in a timely manner‖. Specifically, it should have a policy in place that identifies legal entities, geographical locations, currencies and specific custodial or bank accounts where H QLA are held. In addition, the bank should determine whether any such assets should be excluded for operational reasons and therefore, have the ability to determine the composition of its stock on a daily basis. 36.As noted in paragraphs 171 and 172, qualifying H QLA that are held to meet statutory liquidity requirements at the legal entity or sub consolidated level (where applicable) may only be included in the stock at the consolidated level to the extent that the related risks (as measured by the legal entity‘s or sub-consolidated group‘s net cash outflows in the LCR) are also reflected in the consolidated LCR. Any surplus of HQLA held at the legal entity can only be included in the consolidated stock if those assets would also be freely available to the consolidated (parent) entity in times of stress. 37.In assessing whether assets are freely transferable for regulatory purposes, banks should be aware that assets may not be freely available to the consolidated entity due to regulatory , legal, tax, accounting or other impediments. Assets held in legal entities without market access should only be included to the extent that they can be freely transferred to other entities that could monetise the assets. 38.In certain jurisdictions, large, deep and active repo markets do not exist for eligible asset classes, and therefore such assets are likely to be monetised through outright sale.
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In these circumstances, a bank should exclude from the stock of HQLA those assets where there are impediments to sale, such as large fire-sale discounts which would cause it to breach minimum solvency equirements, or requirements to hold such assets, including, but not limited to, statutory minimum inventory requirements for market making.
39.Banks should not include in the stock of HQLA any assets, or liquidity generated from assets, they have received under right of rehypothecation, if the beneficial owner has the contractual right to withdraw those assets during the 30-day stress period. 40.Assets received as collateral for derivatives transactions that are not segregated and are legally able to be rehypothecated may be included in the stock of HQLA provided that the bank records an appropriate outflow for the associated risks as set out in paragraph 1 16. 41.As stated in Principle 8 of the Sound Principles, a bank should actively manage its intraday liquidity positions and risks to meet payment and settlement obligations on a timely basis under both normal and stressed conditions and thus contribute to the smooth functioning of payment and settlement systems. Banks and regulators should be aware that the LCR stress scenario does not cover expected or unexpected intraday liquidity needs. 42.While the LCR is expected to be met and reported in a single currency, banks are expected to be able to meet their liquidity needs in each currency and maintain H QLA consistent with the distribution of their liquidity needs by currency. The bank should be able to use the stock to generate liquidity in the currency and jurisdiction in which the net cash outflows arise. As such, the LCR by currency is expected to be monitored and reported to allow the bank and its supervisor to track any potential currency mismatch issues that could arise, as outlined in Part 2.

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In managing foreign exchange liquidity risk, the bank should take into account the risk that its ability to swap currencies and access the relevant foreign exchange markets may erode rapidly under stressed conditions.
It should be aware that sudden, adverse exchange rate movements could sharply widen existing mismatched positions and alter the effectiveness of any foreign exchange hedges in place. 43. In order to mitigate cliff effects that could arise, if an eligible liquid asset became ineligible (eg due to rating downgrade), a bank is permitted to keep such assets in its stock of liquid assets for an additional 30 calendar days. This would allow the bank additional time to adjust its stock as needed or replace the asset.

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

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

(i) Level 1 assets
49. Level 1 assets can comprise an unlimited share of the pool and are not subject to a haircut under the LCR. However, national supervisors may wish to require haircuts for Level 1 securities based on, among other things, their duration, credit and liquidity risk, and typical repo haircuts.
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50. Level 1 assets are limited to:
(a)Coins and banknotes; (b)Central bank reserves (including required reserves), to the extent that the central bank policies allow them to be drawn down in times of stress; (c)Marketable securities representing claims on or guaranteed by sovereigns, central banks, PSEs, the Bank for I nternational Settlements, the I nternational Monetary Fund, the European Central Bank and European Community, or multilateral development banks, and satisfying all of the following conditions: - assigned a 0% risk-weight under the Basel I I Standardised Approach for credit risk; - traded in large, deep and active repo or cash markets characterised by a low level of concentration; - have a proven record as a reliable source of liquidity in the markets (repo or sale) even during stressed market conditions; and - not an obligation of a financial institution or any of its affiliated entities. (d)where the sovereign has a non-0% risk weight, sovereign or central bank debt securities issued in domestic currencies by the sovereign or central bank in the country in which the liquidity risk is being taken or in the bank‘s home country; and (e)where the sovereign has a non-0% risk weight, domestic sovereign or central bank debt securities issued in foreign currencies are eligible up to the amount of the bank‘s stressed net cash outflows in that specific foreign currency stemming from the bank‘s operations in the jurisdiction where the bank‘s liquidity risk is being taken.

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

Level 2A assets are limited to the following:
(a)Marketable securities representing claims on or guaranteed by sovereigns, central banks, PSEs or multilateral development banks that satisfy all of the following conditions: - assigned a 20% risk weight under the Basel I I Standardised Approach for credit risk; - traded in large, deep and active repo or cash markets characterised by a low level of concentration; - have a proven record as a reliable source of liquidity in the markets (repo or sale) even during stressed market conditions (ie maximum decline of price not exceeding 10% or increase in haircut not exceeding 10 percentage points over a 30-day period during a relevant period of significant liquidity stress); and - not an obligation of a financial institution or any of its affiliated entities. (b)Corporate debt securities (including commercial paper) and covered bonds that satisfy all of the following conditions: - in the case of corporate debt securities: not issued by a financial institution or any of its affiliated entities;

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- in the case of covered bonds: not issued by the bank itself or any of its affiliated entities;
- either (i)have a long-term credit rating from a recognised external credit assessment institution (ECAI) of at least AA-21 or in the absence of a long term rating, a short-term rating equivalent in quality to the long-term rating; or (ii)do not have a credit assessment by a recognised ECAI but are internally rated as having a probability of default (PD) corresponding to a credit rating of at least AA-; - traded in large, deep and active repo or cash markets characterised by a low level of concentration; and - have a proven record as a reliable source of liquidity in the markets (repo or sale) even during stressed market conditions: ie maximum decline of price or increase in haircut over a 30-day period during a relevant period of significant liquidity stress not exceeding 10%.

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

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- have a proven record as a reliable source of liquidity in the markets (repo or sale) even during stressed market conditions, ie a maximum decline of share price not exceeding 40% or increase in haircut not exceeding 40 percentage points over a 30-day period during a relevant period of significant liquidity.

(iv) Treatment for jurisdictions with insufficient H QLA (a) Assessment of eligibility for alternative liquidity approaches (ALA)
55.Some jurisdictions may have an insufficient supply of Level 1 assets (or both Level 1 and Level 2 assets) in their domestic currency to meet the aggregate demand of banks with significant exposures in this currency. To address this situation, the Committee has developed alternative treatments for holdings in the stock of H QLA, which are expected to apply to a limited number of currencies and jurisdictions. Eligibility for such alternative treatment will be judged on the basis of the qualifying criteria set out in Annex 2 and will be determined through an independent peer review process overseen by the Committee. The purpose of this process is to ensure that the alternative treatments are only used when there is a true shortfall in HQLA in the domestic currency relative to the needs in that currency. 56.To qualify for the alternative treatment, a jurisdiction should be able to demonstrate that: - there is an insufficient supply of HQLA in its domestic currency, taking into account all relevant factors affecting the supply of, and demand for, such H QLA; - the insufficiency is caused by long-term structural constraints that cannot be resolved within the medium term;

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- it has the capacity, through any mechanism or control in place, to limit or mitigate the risk that the alternative treatment cannot work as expected; and
- it is committed to observing the obligations relating to supervisory monitoring, disclosure, and periodic self-assessment and independent peer review of its eligibility for alternative treatment. All of the above criteria have to be met to qualify for the alternative treatment.

57. Irrespective of whether a jurisdiction seeking ALA treatment will adopt the phase-in arrangement set out in paragraph 10 for implementing the LCR, the eligibility for that jurisdiction to adopt ALA treatment will be based on a fully implemented LCR standard (ie 100% requirement).

(b) Potential options for alternative treatment
58. Option 1 – Contractual committed liquidity facilities from the relevant central bank, with a fee:

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

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

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

- Principle 3: Supervisors should ensure that banks have, to the extent practicable, taken reasonable steps to use Level 1 and Level 2 assets and reduce their overall level of liquidity risk to improve the LCR, before the alternative treatment can be applied.
- Principle 4: Supervisors should have a mechanism for restraining the usage of the options to mitigate risks of non-performance of the alternative HQLA.
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(v) Treatment for Shari‘ah compliant banks
68. Shari‘ah compliant banks face a religious prohibition on holding certain types of assets, such as interest-bearing debt securities. Even in jurisdictions that have a sufficient supply of H QLA, an insurmountable impediment to the ability of Shari‘ah compliant banks to meet the LCR requirement may still exist. In such cases, national supervisors in jurisdictions in which Shari‘ah compliant banks operate have the discretion to define Shari‘ah compliant financial products (such as Sukuk) as alternative H QLA applicable to such banks only, subject to such conditions or haircuts that the supervisors may require. It should be noted that the intention of this treatment is not to allow Shari‘ah compliant banks to hold fewer HQLA. The minimum LCR standard, calculated based on alternative HQLA (post-haircut) recognised as H QLA for these banks, should not be lower than the minimum LCR standard applicable to other banks in the jurisdiction concerned. National supervisors applying such treatment for Shari‘ah compliant banks should comply with supervisory monitoring and disclosure obligations similar to those set out in paragraph 66 above.

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

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

1. Cash outflows (i) Retail deposit run-off
73.Retail deposits are defined as deposits placed with a bank by a natural person.

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

(a) Stable deposits (run-off rate = 3% and higher)
75.Stable deposits, which usually receive a run-off factor of 5%, are the amount of the deposits that are fully insured by an effective deposit insurance scheme or by a public guarantee that provides equivalent protection and where: - the depositors have other established relationships with the bank that make deposit withdrawal highly unlikely; or - the deposits are in transactional accounts (eg accounts where salaries are automatically deposited).
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76. For the purposes of this standard, an ―effective deposit insurance scheme‖ refers to a scheme (i) That guarantees that it has the ability to make prompt payouts, (ii) For which the coverage is clearly defined and (iii) Of which public awareness is high. The deposit insurer in an effective deposit insurance scheme has formal legal powers to fulfil its mandate and is operationally independent, transparent and accountable. A jurisdiction with an explicit and legally binding sovereign deposit guarantee that effectively functions as deposit insurance can be regarded as having an effective deposit insurance scheme. 77.The presence of deposit insurance alone is not sufficient to consider a deposit ―stable‖. 78.Jurisdictions may choose to apply a run-off rate of 3% to stable deposits in their jurisdiction, if they meet the above stable deposit criteria and the following additional criteria for deposit insurance schemes: - the insurance scheme is based on a system of prefunding via the periodic collection of levies on banks with insured deposits; - the scheme has adequate means of ensuring ready access to additional funding in the event of a large call on its reserves, eg an explicit and legally binding guarantee from the government, or a standing authority to borrow from the government - access to insured deposits is available to depositors in a short period of time once the deposit insurance scheme is triggered. Jurisdictions applying the 3% run-off rate to stable deposits with deposit insurance arrangements that meet the above criteria should be able to
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provide evidence of run-off rates for stable deposits within the banking system below 3% during any periods of stress experienced that are consistent with the conditions within the LCR.

(b) Less stable deposits (run-off rates = 10% and higher)
79.Supervisory authorities are expected to develop additional buckets with higher runoff rates as necessary to apply to buckets of potentially less stable retail deposits in their jurisdictions, with a minimum run-off rate of 10%. These jurisdiction-specific run-off rates should be clearly outlined and publicly transparent. Buckets of less stable deposits could include deposits that are not fully covered by an effective deposit insurance scheme or sovereign deposit guarantee, high-value deposits, deposits from sophisticated or high net worth individuals, deposits that can be withdrawn quickly (eg internet deposits) and foreign currency deposits, as determined by each jurisdiction.

80.If a bank is not able to readily identify which retail deposits would qualify as ―stable‖ according to the above definition (eg the bank cannot determine which deposits are covered by an effective deposit insurance scheme or a sovereign deposit guarantee), it should place the full amount in the ―less stable‖ buckets as established by its supervisor.
81.Foreign currency retail deposits are deposits denominated in any other currency than the domestic currency in a jurisdiction in which the bank operates. Supervisors will determine the run-off factor that banks in their jurisdiction should use for foreign currency deposits. Foreign currency deposits will be considered as ―less stable‖ if there is a reason to believe that such deposits are more volatile than domestic currency deposits.
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Factors affecting the volatility of foreign currency deposits include the type and sophistication of the depositors, and the nature of such deposits (eg whether the deposits are linked to business needs in the same currency, or whether the deposits are placed in a search for yield).
82.Cash outflows related to retail term deposits with a residual maturity or withdrawal notice period of greater than 30 days will be excluded from total expected cash outflows if the depositor has no legal right to withdraw deposits within the 30-day horizon of the LCR, or if early withdrawal results in a significant penalty that is materially greater than the loss of interest. 83.If a bank allows a depositor to withdraw such deposits without applying the corresponding penalty, or despite a clause that says the depositor has no legal right to withdraw, the entire category of these funds would then have to be treated as demand deposits (ie regardless of the remaining term, the deposits would be subject to the deposit run-off rates as specified in paragraphs 74-81). Supervisors in each jurisdiction may choose to outline exceptional circumstances that would qualify as hardship, under which the exceptional term deposit could be withdrawn by the depositor without changing the treatment of the entire pool of deposits. Such reasons could include, but are not limited to, supervisory concerns that depositors would withdraw term deposits in a similar fashion as retail demand deposits during either normal or stress times, concern that banks may repay such deposits early in stressed times for reputational reasons, or the presence of unintended incentives on banks to impose material penalties on consumers if deposits are withdrawn early. In these cases supervisors would assess a higher run-off against all or some of such deposits.

(ii) Unsecured wholesale funding run-off
85. For the purposes of the LCR, "unsecured wholesale funding‖ is defined as those liabilities and general obligations that are raised from
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non-natural persons (ie legal entities, including sole proprietorships and partnerships) and are not collateralised by legal rights to specifically designated assets owned by the borrowing institution in the case of bankruptcy, insolvency, liquidation or resolution.
Obligations related to derivative contracts are explicitly excluded from this definition. 86.The wholesale funding included in the LCR is defined as all funding that is callable within the LCR‘s horizon of 30 days or that has its earliest possible contractual maturity date situated within this horizon (such as maturing term deposits and unsecured debt securities) as well as funding with an undetermined maturity. This should include all funding with options that are exercisable at the investor‘s discretion within the 30 calendar day horizon. For funding with options exercisable at the bank‘s discretion, supervisors should take into account reputational factors that may limit a bank's ability not to exercise the option. In particular, where the market expects certain liabilities to be redeemed before their legal final maturity date, banks and supervisors should assume such behaviour for the purpose of the LCR and include these liabilities as outflows. 87.Wholesale funding that is callable by the funds provider subject to a contractually defined and binding notice period surpassing the 30-day horizon is not included. 88.For the purposes of the LCR, unsecured wholesale funding is to be categorised as detailed below, based on the assumed sensitivity of the funds providers to the rate offered and the credit quality and solvency of the borrowing bank. This is determined by the type of funds providers and their level of sophistication, as well as their operational relationships with the bank.

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The run-off rates for the scenario are listed for each category .

(a) Unsecured wholesale funding provided by small business customers: 5%, 10% and H igher
89.Unsecured wholesale funding provided by small business customers is treated the same way as retail deposits for the purposes of this standard, effectively distinguishing between a "stable" portion of funding provided by small business customers and different buckets of less stable funding defined by each jurisdiction. The same bucket definitions and associated run-off factors apply as for retail deposits. 90.This category consists of deposits and other extensions of funds made by nonfinancial small business customers. ―Small business customers‖ are defined in line with the definition of loans extended to small businesses in paragraph 231 of the Basel I I framework that are managed as retail exposures and are generally considered as having similar liquidity risk characteristics to retail accounts provided the total aggregated funding raised from one small business customer is less than €1 million (on a consolidated basis where applicable). 91.Where a bank does not have any exposure to a small business customer that would enable it to use the definition under paragraph 231 of the Basel I I Framework, the bank may include such a deposit in this category provided that the total aggregate funding raised from the customer is less than €1 million (on a consolidated basis where applicable) and the deposit is managed as a retail deposit. This means that the bank treats such deposits in its internal risk management systems consistently over time and in the same manner as other retail deposits, and that the deposits are not individually managed in a way comparable to larger corporate deposits.

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92. Term deposits from small business customers should be treated in accordance with the treatment for term retail deposits as outlined in paragraph 82, 83, and 84.

(b) Operational deposits generated by clearing, custody and cash management activities: 25%
93.Certain activities lead to financial and non-financial customers needing to place, or leave, deposits with a bank in order to facilitate their access and ability to use payment and settlement systems and otherwise make payments. These funds may receive a 25% run-off factor only if the customer has a substantive dependency with the bank and the deposit is required for such activities. Supervisory approval would have to be given to ensure that banks utilising this treatment actually are conducting these operational activities at the level indicated. Supervisors may choose not to permit banks to utilise the operational deposit runoff rates in cases where, for example, a significant portion of operational deposits are provided by a small proportion of customers (ie concentration risk). 94.Qualifying activities in this context refer to clearing, custody or cash management activities that meet the following criteria: - The customer is reliant on the bank to perform these services as an independent third party intermediary in order to fulfil its normal banking activities over the next 30 days. For example, this condition would not be met if the bank is aware that the customer has adequate back-up arrangements. - These services must be provided under a legally binding agreement to institutional customers.
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- The termination of such agreements shall be subject either to a notice period of at least 30 days or significant switching costs (such as those related to transaction, information technology, early termination or legal costs) to be borne by the customer if the operational deposits are moved before 30 days.
95.Qualifying operational deposits generated by such an activity are ones where: - The deposits are by-products of the underlying services provided by the banking organisation and not sought out in the wholesale market in the sole interest of offering interest income. - The deposits are held in specifically designated accounts and priced without giving an economic incentive to the customer (not limited to paying market interest rates) to leave any excess funds on these accounts. In the case that interest rates in a jurisdiction are close to zero, it would be expected that such accounts are noninterest bearing. Banks should be particularly aware that during prolonged periods of low interest rates, excess balances (as defined below) could be significant. 96.Any excess balances that could be withdrawn and would still leave enough funds to fulfil these clearing, custody and cash management activities do not qualify for the 25% factor. In other words, only that part of the deposit balance with the service provider that is proven to serve a customer‘s operational needs can qualify as stable. Excess balances should be treated in the appropriate category for non-operational deposits.

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If banks are unable to determine the amount of the excess balance, then the entire deposit should be assumed to be excess to requirements and, therefore, considered non-operational.
97.Banks must determine the methodology for identifying excess deposits that are excluded from this treatment. This assessment should be conducted at a sufficiently granular level to adequately assess the risk of withdrawal in an idiosyncratic stress. The methodology should take into account relevant factors such as the likelihood that wholesale customers have above average balances in advance of specific payment needs, and consider appropriate indicators (eg ratios of account balances to payment or settlement volumes or to assets under custody) to identify those customers that are not actively managing account balances efficiently. 98.Operational deposits would receive a 0% inflow assumption for the depositing bank given that these deposits are required for operational reasons, and are therefore not available to the depositing bank to repay other outflows. 99.Notwithstanding these operational categories, if the deposit under consideration arises out of correspondent banking or from the provision of prime brokerage services, it will be treated as if there were no operational activity for the purpose of determining run-off factors.42 100.The following paragraphs describe the types of activities that may generate operational deposits. A bank should assess whether the presence of such an activity does indeed generate an operational deposit as not all such activities qualify due to differences in customer dependency, activity and practices. 101.A clearing relationship, in this context, refers to a service arrangement that enables customers to transfer funds (or securities) indirectly through direct participants in domestic settlement systems to final recipients.
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Such services are limited to the following activities: transmission, reconciliation and confirmation of payment orders; daylight overdraft, overnight financing and maintenance of post-settlement balances; and determination of intra-day and final settlement positions.
102.A custody relationship, in this context, refers to the provision of safekeeping, reporting, processing of assets or the facilitation of the operational and administrative elements of related activities on behalf of customers in the process of their transacting and retaining financial assets.

Such services are limited to the settlement of securities transactions, the transfer of contractual payments, the processing of collateral, and the provision of custody related cash management services.
Also included are the receipt of dividends and other income, client subscriptions and redemptions. Custodial services can furthermore extend to asset and corporate trust servicing, treasury, escrow, funds transfer, stock transfer and agency services, including payment and settlement services (excluding correspondent banking), and depository receipts. 103.A cash management relationship, in this context, refers to the provision of cash management and related services to customers. Cash management services, in this context, refers to those products and services provided to a customer to manage its cash flows, assets and liabilities, and conduct financial transactions necessary to the customer‘s ongoing operations. Such services are limited to payment remittance, collection and aggregation of funds, payroll administration, and control over the disbursement of funds. 104.The portion of the operational deposits generated by clearing, custody and cash management activities that is fully covered by deposit insurance can receive the same treatment as ―stable‖ retail deposits
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(c) Treatment of deposits in institutional networks of cooperative banks: 25% or 100%
105. An institutional network of cooperative (or otherwise named) banks is a group of legally autonomous banks with a statutory framework of cooperation with common strategic focus and brand where specific functions are performed by central institutions or specialized service providers. A 25% run-off rate can be given to the amount of deposits of member institutions with the central institution or specialised central service providers that are placed (a)due to statutory minimum deposit requirements, which are registered at regulators or (b)in the context of common task sharing and legal, statutory or contractual arrangements so long as both the bank that has received the monies and the bank that has deposited participate in the same institutional network‘s mutual protection scheme against illiquidity and insolvency of its members. As with other operational deposits, these deposits would receive a 0% inflow assumption for the depositing bank, as these funds are considered to remain with the centralised institution. 106. Supervisory approval would have to be given to ensure that banks utilising this treatment actually are the central institution or a central service provider of such a cooperative (or otherwise named) network. Correspondent banking activities would not be included in this treatment and would receive a 100% outflow treatment, as would funds placed at the central institutions or specialised service providers for any other reason other than those outlined in (a) and (b) in the paragraph above, or for operational functions of clearing, custody, or cash management as outlined in paragraphs 101-103.

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

(e) Unsecured wholesale funding provided by other legal entity customers: 100%
109.This category consists of all deposits and other funding from other institutions (including banks, securities firms, insurance companies, etc), fiduciaries, beneficiaries, conduits and special purpose vehicles, affiliated entities of the bank and other entities that are not specifically held for operational purposes (as defined above) and not included in the prior three categories.

The run-off factor for these funds is 100%.
110.All notes, bonds and other debt securities issued by the bank are included in this category regardless of the holder, unless the bond is sold exclusively in the retail market and held in retail accounts (including

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small business customer accounts treated as retail per paragraphs 89-91), in which case the instruments can be treated in the appropriate retail or small business customer deposit category.
To be treated in this manner, it is not sufficient that the debt instruments are specifically designed and marketed to retail or small business customers. Rather there should be limitations placed such that those instruments cannot be bought and held by parties other than retail or small business customers. 1 1 1. Customer cash balances arising from the provision of prime brokerage services, including but not limited to the cash arising from prime brokerage services as identified in paragraph 99, should be considered separate from any required segregated balances related to client protection regimes imposed by national regulations, and should not be netted against other customer exposures included in this standard. These offsetting balances held in segregated accounts are treated as inflows in paragraph 154 and should be excluded from the stock of HQLA.

(iii) Secured funding run-off
112.For the purposes of this standard, ―secured funding‖ is defined as those liabilities and general obligations that are collateralised by legal rights to specifically designated assets owned by the borrowing institution in the case of bankruptcy, insolvency, liquidation or resolution. 113.Loss of secured funding on short-term financing transactions: I n this scenario, the ability to continue to transact repurchase, reverse repurchase and other securities financing transactions is limited to transactions backed by HQLA or with the bank‘s domestic sovereign, PSE or central bank.

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Collateral swaps should be treated as repurchase or reverse repurchase agreements, as should any other transaction with a similar form.
Additionally, collateral lent to the bank‘s customers to effect short positions should be treated as a form of secured funding. For the scenario, a bank should apply the following factors to all outstanding secured funding transactions with maturities within the 30 calendar day stress horizon, including customer short positions that do not have a specified contractual maturity . The amount of outflow is calculated based on the amount of funds raised through the transaction, and not the value of the underlying collateral. 114.Due to the high-quality of Level 1 assets, no reduction in funding availability against these assets is assumed to occur. Moreover, no reduction in funding availability is expected for any maturing secured funding transactions with the bank‘s domestic central bank.

A reduction in funding availability will be assigned to maturing transactions backed by Level 2 assets equivalent to the required haircuts.
A 25% factor is applied for maturing secured funding transactions with the bank‘s domestic sovereign, multilateral development banks, or domestic PSEs that have a 20% or lower risk weight, when the transactions are backed by assets other than Level 1 or Level 2A assets, in recognition that these entities are unlikely to withdraw secured funding from banks in a time of market-wide stress. This, however, gives credit only for outstanding secured funding transactions, and not for unused collateral or merely the capacity to borrow. 115.For all other maturing transactions the run-off factor is 100%, including transactions where a bank has satisfied customers‘ short positions with its own long inventory.
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The table below summarises the applicable standards:

(iv) Additional requirements
116.Derivatives cash outflows: the sum of all net cash outflows should receive a 100% factor.
Banks should calculate, in accordance with their existing valuation methodologies, expected contractual derivative cash inflows and outflows. Cash flows may be calculated on a net basis (ie inflows can offset outflows) by counterparty, only where a valid master netting agreement exists. Banks should exclude from such calculations those liquidity requirements that would result from increased collateral needs due to market value movements or falls in value of collateral posted. Options should be assumed to be exercised when they are ‗in the money‘ to the option buyer. 117.Where derivative payments are collateralised by HQLA, cash outflows should be calculated net of any corresponding cash or collateral inflows that would result, all other things being equal, from contractual
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obligations for cash or collateral to be provided to the bank, if the bank is legally entitled and operationally capable to re-use the collateral in new cash raising transactions once the collateral is received.
This is in line with the principle that banks should not double count liquidity inflows and outflows. 118.Increased liquidity needs related to downgrade triggers embedded in financing transactions, derivatives and other contracts: (100% of the amount of collateral that would be posted for, or contractual cash outflows associated with, any downgrade up to and including a 3-notch downgrade). Often, contracts governing derivatives and other transactions have clauses that require the posting of additional collateral, drawdown of contingent facilities, or early repayment of existing liabilities upon the bank‘s downgrade by a recognised credit rating organisation. The scenario therefore requires that for each contract in which ―downgrade triggers‖ exist, the bank assumes that 100% of this additional collateral or cash outflow will have to be posted for any downgrade up to and including a 3-notch downgrade of the bank‘s long-term credit rating. Triggers linked to a bank‘s short-term rating should be assumed to be triggered at the corresponding long-term rating in accordance with published ratings criteria. The impact of the downgrade should consider impacts on all types of margin collateral and contractual triggers which change rehypothecation rights for non-segregated collateral. 119.Increased liquidity needs related to the potential for valuation changes on posted collateral securing derivative and other transactions: (20% of the value of non- Level 1 posted collateral). Observation of market practices indicates that most counterparties to derivatives transactions typically are required to secure the mark-to-market valuation of their positions and that this is predominantly
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done using cash or sovereign, central bank, multilateral development banks, or PSE debt securities with a 0% risk weight under the Basel I I standardised approach.
When these Level 1 liquid asset securities are posted as collateral, the framework will not require that an additional stock of H QLA be maintained for potential valuation changes. If however, counterparties are securing mark-to-market exposures with other forms of collateral, to cover the potential loss of market value on those securities, 20% of the value of all such posted collateral, net of collateral received on a counterparty basis (provided that the collateral received is not subject to restrictions on reuse or rehypothecation) will be added to the stock of required H QLA by the bank posting such collateral. This 20% will be calculated based on the notional amount required to be posted as collateral after any other haircuts have been applied that may be applicable to the collateral category. Any collateral that is in a segregated margin account can only be used to offset outflows that are associated with payments that are eligible to be offset from that same account. 120.Increased liquidity needs related to excess non-segregated collateral held by the bank that could contractually be called at any time by the counterparty: 100% of the non-segregated collateral that could contractually be recalled by the counterparty because the collateral is in excess of the counterparty‘s current collateral requirements. 121.Increased liquidity needs related to contractually required collateral on transactions for which the counterparty has not yet demanded the collateral be posted: 100% of the collateral that is contractually due but where the counterparty has not yet demanded the posting of such collateral. 1 2 2 . I ncreased liquidity needs related to contracts that allow collateral substitution to non-HQLA assets: 100% of the amount of H QLA
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collateral that can be substituted for non-HQLA assets without the bank‘s consent that have been received to secure transactions that have not been segregated.
123.Increased liquidity needs related to market valuation changes on derivative or other transactions: As market practice requires collateralisation of mark-to-market exposures on derivative and other transactions, banks face potentially substantial liquidity risk exposures to these valuation changes. I nflows and outflows of transactions executed under the same master netting agreement can be treated on a net basis.

Any outflow generated by increased needs related to market valuation changes should be included in the LCR calculated by identifying the largest absolute net 30-day collateral flow realised during the preceding 24 months.
The absolute net collateral flow is based on both realised outflows and inflows. Supervisors may adjust the treatment flexibly according to circumstances. 124.Loss of funding on asset-backed securities, 49 covered bonds and other structured financing instruments: The scenario assumes the outflow of 100% of the funding transaction maturing within the 30-day period, when these instruments are issued by the bank itself (as this assumes that the re-financing market will not exist). 125. Loss of funding on asset-backed commercial paper, conduits, securities investment vehicles and other such financing facilities: (100% of maturing amount and 100% of returnable assets). Banks having structured financing facilities that include the issuance of short-term debt instruments, such as asset backed commercial paper, should fully consider the potential liquidity risk arising from these structures. These risks include, but are not limited to, (i) the inability to refinance maturing debt, and
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(ii) the existence of derivatives or derivative-like components contractually written into the documentation associated with the structure that would allow the ―return‖ of assets in a financing arrangement, or that require the original asset transferor to provide liquidity, effectively ending the financing arrangement (―liquidity puts‖) within the 30-day period.
Where the structured financing activities of a bank are conducted through a special purpose entity50 (such as a special purpose vehicle, conduit or structured investment vehicle - SIV), the bank should, in determining the HQLA requirements, look through to the maturity of the debt instruments issued by the entity and any embedded options in financing arrangements that may potentially trigger the ―return‖ of assets or the need for liquidity, irrespective of whether or not the SPV is consolidated.

126. Drawdowns on committed credit and liquidity facilities: For the purpose of the standard, credit and liquidity facilities are defined as explicit contractual agreements or obligations to extend funds at a future date to retail or wholesale counterparties. For the purpose of the standard, these facilities only include contractually irrevocable (―committed‖) or conditionally revocable agreements to extend funds in the future. Unconditionally revocable facilities that are unconditionally cancellable by the bank (in particular, those without a precondition of a material change in the credit condition of the borrower) are excluded from this section and included in ―Other Contingent Funding Liabilities‖.

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These off balance sheet facilities or funding commitments can have long or short-term maturities, with short-term facilities frequently renewing or automatically rolling-over.
In a stressed environment, it will likely be difficult for customers drawing on facilities of any maturity, even short-term maturities, to be able to quickly pay back the borrowings. Therefore, for purposes of this standard, all facilities that are assumed to be drawn (as outlined in the paragraphs below) will remain outstanding at the amounts assigned throughout the duration of the test, regardless of maturity. 127.For the purposes of this standard, the currently undrawn portion of these facilities is calculated net of any H QLA eligible for the stock of HQLA, if the HQLA have already been posted as collateral by the counterparty to secure the facilities or that are contractually obliged to be posted when the counterparty will draw down the facility (eg a liquidity facility structured as a repo facility), if the bank is legally entitled and operationally capable to re-use the collateral in new cash raising transactions once the facility is drawn, and there is no undue correlation between the probability of drawing the facility and the market value of the collateral. The collateral can be netted against the outstanding amount of the facility to the extent that this collateral is not already counted in the stock of HQLA, in line with the principle in paragraph 72 that items cannot be double-counted in the standard. 128.A liquidity facility is defined as any committed, undrawn back-up facility that would be utilised to refinance the debt obligations of a customer in situations where such a customer is unable to rollover that debt in financial markets (eg pursuant to a commercial paper programme, secured financing transactions, obligations to redeem units, etc). For the purpose of this standard, the amount of the commitment to be treated as a liquidity facility is the amount of the currently outstanding
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debt issued by the customer (or proportionate share, if a syndicated facility) maturing within a 30 day period that is backstopped by the facility.
The portion of a liquidity facility that is backing debt that does not mature within the 30-day window is excluded from the scope of the definition of a facility. Any additional capacity of the facility (ie the remaining commitment) would be treated as a committed credit facility with its associated drawdown rate as specified in paragraph 131. General working capital facilities for corporate entities (eg revolving credit facilities in place for general corporate or working capital purposes) will not be classified as liquidity facilities, but as credit facilities. 129.Notwithstanding the above, any facilities provided to hedge funds, money market funds and special purpose funding vehicles, for example SPEs (as defined in paragraph 125) or conduits, or other vehicles used to finance the banks own assets, should be captured in their entirety as a liquidity facility to other legal entities. 130.For that portion of financing programs that are captured in paragraphs 124 and 125 (ie are maturing or have liquidity puts that may be exercised in the 30-day horizon), banks that are providers of associated liquidity facilities do not need to double count the maturing financing instrument and the liquidity facility for consolidated programs. 131.Any contractual loan drawdowns from committed facilities 51 and estimated drawdowns from revocable facilities within the 30-day period should be fully reflected as outflows.

(a) Committed credit and liquidity facilities to retail and small business customers:
Banks should assume a 5% drawdown of the undrawn portion of these facilities.

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(b)Committed credit facilities to non-financial corporates, sovereigns and central banks, PSEs and multilateral development banks: Banks should assume a 10% drawdown of the undrawn portion of these credit facilities.
(c)Committed liquidity facilities to non-financial corporates, sovereigns and central banks, PSEs, and multilateral development banks: Banks should assume a 30% drawdown of the undrawn portion of these liquidity facilities. (d)Committed credit and liquidity facilities extended to banks subject to prudential supervision: Banks should assume a 40% drawdown of the undrawn portion of these facilities. (e)Committed credit facilities to other financial institutions including securities firms, insurance companies, fiduciaries and beneficiaries: Banks should assume a 40% drawdown of the undrawn portion of these credit facilities. (f)Committed liquidity facilities to other financial institutions including securities firms, insurance companies, fiduciaries, and beneficiaries: Banks should assume a 100% drawdown of the undrawn portion of these liquidity facilities. (g)Committed credit and liquidity facilities to other legal entities (including SPEs (as defined on paragraph 125), conduits and special purpose vehicles,54 and other entities not included in the prior categories): Banks should assume a 100% drawdown of the undrawn portion of these facilities. 132.Contractual obligations to extend funds within a 30-day period. Any contractual lending obligations to financial institutions not captured elsewhere in this standard should be captured here at a 100% outflow rate. 1 3 3 . I f the total of all contractual obligations to extend funds to retail and non-financial corporate clients within the next 30 calendar days (not captured in the prior categories) exceeds 50% of the total contractual

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inflows due in the next 30 calendar days from these clients, the difference should be reported as a 100% outflow.
134.Other contingent funding obligations: (run-off rates at national discretion). National supervisors will work with supervised institutions in their jurisdictions to determine the liquidity risk impact of these contingent liabilities and the resulting stock of HQLA that should accordingly be maintained. Supervisors should disclose the run-off rates they assign to each category publicly. 135.These contingent funding obligations may be either contractual or non-contractual and are not lending commitments. Non-contractual contingent funding obligations include associations with, or sponsorship of, products sold or services provided that may require the support or extension of funds in the future under stressed conditions. Non-contractual obligations may be embedded in financial products and instruments sold, sponsored, or originated by the institution that can give rise to unplanned balance sheet growth arising from support given for reputational risk considerations. These include products and instruments for which the customer or holder has specific expectations regarding the liquidity and marketability of the product or instrument and for which failure to satisfy customer expectations in a commercially reasonable manner would likely cause material reputational damage to the institution or otherwise impair ongoing viability. 136.Some of these contingent funding obligations are explicitly contingent upon a credit or other event that is not always related to the liquidity events simulated in the stress scenario, but may nevertheless have the potential to cause significant liquidity drains in times of stress.
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For this standard, each supervisor and bank should consider which of these ―other contingent funding obligations‖ may materialise under the assumed stress events.
The potential liquidity exposures to these contingent funding obligations are to be treated as a nationally determined behavioural assumption where it is up to the supervisor to determine whether and to what extent these contingent outflows are to be included in the LCR. All identified contractual and non-contractual contingent liabilities and their assumptions should be reported, along with their related triggers. Supervisors and banks should, at a minimum, use historical behaviour in determining appropriate outflows. 137.Non contractual contingent funding obligations related to potential liquidity draws from joint ventures or minority investments in entities, which are not consolidated per paragraph 164 should be captured where there is the expectation that the bank will be the main liquidity provider when the entity is in need of liquidity. The amount included should be calculated in accordance with the methodology agreed by the bank‘s supervisor. 1 3 8 . I n the case of contingent funding obligations stemming from trade finance instruments, national authorities can apply a relatively low run-off rate (eg 5% or less). Trade finance instruments consist of trade-related obligations directly underpinned by the movement of goods or the provision of services, such as:

- documentary trade letters of credit, documentary and clean collection, import bills, and export bills; and
- guarantees directly related to trade finance obligations, such as shipping guarantees.

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139.Lending commitments, such as direct import or export financing for non-financial corporate firms, are excluded from this treatment and banks will apply the draw-down rates specified in paragraph 131.
140.National authorities should determine the run-off rates for the other contingent funding obligations listed below in accordance with paragraph 134. Other contingent funding obligations include products and instruments such as:

- unconditionally revocable "uncommitted" credit and liquidity facilities;
- guarantees and letters of credit unrelated to trade finance obligations (as described in paragraph 138); - non-contractual obligations such as: - potential requests for debt repurchases of the bank's own debt or that of related conduits, securities investment vehicles and other such financing facilities; - structured products where customers anticipate ready marketability, such as adjustable rate notes and variable rate demand notes (VRDNs); and - managed funds that are marketed with the objective of maintaining a stable value such as money market mutual funds or other types of stable value collective investment funds etc. - For issuers with an affiliated dealer or market maker, there may be a need to include an amount of the outstanding debt securities (unsecured and secured, term as well as short-term) having maturities greater than 30 calendar days, to cover the potential repurchase of such outstanding securities.

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- Non contractual obligations where customer short positions are covered by other customers‘ collateral: A minimum 50% run-off factor of the contingent obligations should be applied where banks have internally matched client assets against other clients‘ short positions where the collateral does not qualify as Level 1 or Level 2, and the bank may be obligated to find additional sources of funding for these positions in the event of client withdrawals.
141. Other contractual cash outflows: (100%). Any other contractual cash outflows within the next 30 calendar days should be captured in this standard, such as outflows to cover unsecured collateral borrowings, uncovered short positions, dividends or contractual interest payments, with explanation given as to what comprises this bucket. Outflows related to operating costs, however, are not included in this standard.

2. Cash inflows
142.When considering its available cash inflows, the bank should only include contractual inflows (including interest payments) from outstanding exposures that are fully performing and for which the bank has no reason to expect a default within the 30-day time horizon. Contingent inflows are not included in total net cash inflows. 143.Banks and supervisors need to monitor the concentration of expected inflows across wholesale counterparties in the context of banks‘ liquidity management in order to ensure that their liquidity position is not overly dependent on the arrival of expected inflows from one or a limited number of wholesale counterparties.

144.Cap on total inflows: I n order to prevent banks from relying solely on anticipated inflows to meet their liquidity requirement, and also to ensure a minimum level of HQLA holdings, the amount of inflows that can offset outflows is capped at 75% of total expected cash outflows as calculated in the standard.

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This requires that a bank must maintain a minimum amount of stock of HQLA equal to 25% of the total net cash outflows.
(i) Secured lending, including reverse repos and securities borrowing 145.A bank should assume that maturing reverse repurchase or securities borrowing agreements secured by Level 1 assets will be rolled-over and will not give rise to any cash inflows (0%). Maturing reverse repurchase or securities lending agreements secured by Level 2 HQLA will lead to cash inflows equivalent to the relevant haircut for the specific assets. A bank is assumed not to roll-over maturing reverse repurchase or securities borrowing agreements secured by non-H QLA assets, and can assume to receive back 100% of the cash related to those agreements. Collateralised loans extended to customers for the purpose of taking leveraged trading positions (―margin loans‖) should also be considered as a form of secured lending; however, for this scenario banks may recognise no more than 50% of contractual inflows from maturing margin loans made against non-HQLA collateral. This treatment is in line with the assumptions outlined for secured funding in the outflows section. 146.As an exception to paragraph 145, if the collateral obtained through reverse repo, securities borrowing, or collateral swaps, which matures within the 30-day horizon, is re-used (ie rehypothecated) and is used to cover short positions that could be extended beyond 30 days, a bank should assume that such reverse repo or securities borrowing arrangements will be rolled-over and will not give rise to any cash inflows (0%), reflecting its need to continue to cover the short position or to re-purchase the relevant securities. Short positions include both instances where in its ‗matched book‘ the bank sold short a security outright as part of a trading or hedging strategy and instances where the bank is short a security in the ‗matched‘ repo
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book (ie it has borrowed a security for a given period and lent the security out for a longer period).

1 4 7 . I n the case of a bank‘s short positions, if the short position is being covered by an unsecured security borrowing, the bank should assume the unsecured security borrowing of collateral from financial market participants would run-off in full, leading to a 100% outflow of either cash or HQLA to secure the borrowing, or cash to close out the short position by buying back the security.

This should be recorded as a 100% other contractual outflow according to paragraph 141.
If, however, the bank‘s short position is being covered by a collateralised securities financing transaction, the bank should assume the short position will be maintained throughout the 30-day period and receive a 0% outflow. 148.Despite the roll-over assumptions in paragraphs 145 and 146, a bank should manage its collateral such that it is able to fulfil obligations to return collateral whenever the counterparty decides not to roll-over any reverse repo or securities lending transaction. This is especially the case for non-H QLA collateral, since such outflows are not captured in the LCR framework.
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Supervisors should monitor the bank's collateral management.

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

(iii) Other inflows by counterparty
150.For all other types of transactions, either secured or unsecured, the inflow rate will be determined by counterparty. In order to reflect the need for a bank to conduct ongoing loan origination/ roll-over with different types of counterparties, even during a time of stress, a set of limits on contractual inflows by counterparty type is applied. 151.When considering loan payments, the bank should only include inflows from fully performing loans. Further, inflows should only be taken at the latest possible date, based on the contractual rights available to counterparties. For revolving credit facilities, this assumes that the existing loan is rolled over and that any remaining balances are treated in the same way as a committed facility according to paragraph 131.
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152. I nflows from loans that have no specific maturity (ie have non-defined or open maturity) should not be included; therefore, no assumptions should be applied as to when maturity of such loans would occur.
An exception to this would be minimum payments of principal, fee or interest associated with an open maturity loan, provided that such payments are contractually due within 30 days. These minimum payment amounts should be captured as inflows at the rates prescribed in paragraphs 153 and 154.

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

(b) Other wholesale inflows
154. This scenario assumes that banks will receive all payments (including interest payments and instalments) from wholesale customers that are fully performing and contractually due within the 30-day horizon. In addition, banks are assumed to continue to extend loans to wholesale clients, at a rate of 0% of inflows for financial institutions and central banks, and 50% for all others, including non-financial corporates, sovereigns, multilateral development banks, and PSEs. This will result in an inflow percentage of:
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- 100% for financial institution and central bank counterparties; and
- 50% for non-financial wholesale counterparties. 1 5 5 . I nflows from securities maturing within 30 days not included in the stock of H QLA should be treated in the same category as inflows from financial institutions (ie 100% inflow). Banks may also recognise in this category inflows from the release of balances held in segregated accounts in accordance with regulatory requirements for the protection of customer trading assets, provided that these segregated balances are maintained in H QLA. This inflow should be calculated in line with the treatment of other related outflows and inflows covered in this standard. Level 1 and Level 2 securities maturing within 30 days should be included in the stock of liquid assets, provided that they meet all operational and definitional requirements, as laid out in paragraphs 28-54. 156.Operational deposits: Deposits held at other financial institutions for operational purposes, as outlined in paragraphs 93-103, such as for clearing, custody, and cash management purposes, are assumed to stay at those institutions, and no inflows can be counted for these funds – ie they will receive a 0% inflow rate, as noted in paragraph 98. 157.The same treatment applies for deposits held at the centralised institution in a cooperative banking network, that are assumed to stay at the centralised institution as outlined in paragraphs 105 and 106; in other words, the depositing bank should not count any inflow for these funds – ie they will receive a 0% inflow rate.

(iv) Other cash inflows
158. Derivatives cash inflows: the sum of all net cash inflows should receive a 100% inflow factor.

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The amounts of derivatives cash inflows and outflows should be calculated in accordance with the methodology described in paragraph 1 16.
159.Where derivatives are collateralised by HQLA, cash inflows should be calculated net of any corresponding cash or contractual collateral outflows that would result, all other things being equal, from contractual obligations for cash or collateral to be posted by the bank, given these contractual obligations would reduce the stock of H QLA. This is in accordance with the principle that banks should not double-count liquidity inflows or outflows. 160.Other contractual cash inflows: Other contractual cash inflows should be captured here, with explanation given to what comprises this bucket. Inflow percentages should be determined as appropriate for each type of inflow by supervisors in each jurisdiction. Cash inflows related to non-financial revenues are not taken into account in the calculation of the net cash outflows for the purposes of this standard.

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

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

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

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167. To ensure consistency in applying the consolidated LCR across jurisdictions, further information is provided below on two application issues.

1. Differences in home / host liquidity requirements
168.While most of the parameters in the LCR are internationally ―harmonised‖, national differences in liquidity treatment may occur in those items subject to national discretion (eg deposit run-off rates, contingent funding obligations, market valuation changes on derivative transactions, etc) and where more stringent parameters are adopted by some supervisors. 169.When calculating the LCR on a consolidated basis, a cross-border banking group should apply the liquidity parameters adopted in the home jurisdiction to all legal entities being consolidated except for the treatment of retail / small business deposits that should follow the relevant parameters adopted in host jurisdictions in which the entities (branch or subsidiary) operate. This approach will enable the stressed liquidity needs of legal entities of the group (including branches of those entities) operating in host jurisdictions to be more suitably reflected, given that deposit run-off rates in host jurisdictions are more influenced by jurisdiction-specific factors such as the type and effectiveness of deposit insurance schemes in place and the behaviour of local depositors. 1 7 0 . H ome requirements for retail and small business deposits should apply to the relevant legal entities (including branches of those entities) operating in host jurisdictions if: (i)there are no host requirements for retail and small business deposits in the particular jurisdictions; (ii)those entities operate in host jurisdictions that have not implemented the LCR; or

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(iii) the home supervisor decides that home requirements should be used that are stricter than the host requirements.

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

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

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

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Summary Responses To the Commissions‘ Green Paper on Shadow Banking 1.Executive Summary
The European Commission's consultation on shadow banking attracted high interest from stakeholders. The comments provided cover a broad range of issues and responded to all the questions raised by the European Commission Green Paper. The Commission received in total 140 contributions, of which 24 from Public Authorities; 47 from registered organisations; and, 64 from individual organisations. Five organisations asked for their submissions to remain confidential.

The key messages received from stakeholders are broadly in line with the feedback received at the shadow banking conference, organised by the European Commission on 27 April 2012 in Brussels:
-There is general support for the European Commission's initiative in this area. Work should continue to improve the regulatory system in the EU and to ensure global consistency -There is a growing consensus that supervision and a strengthened regulatory framework is needed to harness the shadow banking system -It is necessary to preserve a useful channel of financial intermediation that can provide benefits to the real economy at a time when bank financing is more constrained -The scope of regulation should be comprehensive and flexible enough to be adaptable to future developments
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-The room for regulatory arbitrage should be reduced and regulatory divergence in the EU eliminated
- The focus should be on activities and entities that could pose systemic risk to the financial markets -Potential legislative measures should take existing legislation into account and should be proportionate; and -Transparency and data collection need to be improved in order to strengthen the basis for further policy decisions. In addition to the key messages, more detailed comments have been provided in response to the different areas covered by the Green Paper.

Scope and definition
Respondents to the consultation acknowledged that the term "shadow banking" is widely used and broadly supported, but some stakeholders suggested that the term should be changed.

They argued that the current term is very broad and provides a negative connotation.
Some stakeholders suggested that the term should better reflect the characteristics of the entities or activities and suggested to replace it by "activities that are not regulated and not supervised"; "parallel banking"; or "market-based finance". Some stakeholders underlined the need for more specified definitions. For example, issues such as credit activities, credit guarantees, leasing or finance companies providing credit or credit guarantees should be used in a more consistent manner, at least at European level. On the other hand, some respondents commented that a definition for shadow banking needs to be sufficiently flexible to be adaptable to future developments in the area of shadow banking.
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Other stakeholders suggested that the scope of shadow banking needs to be further specified.
The Financial Stability Board (FSB) has put forward a definition which is acceptable to many stakeholders (in short: non-banks performing credit intermediation), although some of them argue that it should either be more comprehensive or should provide a better distinction between entities and activities. Stakeholders commented that shadow banking should only include entities and credit activities which are currently not (or not sufficiently) regulated and pose a systemic risk to the financial system. According to them credit intermediation and maturity transformation are key features of shadow banking activities. More focus should be on the issue of systemically relevant activities. Representatives of certain industries (e.g. investment funds, leasing companies, Factoring companies or credit insurance undertakings) argued that their activities should not be within the scope of shadow banking either because they don‘t meet the definition, or because they are already subject to regulation and double regulation should be avoided.

General principles to follow
Many stakeholders underlined that shadow banking activities largely serve the real economy. Existing channels of financing should be preserved. However, some expressed concerns about the usefulness of certain activities in view of their contribution to the overall social welfare. Stakeholders in general expressed support for measures already taken at EU level, although some respondents suggested that non-binding measures might not be sufficient to address existing shortcomings of regulation.
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The point was made that new regulation should take current developments in other areas where existing regulation is currently being revised (CRD IV, Solvency I I, etc.) into account, since they may alter the structural characteristics of the EU financial system.
Stakeholders reminded that bank and non-bank activities are intertwined. Several stakeholders asked for a careful assessment of the potential consequences of any new initiatives and their cumulative impacts with other financial regulations to be implemented.

Any legal measure should be proportionate and primarily targeted at entities and activities that pose significant systemic risk to the financial system.
Support was expressed for the general principles for the supervision of shadow banking, including that it should: (i) Be performed at the appropriate level, i.e. national and/ or European (ii) Be proportionate (iii)Take into account existing supervisory capacity and expertise (iv) Be integrated with the macro-prudential framework Other respondents proposed the elimination of existing differences in EU supervision in order to reduce regulatory arbitrage, at least in Europe, but also internationally. Ideally, stakeholders would like to see any response to "shadow banking" activities to be coordinated on a global level in a coherent way and stressed that coordination is needed between existing work streams at the level of FSB, I OSCO, ECB, ESMA and the Basel Committee. Some stakeholders expressed concerns whether traditional banking regulation per se may be appropriate to address the risks inherent in the shadow banking system.
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However, they underlined that activities that involve credit risk should be subject to similar solvency and liquidity requirements as credit institutions starting from a certain threshold, i.e. similar activities should be subject to similar regulations.
In addition, respondents to the consultation (called for?) improved convergence and equivalence in the area of related international standards, such as Basel requirements or I nternational Financial Reporting Standards (IFRS), which could result in improved transparency for example regarding off-balance sheet activities.

Many stakeholders expressed support for an enhancement of the existing legal framework, (e.g. UCITs, AIFMD, EM IR, CRD, etc.), rather than the development of a separate regulatory regime focusing on shadow banking activities.
They feared that this would avoid distortion of the competitiveness of the EU financial sector.

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

Monitoring and transparency
There was broad agreement amongst stakeholders that transparency should be enhanced with a view to improve supervision and market discipline.
Data collection was seen by many respondents as a prerequisite for a
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better understanding of shadow banking activities and their implications in order to facilitate monitoring solutions, which would allow for better targeted interventions.
Indirect regulation was regarded by a number of respondents as an efficient tool to capture some of the risks posed by shadow banks. It was suggested that for example the large exposures regime should act as a backstop regime also to shadow banking activities and tackle the risk of interconnectivity by ensuring proper identification of interconnections.

Stakeholders did not object to the idea of regular monitoring and data collection in general and welcomed the work of the European Central Bank (ECB) in this area so far.
In addition, they suggested that the role of the European Systemic Risk Board (ESRB) regarding monitoring macroeconomic risks by collecting and bundling EU wide information should be further clarified.

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

2. Feedback Statement 1. Introduction and international developments
The 2008 global financial crisis was caused by regulatory gaps, ineffective supervision, opaque markets and overly-complex products. The European Union has shown global leadership in implementing the G20 commitments and has undertaken the biggest financial regulatory reform ever. However, there is still an increasing area of non-bank credit activity, or shadow banking, which has not been the prime focus of prudential regulation and supervision to date. Although shadow banking performs important functions in the financial system, there is a common understanding that it can also pose potential threats to long-term financial stability. Against this background, the Commission considers it a priority to examine in detail the issues posed by shadow banking activities and entities. The objectives are to respond actively and further contribute to the global debate; to continue to increase the resilience of the Union‘s financial system; and, to ensure that all financial activities contribute to economic growth. The European Commission Green Paper described shadow banking as "the system of credit intermediation that involves entities and activities (fully or partially) outside the regular banking system." This definition is in line with the definition proposed by the Financial Stability Board (FSB).

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

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

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

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

2. Responses to the Consultation 1.Summary of Responses General Comments
Consultation respondents provided very detailed responses to the specific questions raised by the Green Paper. Many of them also provided general comments covering a broad range of areas.
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Some respondents regarded the term shadow banking inappropriate since it seems to suggest – in particular when translated into other languages - that activities within the scope of the shadow banking definition are regarded as harmful and that there is a lack of regulation outside the banking sector in Europe.
Although a large number of respondents agreed with the definition of shadow banking used in the Green Paper, some stakeholders argued that the definition developed by FSB is generally too broad. As a consequence certain sectors, entities or activities should not be captured by the definition, e.g. factoring, certain insurance activities and investment funds since they are already subject to regulation. On the other hand other stakeholders argued that the definition should be broad enough to catch as many activities as possible. Many stakeholders emphasised the need for global coordination in order to make sure that existing or future incentives for regulatory arbitrage are limited, in particular in view of the stricter regulation for banks and insurance entities currently under negotiation. Stakeholders stressed that an EU approach should not contradict recommendations developed by international organisations such as FSB, Basel or IOSCO. Some stakeholders warned that the benefits coming from the shadow banking system should be identified and conserved and they stressed the importance of considering the negative effects posed by any new regulation on different market participants. Other stakeholders argued that any future regulation should be proportionate and focused on entities/activities posing systemic risks to the financial system. The preference should be for enhancement of the existing legal framework instead of issuing a separate shadow banking regulation regime.
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Part of the policy reaction should be to look at the nonhomogenous supervisory architecture in Europe and increase the level of harmonisation.
Existing and future policy proposals should be coherent. The point was made that the interconnectedness between the banking and the nonbanking sector was regarded as substantial. Therefore more transparency is needed in the banking sector.

It was highlighted that there is a need for better information collection processes, greater market transparency and regular monitoring to identify areas of systemic risk.

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

It should be more specifically looking at non regulated activities.
Other respondents to the consultation expressed the view that the proposed definition is a good basis mainly because it covers entities as well as activities, which seemed to be a critical issue.
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Some stakeholders suggested defining entities/activities that should not be in the scope of shadow banking rather than the other way around.
This would avoid that the approach becomes too broad. Others suggested that the definition should be operational, open and as broad as possible in order to be adaptable to changing market realities and entities and activities that should be included. A number of respondents stressed the need for compliance with the FSB definition and made a strong case for using a common global definition in order to limit the potential room for arbitrage and to ensure global consistency.

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

A number of stakeholders suggested that certain activities should not be in the focus of the shadow banking debate.
The argument was made, mainly by industry representatives, that activities for example in the area of securities lending and repo activities should be considered as shadow banking only with supplementary criteria (e.g. use of repo to gain leverage in excess of a certain hurdle). Others argued that the definition of MMF type funds within the sector of shadow banking is not satisfactory, as it suggests a link between risk run and deposit-like characteristics. The argument was made that the risk born by MMFs stems from the discrepancy between mark-to-market and published N AV in the specific case of MMFs measured at a constant value (C-NAVs).

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

Question c - Do you agree that shadow banking can contribute positively to the financial system? Are there other beneficial aspects from these activities that should be retained and promoted in the future?
The positions expressed by respondents to the consultation were mixed on this question.
A number of stakeholders acknowledged that there are benefits created by the shadow banking sector, e.g. the enhancement of innovation and competition or diversification of investments.
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They suggested that shadow banking also contributed to the wider economy by providing credible, sound and alternative investment opportunities and vital sources of financing for businesses. Other benefits mentioned included the following: - Shadow banking increases the number of financial firms and thus can reduce the size of market participants. In this sense it can help address the risks of ‗too big to fail‘ financial institutions. - Shadow banking provides additional diversity in the financial ecosystem, helping to ensure that it does not become widely or mainly dependent on the behaviour of banks. - It is important not to create a system in which all or most of the players act like banks. - Shadow banking can provide financial services not necessarily offered by regular banks, such as market making, thereby improving market liquidity. - Shadow banking can help closing a funding gap and reinforce the stability of the financial system (a decentralised financial system avoids concentration of business; less transmission of systemic risk). - The emergence of alternative funding solutions should not be deterred by heavy regulation. Other stakeholders were more cautious in terms of the potential benefits and expressed support only if shadow banking facilitates long-term investment and thus were doubtful about benefit of financial innovation to growth. On the other hand several stakeholders argued that there are no benefits related to shadow banking activities, since their success appears only to be linked to the fact that they rely on a lack of regulation and are based on unfair competition.
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It was doubted that unregulated activities could be seen as contributing to a more stable financial system and add social welfare to the society as a whole.
Some stakeholders were also concerned about access to finance for companies, in particular SMEs. They suggested that any new legislation should not work against the interest and needs of firms. As regards the possible risk diversification, some respondents expressed the view that shadow banking activities can even increase the risks for the real economy, since it is questionable whether they can provide an alternative source of funding during a period of crisis. Overall, stakeholders expressed a clear view that, notwithstanding the benefits, the inherent risks of shadow banking justify an appropriate policy response.

Question d - Do you agree with the description of channels through which shadow banking activities are creating new risks or transferring them to other parts of the financial system?
Although there was general support for the description of the channels through which shadow banking systems are creating new risks, most respondents expressed reservations. One respondent expressed disagreement with the implicit assumption that institutions that facilitate or support shadow banking are doing this only to avoid regulatory intervention. Others argued that the description is only applicable to certain types of shadow banking activities, since there are many other non-bank activities which simply supply the market with additional liquidity, without using excessive leverage, e.g. asset management funds.

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In the same context, a number of respondents, mainly from the financial sector, argued that, in contrast to general assumptions, certain entities or activities, such as investment funds, do not pose systemic risks.
For example, MMFs create less liquidity transformation than banks; asset-liability maturity mismatch is very limited; credit quality is high; and, there are already high standards for liquidity risk management ensuring that redemption requests are met. The argument was made that in some areas the level of regulation is already high, such as risk management and leverage, as covered by the UCITS and AIFM regime. In addition, fund managers can temporarily suspend redemptions or use "gates" to manage redemption requests. The high degree of existing regulation and supervision prevents investment funds from being used to circumvent banking regulation. Other areas of risk (for example hidden leverage, regulatory arbitrage, disorderly failures, massive sales and runs) where regarded by some respondents as overstated or not limited to the shadow banking sector alone, and thus specific regulation aimed at shadow banking activities was not regarded as the preferred response. A number of respondents expressed support for the risks mentioned in the Green Paper and stressed that four risk groups should in particular be addressed: (i)A more focused monitoring system should be put in place; (ii)A tighter and better coordinated regulation focussing on stability/ health of financial system is needed; (iii)Convergence with other international regulatory systems, e.g. the US Dodd-Frank Act, might be useful; and

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(iv) Enhanced transparency and quantification of the impact of shadow banking activities is necessary.
Another suggestion made was to investigate the separation between commercial banking activities and other activities of the banking group. This would be in follow-up to the report issued by the High Level Expert Group chaired by Erkki Liikanen.

Question e - Should other channels be considered through which shadow banking activities are creating new risks or transferring them to other parts of the financial system?
A number of respondents to the consultation stated that additional channels should be considered. Some respondents underlined that in addition to the general size of shadow banking, which can cause systemic risks, the reputational risk that shadow banking may entail for regular banks should be considered. Another issue mentioned was called the ―Paradox of diversification‖, meaning that the more financial institutions start to behave similarly in their diversification strategy to reduce individual risks, the more the correlation of assets classes will increase resulting in higher systemic risk. Also the risk of shadow banking institutions being used as instruments to hide illicit activities (e.g. tax fraud or money laundering strategies) was mentioned. Many respondents confirmed that a significant amount of the risk is linked to the complexity and lack of transparency of products, structures or activities in the area of shadow banking. It was mentioned that misalignments or even conflicts of interests may arise in securitisation-based credit intermediation, which do not exist for a traditional bank lending from its own balance sheet.

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This may result in a supply of poorly underwritten loans and structured securities, which could threaten the collapse of entire markets.
Complexity was mentioned by some respondents as another channel through which risks can be created, since the longer the chain of financial intermediation in shadow banking is, the more entities will be exposed to the knock-on effects of dislocation at some point further up the chain. Moreover, the complexity of the links that may form between shadow banks could have destabilising network effects.

In addition, the lower the quality of the loan, the longer the chain that may be required to enhance the quality of the assets to the standards needed to sell to money market mutual funds and other end investors, thereby creating more risks.
Some respondents commented that complexity reduces transparency, which can be misleading for intermediaries, investors and regulators in terms of risk allocation. This may allow ―risks to accumulate unnoticed and unchecked‖ giving rise to the possibility that, ―when hidden risks suddenly become apparent, market participants effectively panic‖. Opacity may also spawn ―fraud, misconduct, and other opportunistic behaviour‖. Others suggested that the reliance of shadow banking on collateralised wholesale market funding may amplify economic and market cycles by facilitating leverage when asset prices are buoyant and margins and haircuts are low.

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

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

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

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Some respondents highlighted that, since the shadow banking system will continue to evolve, it is important that regulation can be adapted to new developments.
Others stressed the need for regulation and principles to be deliverable and operational. In addition, new policy should only be adopted subject to EU wide consultation and cost benefit analysis. Some respondents expressed disagreement with the principles, unless a more extensive mapping of shadow banking with an indication of the corresponding level of risk for each activity and entity is undertaken. Furthermore a clearer definition of priorities and exemptions should be developed before the principles are applied.

Question I - Do you agree with the general principles for regulatory responses set out above?
Stakeholders broadly agreed with the general principles for regulatory responses (Green Paper, page 7), but expressed some preferences and nuances to the approach: Stakeholders suggested that shadow banking entities and activities that incur credit risk (even those that do not collect customer deposits) should be subject to similar solvency and liquidity requirements as credit institutions once their level of activity passes a certain threshold. However, the different stages of development in different countries should be recalled in this context. Others warned that the extension of existing banking regulation to shadow banking entities should be carefully considered, in order to determine whether the provisions suitable for the banking sector will have the same effect on the shadow banking sector.

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In addition there has to be clear distinction between banks and shadow banks, so that credit institutions are not subjected to double regulation.
It was suggested by some respondents that a regulatory response should be appropriately calibrated, in order to carefully consider how market activities are performed; avoid unintended consequences; preserve the benefits of shadow banking; and, ensure a level playing field between the regulated banking and non-regulated financial sectors performing similar activities. Any regulatory proposal should comply with the policy recommendations developed by FSB, I OSCO or the Basel Committee. Stakeholders stressed that, in their view, the most effective approach would be to focus on the extension or revision of existing mechanisms. They argued that any new measures would suffer from static definitions and that indirect regulation might not sufficiently target shadow banking concerns. Aspects such as tax avoidance schemes should also be taken into account. An approach based on economic substance and activity, rather than on fixed and narrowly-defined entities, was regarded as more effective. Instruments for addressing the links between regulated entities/ activities and the shadow banking sector were regarded as necessary. It was suggested that for this purpose a number of micro-prudential instruments could be used to address macro-prudential aims, for example:

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

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

Question j - What measures could be envisaged to ensure international consistency in the treatment of shadow banking and avoid global regulatory arbitrage?
This issue was regarded by almost all stakeholders as key, in order to avoid the creation of loopholes or incentives for regulatory arbitrage at the international level. Most respondents therefore argued for consistent regulatory guidelines across countries. In particular the FSB and IOSCO were mentioned as organisations which should ensure international coordination. For example the adoption of an internationally-consistent definition for shadow banking systems was regarded as a crucial element.

It was suggested that the EU should comply with the FSB's recommendations as far as possible and it should establish an integrated framework for macro and micro prudential supervision alongside global information and data exchange framework at global level.
A regular exchange and sharing of information and data between authorities could be achieved by the implementation of the Global Legal Entity I dentifier (LEI). Certain respondents highlighted that the existing regulatory framework, i.e. Basel 2 and 2.5, already contain sufficient regulatory instruments that would allow for a stronger focus on international consistency . The important role of peer reviews was mentioned in this context.

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Others suggested that more harmonisation through the removal of materially-unjustified differences (e.g. in accounting and consolidation rules) should be achieved.
They stressed that risks related to the shadow banking sector are currently heightened to a varying extent across the EU, not only due to differences in regulation but also because of differences in interpretation and enforcement. To this end, a greater use of regulations instead of directives in EU legislation and direct supervision at EU level were mentioned as appropriate measures. On the other hand, some stakeholders warned that full harmonisation and coordination at the international level may not be achievable due to the different structures of different markets, e.g. MMFs. Others were more cautious and warned that global harmonisation would be unrealistic at this stage. However, they were optimistic that reliance on the FSB framework and more extensive use of peer reviews (e.g. by the IM F FSAP and FSB) could be beneficial.

Question k - What are your views on the current measures already taken at the EU level to deal with shadow banking issues?
Stakeholders summarised measures already taken at EU level, in particular legislation in the area of AIFMD, MiFID, UCIT S or CRAs. These were broadly welcomed and regarded as appropriate measures for addressing key concerns. However, some respondents expressed concerns regarding the cumulative impact of the measures and commented that the effect on

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

Question l - Do you agree with the analysis of the issues currently covered by the five key areas where the Commission is further investigating options?
Stakeholders broadly agreed with the five areas mentioned (Green Paper, pages 1 1-13), which largely reflect the five work streams set up by the FSB.

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Hence, most respondents stressed that the final outcome of the FSB work should be taken into account.
The following specific comments were made:

(i) Banking regulation
Most respondents believe that CRD/ CRR IV will improve the regulation of shadow banks and will provide powers to set capital and liquidity guidance via a macro-prudential tool-kit.

As regards the links between the banking and unregulated sectors, consolidation policy can play a role in ensuring the "same business, same rules" principle.
Financial reporting requirements according to IFRS and capital guidance under CRDII / I I I, if applied consistently, provide a good basis for managing risks arising from banks' interaction with the shadow banking sector.

(ii) Asset management regulation issues
Most of the comments were related to MMFs and ETFs. Regarding MMFs the risks highlighted by I OSCO (runs, contagion risk, and implicit guarantee of sponsors for return of capital, constant NAV funds, rating risk) were mentioned. Views regarding valuation (constant versus variable NAV) were mixed. Some respondents suggested that MMFs are not vulnerable to massive redemptions and should not be considered shadow banking entities/activities, with the exception of C-NAV MMFs. They considered that MMFs are not a source of significant maturity transformation within Europe and represent limited risk.

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Others took the opposite view and argued for a substantial revision of MMF regulation.
Other comments included a proposal to exclude certain asset classes, such as raw materials, from UCITS since they would not provide added value to the society, Regarding ETFs the ESMA guidelines were considered to establish a harmonized framework on the quality of collateral; prohibited transaction for re-use of collateral; prevention of conflicts of interest; and liquidity of the fund, although there seemed to be a preference for making those rules binding.

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

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

(v) Other shadow banking entities
This area is still under consideration by the FSB (work stream 3). Most respondents therefore asked for further clarification and suggested waiting for the outcome of the FSB work. Based on initial results of the FSB work, mapping of entities, risks and regulation was regarded as the right approach, with a clear focus on activities and not entities. In addition to the five key areas, a number of respondents argued for improvements regarding the overall transparency of the shadow banking sector and in particular in the area of repos and securities lending transactions.

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The setting up of trade repositories was broadly supported, mainly because this could help tracking counterparty risk and potential conflicts of interest.
However, this should ideally be pursued in parallel to harmonised reporting and accounting requirements.

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

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For example it could be assessed by EBA and recognised as eligible asset in the context of CRD I V.

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

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Others argued in the opposite direction, maintaining that the current regulation of MMFs appropriately addresses inherent risks.

Question o - What other measures, such as increased monitoring or non-binding measures should be considered?
Stakeholders suggested a number of other measures that should be considered: - A constant reassessment of risk mapping exercise should be conducted by relevant authorities; - The regulatory system needs to be suitably dynamic in order to address new regulatory issues related to the inventiveness of shadow banking sector; - Transparency of supervisory systems can be improved by the publication of core indicators, such as supervisory personnel per employee in the financial sector etc.; - While the "single rule book" is supported, a framework should be set up allowing macro-prudential authorities some "constrained discretion" (with safeguards) in setting higher standards to deal with financial stability risks in their jurisdiction arising from SB. In addition, subject to the safeguards, it is necessary to allow for a flexible and targeted application of macro-prudential instruments to sectors, entities and activities (including a process enabling new instruments to be activated swiftly when need arises to address specific systemic risks concerns); - More transparency is needed, e.g. a European trade repository for repos; and - A better exchange of data and information between supervisors and the creation of EU databases without duplication of data or overburden regulated intermediaries would be beneficial in order to reduce systemic risks.
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2.2.2. General Overview of the Consultation
In order to develop a deeper understanding of the issues, the European Commission launched a Green Paper and consultation from 19 March to 15 June 2012. The key objective of the Green Paper was to consult stakeholders on shadow banking issues: definition, risks and benefits, the need for stricter monitoring and regulation, outstanding issues and possible next steps. The Commission received in total 140 contributions, of which 24 from Public Authorities, 47 from registered organisations and 64 from individual organisations. Five organisations asked for their submission to remain confidential. The largest number of responses was submitted from stakeholders in the UK, France, and Germany and from EU based firms or associations. In terms of professional background, the most submissions came by far from the financial sector, including financial institutions and associations. A considerable number of submissions came from the public sector, governments, national banks and regulators.

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2.2.3. List of participants
1.National Bank of Romania 2. AXA Investment Managers 3. ABI Associazione Bancaria I taliana 4. Confidentiality requested 5. Nomura International plc 6. CNMV Advisory Committee of the Spanish Securities Market Law 7. Markit I nc 8. EIOPA – European I nsurance and Occupational Pensions Authority 9. HFSB – Hedge Fund Standards Board 10.MFA – Managed Funds Association 11.European Network of Credit Unions 12.VGF - Verband Geschlossene Fonds 13.EBG - European Banking Group 14.DIH K – Deutscher Industrie- und H andelskammertag e.V. 15.Rolls Royce plc 16.LeaseEurope AISBL 17.CLLS - City of London Law Society
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1 8 . I FCR - International Centre for Financial Regulation 19.Confidentiality requested 20. ESBG - European Savings Bansk Group 21.BBA - British Bankers' Association 22.Dansk Aktionaerforening 23.Eurofinas AISBL 24. Genworth I nc 25.Finance Watch AISBL 26.EBF - European Banking Federation 27. Government of Poland 28. Central Bank of Ireland 29.VÖB - Bundesverband Öffentlicher Banken Deutschlands 30.VNO-NCW and MKB Netherlands 31. ASF Association Française des Societes Financieres 32.Tamar Joulia Paris and Casey Campbell 33.Trade Union Pro Finland 34. Clifford Chance 35.FLA - Finance and Leasing Association 36.Ministry of Finance Finland 37.VVD Group – Volkspartij voor Vrijheid en Democratie 38.TSI True Sale I nternational GmbH 39.MBIA UK I nsurance Limited 40.AFGI Association of Financial Guaranty I nsurers 41. GCAE - Group Consultatif Actuariel European 4 2 . Z IA - Zentraler Immobilien Ausschuss e.V. 43.Lithuanian Free Market I nstitute 44. Royal Ministry of Finance Norway 45.FMA – Financial Market Authority Austria 46. Groupe GTI – Gestion et Titrisation Internationales 47. BdB – Bundesverband Deutscher Banken 48. APB - Portuguese Banking Association 49.Tiberiu Tudor Salantiu 50.UniCredit Group 51.ABFA – Asset Based Finance Association 52. Mazars 53.AMUNDI Asset Management 54. BBF - Belgian Association of Factoring Companies 55.Financial Services User Group
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56.CGPME 57. Jersey Financial Services Commission 58.MEDEF – Mouvement des Entreprises de France 59. Sciteb 60.Deutscher Factoring Verband e.V. 61.NFU - Nordic Financial Unions 62. BAK - Bundesarbeitskammer Austria 63. Confidentiality requested 64.Ministry of Finance Czech Republic 65. af2i – association française des investisseurs institutionnels 66.ICMA - ERC European Repo Council 67. ESRB – European Systemic Risk Board 68.DSGV – German Savings Banks Association 69.FAAN – Factoring and asset-based financing Association Netherlands 70.Melanie L. Fein 71.CNB – Czech N ational Bank 72.UNI Europa 73. Government of the N etherlands 74.IFC Forum 75.GDV – Gesamtverband der Deutschen Versicherungswirtschaft e.V. 76. RBS Group plc 77. KEPKA – Consumer Protection Centre Greece 78.IM MFA – Institutional Money Market Funds Association 79. Allianz SE 80. HSBC Global Asset Management 81.LMA - The Loan Market Association 82. Veblen I nstitute for Economic Reforms 83. Chris Barnard, Actuary, Germany 84.Maria Niewiadoma, Poland 85.ICISA – International Credit I nsurance & Surety Association 86. Jeroen Spaargaren 87.ABI - Association of British I nsurers 88. Banco de Portugal 89. CBI – Confederation of British I ndustry 90.ICI - Investment Company I nstitute 9 1 . I IF – Institute of International Finance
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92.German Authorities – Deutsche Bundesbank, Bundesministerium der Finanzen, BaFin 93.ALFI – association of the luxembourg fund industry 94.AIMA – Alternative I nvestment Management Association 95. UBS AG 96. ISLA – International Securities Lending Association 97.IM A – Investment Management Association 98. afg – association française de la gestion financière 99.NATIXIS Asset Management 100.EACH – European Association of CCP Clearing H ouses 101.EuroFinuse – EuroInvestors – The European Federation of Financial Services Users 102.Ministry of Business and Growth Denmark 103.Confidentiality requested 104.OFPE – Observatoire des Fonds de Près a l'Economie 105.EFAMA – European Fund and Asset Management Association 106.BARCLAYS 107.BVI – Bundesverband I nvestment und Asset Management e.V. 1 0 8 . I ntesaSanpaolo 109.EACB – European Association of Co-operative Banks 110.IRSG - International Regulatory Strategy Group 111.PricewaterhouseCoopers I nternational Ltd 112.Confidentiality requested 113.FBF - Fédération Bancaire Française 114.INVERCO - Spanish Assoc. of Collective I nvestment Schemes and Pension Funds 115.SOMO - Centre for Research on Multinational Corporations 116.ICI Global 117.Federated I nvestors I nc 118.ICMA - Asset Management and I nvestors Council 119.BNP Paribas 1 2 0 . H M Treasury United Kingdom 121.CFA Institute 122.ifia - Irish Funds I ndustry Association 123. State Street Corporation 124. afme - Association for Financial Markets in Europe 125.BlackRock 126.AFTE - Association Française des Trésoriers d'Entreprise
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127.Italian Ministry of economy and finance and I talian supervisory Authorities 128. JWG 129.Fidelity I nvestments 130. Swedish Authorities 1 3 1 . I nsurance Europe AISBL 132.French Authorities 133.LSEG - London Stock Exchange Group 134.Government of Ireland 135.Bundesrat Germany 136. Swedish Parliament 137.EBA - European Banking Authority 138.ECB-European Central Bank - Eurosystem 139.BusinessEurope 140.ESMA- European Securities and Markets Authority

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European Union: Financial Sector Assessment, Preliminary Conclusions by the IMF Staff
A Financial Sector Assessment Program (FSAP) team led by the Monetary and Capital Markets Department of the International Monetary Fund (IM F) visited the European Union (EU) during November 27–December 13, 2012, to conduct a first-ever overall EU-wide assessment of the soundness and stability of the EU‘s financial sector (EU FSAP).

The EU FSAP builds on the 2011 European Financial Stability Exercise (EFFE) and on recent national FSAPs in EU member states.
The mission arrived at the following preliminary conclusions, which are subject to review and consultation with European institutions and national authorities:

The EU is facing great challenges, with continuing banking and sovereign debt crises in some parts of the Union.
Significant progress has been made in recent months in laying the groundwork for strengthening the EU‘s financial sector. Implementation of policy decisions is needed. Although the breadth of the necessary agenda is significant, the details of the agreed frameworks need to be put in place to avoid delays in reaching consensus on key issues.

The present conjuncture makes management of the situation particularly difficult.
The crisis reveals that handling financial system problems at the national level has been costly , calling for a Europe-wide approach. Interlinkages among the countries of the EU are particularly pronounced, and the need to provide more certainty on the health of banks has led to proposals for establishing a single supervisory mechanism (SSM) associated with the European Central Bank (ECB), initially for the euro area but potentially more widely in the EU.
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The mission‘s recommendations include the following: Steps toward banking union
The December 13 EU Council agreement on the SSM is a strong achievement. It needs to be followed up with a structure that has as few gaps as possible, including with regard to the interaction of the SSM with national authorities under the prospective harmonized resolution and deposit guarantee arrangements. The SSM is only an initial step toward an effective Banking Union— actions toward a single resolution authority with common backstops, a deposit guarantee scheme, and a single rulebook, will also be essential.

Reinvigorating the single financial market in Europe
Harmonization of the regulatory structure across Europe needs to be expedited. EU institutions should accelerate passage of the Fourth Capital Requirements Directive, the Capital Requirements Regulation, the directives for harmonizing resolution and deposit insurance, as well as the regulatory regime for insurance Solvency I I at the latest by mid–2013, thus enabling the issuance of single rulebooks for banking, insurance, and securities. Moreover, the European Commission should increase the resources and powers of the European Supervisory Authorities as needed to successfully achieve those mandates, while also enhancing their operational independence.

Improved and expanded stress testing
European stress testing needs to go beyond microprudential solvency, and increasingly serve to identify other vulnerabilities, such as liquidity risks and structural weaknesses. Confidence in the results of stress tests can be enhanced by an asset quality review, harmonized definitions of non-performing loans, and standardized loan classification, while maintaining a high level of disclosure.

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Experience suggests that the benefits of a bold approach outweigh the risks.

Splitting bank and sovereign risk
Measures must be pursued to separate bank and sovereign risk, including by making the ESM operational expeditiously for bank recapitalizations. Strong capital buffers will be important for the banks to perform their intermediating role effectively, to stimulate growth, and so safeguard financial stability.

Effective crisis management framework to minimize costs to taxpayers
Taxpayers‘ potential liability following bank failures can be reduced by resolution regimes that include statutory bail-in powers. A common deposit insurance fund, preferably financed ex ante by levies on the banking sector, could also reduce the cost to taxpayers, even if it takes time to build up reserves. Granting preferential rights to depositor guarantee schemes in the creditor hierarchy could also reduce costs, particularly while guarantee funds are being built. The European Commission and member states should assess the costs and benefits of the various plans for structural measures aimed at reducing banks‘ complexity and potential taxpayer liability with a view towards formulating a coordinated proposal. If adopted, it would be important to ensure that such measures are complementary to the international reform agenda, not cause distortions in the single market, and not lead to regulatory arbitrage. Lastly, the mission would like to extend their thanks to European institutions for close cooperation and assistance in completing this FSAP analysis.

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European Cybercrime Centre (EC3) opens on 1 1 January
As from 1 1 January the new European Cybercrime Centre (EC3) will be up and running to help protect European citizens and businesses from cyber-crime. EU Commissioner for Home Affairs Cecilia Malmström will participate in the official opening of the Centre established at the European Police Office, Europol in the Hague (the Netherlands). "The Cybercrime Centre will give a strong boost to the EU's capacity to fight cybercrime and defend an internet that is free, open and secure. Cybercriminals are smart and quick in using new technologies for criminal purposes; the EC3 will help us become even smarter and quicker to help prevent and fight their crimes", said Commissioner Malmström. "In combatting cybercrime, with its borderless nature and huge ability for the criminals to hide, we need a flexible and adequate response.

The European Cybercrime Centre is designed to deliver this expertise as a fusion centre, as a centre for operational investigative and forensic support, but also through its ability to mobilise all relevant resources in EU Member States to mitigate and reduce the threat from cybercriminals wherever they operate from", said Troels Oerting, H ead of the European Cybercrime Centre
Investigations into online fraud, child abuse online and other cybercrimes regularly involve hundreds of victims at a time, and suspects in many different parts of the world. Operations of this magnitude cannot be successfully concluded by national police forces alone. The opening of the European Cybercrime Centre (EC3) marks a significant shift in how the EU has been addressing cybercrime so far.
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Above all, the approach of the EC3 will be more forward-thinking and inclusive.
It will pool expertise and information, support criminal investigations and promote EU-wide solutions. The EC3 will focus on illegal online activities carried out by organised crime groups, especially attacks targeting e-banking and other online financial activities, online child sexual exploitation and those crimes that affect the critical infrastructure and information systems in the EU. The Centre will also facilitate research and development and ensure capacity building among law enforcement, judges and prosecutors and will produce threat assessments, including trend analyses, forecasts and early warnings. In order to dismantle more cybercrime networks and prosecute more suspects, the EC3 will gather and process cybercrime related data and will provide a Cybercrime H elp desk for EU countries' law enforcement units. It will offer operational support to EU countries (e.g. against intrusion, fraud, online child sexual abuse, etc.) and deliver high-level technical, analytical and forensic expertise in EU joint investigations.

According to a recent Eurobarometer, Europeans remain very concerned about cyber security. 89% of internet users avoid disclosing personal information online, and 12% have already experienced online fraud.
Around one million people worldwide fall victim to some form of cybercrime every day. Estimates indicate that victims lose around €290 billion each year worldwide as a result of cybercriminal activities (Norton, 2011).

Background
The Commission announced its intention to establish a European Cybercrime Centre (EC3) in the 'EU Internal Security Strategy in Action' (IP/10/1535 and MEMO/ 10/598), adopted on 22 November 2010 by the Commission.

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The setting up of a (EC3) European Cybercrime Centre (I P /12/317 and MEMO/ 12/221) is part of a series of measures that seek to protect citizens from online crimes.
It complements legislative proposals such as the Directive on attacks against information systems (IP/10/1239 and MEMO/ 10/463) and the Directive on combating the sexual exploitation of children online and child pornography adopted in 2011 (IP/11/ 1255). The official opening Ceremony of the EC3 will take place on the 1 1 January at the headquarters of Europol in the Hague, the Netherlands.

Registration for media
Please register for the official opening in the Hague by using the media request form https:// www.europol.europa.eu/ webform/ media-request giving the names of participants, their media organisation and the type of media organisation. Deadline for registration is 10 January 2013, 14:00. Please bring a valid ID and a press card. For further details on the programme, please see the Europol website https://www.europol.europa.eu/ content/ news/ec3-opening-europeancybercrime-centre-1933

For more information

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Frequently asked questions: The European Cybercrime Center EC
What are the objectives?
The main task of the European Cybercrime Centre is to disrupt the operations of organised crime networks that commit a large share of the serious and organised cybercrimes. Offences include those generating large criminal profits, those causing serious harm to their victims or those affecting our vital infrastructure and I T systems. The Centre will gather information from a variety of sources – not only law enforcement authorities – to support investigations conducted by Member States' authorities. This will allow the Centre to identify the most dangerous, pressing cybercrime threats and single out key cybercrime networks in the EU. The Centre will also provide an early warning system for national law enforcement on new vulnerabilities criminals have started to exploit or on how to handle new, technically challenging cases. The Centre will further develop a common standard for cybercrime reporting so that serious cybercrime can be reported to national law enforcement authorities in a uniform way. Information from a citizen in one Member State reporting a compromise of his bank account could easily be linked to other citizens reporting similar incidents affecting the same bank in their respective countries. In such cases, the Centre will be able to immediately alert all other Member States' authorities. The Centre will also respond to queries from cybercrime investigators, prosecutors and judges as well as the private sector on specific technical and forensic issues, and would bring together the various players in cybercrime training with the aim of increasing the overall offer of training possibilities and expanding such courses to the judiciary. Finally, the Centre would assume the collective voice of European cybercrime investigators, providing a platform to develop common positions of Union law enforcement authorities on key issues, for
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example on I nternet governance structures or in building trusted networks with the private sector and non-governmental organisations, and providing the natural interface for international initiatives to curb cybercrime, such as Interpol's work in this domain.

How will it work?
Equipped with state-of-the-art technology and a strong team of highly qualified and specialised personnel offering a wide spectrum of services - from helping Member States analyse complex digital forensic evidence to forecasting trends and scenarios, the European Cybercrime Centre will become the focal point in the fight against cybercrime in the Union.

How is the EC³ staffed and funded?
Since the EC³ will be launched within Europol its budget will form part of the general Europol budget (which amounted to around €84 million in 2012). Around 7 million euros will be available for the EC³ operational activities within the Europol 2013 budget. As for the staff, 30 full time positions are already operating within the EC³ and in the course of 2013 Europol will make additional redistributions of tasks, so as to free around 10 additional posts, bringing the total EC³ staff to around 40 people. As for subsequent years, additional reinforcements will be necessary to meet the increased workload of the Centre. The Commission is at work to find ways to increase Europol's budget accordingly with the Agency's expanding mandate in the field of cybercrime.

What is the extent of the cybercrime problem?
According to a recent study, Internet users remain very concerned about cyber security.
As many as 89% of them avoid disclosing personal information online and 74% agree that the risk of becoming a victim of cybercrime has increased in the past year.
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In fact, about one million people worldwide fall victim to some form of cybercrime every day.
Some estimate that victims lose around €290 billion2 each year worldwide as a result of cybercriminal activities. According to a McAfee study cybercrime profits amount to 750 billion a year, with 150.000 computer viruses in circulation every day and 148.000 computers compromised daily

What type of operations will be carried out?
In the past months, Europol has also significantly increased its practical support to cybercrime investigations in Member States. Only last year and to cite only one example, Operation I carus, coordinated by Europol, identified 273 online child sexual abuse suspects and 1 13 of those suspects spread across 23 countries were arrested. This is the scale and complexity of operations the European Cybercrime Centre will focus on.

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Sebastian von Dahlen and Goetz von Peter

Natural catastrophes and global reinsurance – exploring the linkages
Natural disasters resulting in significant losses have become more frequent in recent decades, with 2011 being the costliest year in history. This feature explores how risk is transferred within and beyond the global insurance sector and assesses the financial linkages that arise in the process. In particular, retrocession and securitisation allow for risk-sharing with other financial institutions and the broader financial market. While the fact that most risk is retained within the global insurance market makes these linkages appear small, they warrant attention due to their potential ramifications and the dependencies they introduce. The views expressed in this article are those of the authors and do not necessarily reflect those of the BIS, the I AIS or any affiliated institution. We would like to thank Anamaria I lles for excellent research assistance, and Claudio Borio, Stephen Cecchetti, Emma Claggett, Daniel Hofmann, Anastasia Kartasheva, Andrew Stolfi and Christian Upper for helpful comments The physical destruction caused by severe natural catastrophes triggers a series of adverse effects. Damaged production facilities, shattered transportation infrastructure and business interruption produce both direct losses and indirect macroeconomic costs in the form of foregone output (von Peter et al (2012)).
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Beyond these economic costs are enormous human suffering and a host of longerterm socioeconomic consequences, documented by the World Bank and United N ations (2010).
By examining catastrophe-related losses over the past three decades, this special feature explores the linkages that arise in the transfer of risk from policyholders all the way to the ultimate bearer of risk. It describes the contracts and premiums exchanged for protection, and the way reinsurers diversify and retain risks on their balance sheets.

In so doing, the feature traces how losses cascade through the system when large natural disasters occur.
Losses from insured property and infrastructure first affect primary insurers, who in turn rely on reinsurers to absorb peak risks – low-probability, high-impact events. Reinsurers, in turn, use their balance sheets and, to a lesser extent, retrocession and securitization arrangements, to manage peak risks across time and space. [Retrocession takes place when a reinsurer buys insurance protection from another entity. Securitisation refers to the transfer of insurance-related risks (liabilities) to financial markets.] This global risk transfer creates linkages within the insurance industry and between insurers and financial markets. While securitisation to financial markets remains relatively small, linkages between financial institutions produced through retrocession have not been fully assessed as detailed data are lacking. Further linkages can arise when reinsurers go beyond their traditional insurance business to engage in financial market activities such as
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investment banking or CDS writing; the implications of those activities are beyond the scope of this feature.
Comprehensive information is needed to monitor the entire risk transfer cascade and assess its wider repercussions in financial markets.

Physical damage and financial losses
Natural catastrophes resulting in significant financial losses have become more frequent over the past three decades (Kunreuther and Michel-Kerjan (2009), Cummins and Mahul (2009)). The year 2011 witnessed the greatest natural catastrophe-related losses in history, reaching $386 billion (Graph 1, top panel). The trend in loss developments can be attributed in large measure to weather-related events (Graph 1, bottom right-hand panel). And losses have been compounded by rising wealth and increased population concentration in exposed areas such as coastal regions and earthquake-prone cities. These factors translate into greater insured losses where insurance penetration is high. At $110 billion, insured losses in 2011 came close to the 2005 record of $116 billion (in constant 2011 dollars). The reinsurance sector absorbed more than half of insured catastrophe losses in 2011. This considerable burden on reinsurers reflected the materialisation of various peak risks, notably in Japan, New Zealand, Thailand and the United States. The level of insured losses also depends on catastrophes‘ geography and physical type.
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The bottom panels of Graph 1 show that losses due to earthquakes (geophysical events) have been less insured on average than those from storms (meteorological events).
The highest economic losses caused by geophysical events occurred in 2011 in the wake of the Great East Japan earthquake and tsunami ($210 billion), for which private insurance coverage was relatively low at 17% (lefthand panel). Droughts can be even more difficult to quantify and insure.

By contrast, the right-hand panel of Graph 1 shows that meteorological events produced record losses in 2005, when Hurricanes Katrina, Rita and Wilma devastated a region of the US Gulf Coast having 50% or more in insurance coverage.
The volume of insured losses differs substantially across continents, depending on the availability of and demand for insurance. While overall a slight upward trend can be discerned over the past 10 years, the wide dispersion in insurance density indicates that the stage of a region‘s economic development plays an important role (Graph 2, left-hand panel). Residents of North America, Oceania and Europe spend significant amounts on non-life (property and casualty) insurance, whereas many populous countries in Latin America, Asia and Africa host underdeveloped insurance markets. Poor countries typically lack the financial and technical capacity to provide affordable insurance coverage.

For example, less than 1% of the staggering economic losses due to Haiti‘s 2010 earthquake were insured.
The pattern of insured losses thus only partly reflects the geography of natural catastrophes.
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Sources: Centre for Research on the Epidemiology of Disasters EM-DAT database; MunichRe NatCatSERVICE; authors’ calculations.

North America accounts for the largest insured losses associated with natural disasters (Graph 2, right-hand panel). In 23 of the 32 years since 1980, more than half of global insured losses originated in the region, though part of this volume was redistributed through global reinsurance companies.
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Asia, Oceania and, to a lesser extent, Latin America saw increases in catastrophe-related losses on the back of rising insurance density over the past 10 years.
Correspondingly, these three regions account for a rising share of insured losses.

Risk transfer
Natural catastrophe-related losses are large and unpredictable.

The insured losses shown in Graphs 1 and 2 reflect recent experience.
This section describes the sequence of payments based on contractual obligations that is triggered when an insured event materialises. One can think of the insurance market as organising risk transfer in a hierarchical way.

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Losses cascade down from insured policyholders to the ultimate bearers of risk (Graph 3).
When catastrophe strikes, the extent of physical damage determines total economic losses, a large share of which is typically uninsured. The insured losses, however, must be shouldered by the global insurance market (Graph 3, light grey area). The public sector, when it insures infrastructure, often does so directly with reinsurers through public-private partnerships, although more data would be necessary to pin down the exact scope worldwide. The majority of the losses relate to private entities contracting with primary insurers, the firms that locally insure policyholders against risks. Claims for reimbursement thus first affect primary insurers. But they absorb only some of the losses, having ceded (transferred) a share of their exposure to reinsurance companies. Reinsurers usually bear 55–65% of insured losses when a large natural disaster occurs. They diversify concentrated risks among themselves and pass a fraction of losses on to the broader financial market, while ultimately retaining most catastrophe-related risk (see section below). Before disaster strikes, however, there is a corresponding premium flow in exchange for protection. Based on worldwide aggregate premium payments in 2011, policyholders and insured entities, both private and public sector, spent $4,596 billion to receive insurance protection. Some 43% of this global premium volume ($1,969 billion) relates to non-life insurance and the remainder to life insurance products (IAIS (2012)).

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Primary insurers, in turn, paid close to $215 billion to buy coverage from reinsurers.
The lion‘s share, nearly $165 billion, came from primary insurers active in the non-life business. About one third of this amount, $65 billion, was geared towards protection against peak risks, with $18 billion for specific natural catastrophe contracts. By way of comparison, life insurance companies spent 2% of their premium income, $40 billion, on reinsurance protection. This comparatively low degree of reinsurance protection is due to the fact that results are typically less volatile in life insurance than in non-life insurance. Following any risk transfer, insurers remain fully liable vis-à-vis the policyholder based on the initial contractual obligations, regardless of whether or not the next instance pays up on the ceded risk.

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Reinsurance companies, in turn, buy protection against peak risks from other reinsurers and financial institutions. In this process of retrocession, reinsurers spent $25 billion in 2011 to mitigate their own downside risk.

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The bulk of this amount represents retroceded risks transferred to other reinsurance companies ($20 billion in premiums), while a relatively small share is ceded to other market participants such as hedge funds and banks ($4 billion) and financial markets ($1 billion).
An important aspect of this structure is the prefunding of insured risks. Premiums are paid ex ante for protection against an event that may or may not materialise over the course of the contract. These payments by policyholders and insurers generate a steady premium flow to insurers and reinsurers, respectively. Only if and when an event with the specified characteristics occurs are the claims payments shown in Graph 3 triggered. At all other times, premium flows are accumulated in the form of assets held against technical reserves (see next section). Reinsurance contracts come in two basic forms which differ in the way primary insurers and reinsurers determine premiums and losses. Proportional reinsurance contracts share premiums and losses in a predefined ratio. Since the 1970s, non proportional contracts have increasingly been used as a substitute. Instead of sharing losses and premiums in fixed proportions, both parties agree on the insured risks and calculate a specific premium on that basis. The typical non-proportional contract specifies the amount beyond which the reinsurer assumes losses, up to an agreed upon ceiling (first limit). Depending on the underlying exposure, a primary insurer may decide to buy additional layers of reinsurance cover, for example with other reinsurers, on top of the first limit.
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―Excess of loss‖ agreements are the most common form of non-proportional reinsurance cover.
For natural catastrophes, these contracts are known as CatXL (catastrophe excess of loss) and cover the loss exceeding the primary insurer‘s retention for a single event. A major earthquake, for example, is likely to affect the entire portfolio of a primary insurer, leading to thousands of claims in different lines of business, such as motor, business interruption and private property insurance. As a result, primary insurers often purchase CatXL coverage to protect themselves against peak risks.

Peak risks and the reinsurance market
A reinsurer‘s balance sheet reflects its current and past acceptance of risks through its underwriting activity. Dealing with exposure to peak risks, which relate to natural catastrophes, is the core business of the reinsurance industry. Natural catastrophes are rooted in idiosyncratic physical events such as earthquakes. When underwriting natural catastrophe risks, reinsurers can rely to a large extent on the fact that physical events do not correlate endogenously in the way financial risk does. To achieve geographical diversification, reinsurers offer peak risk protection not just for one country but ideally on a worldwide basis.

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Another form of diversification takes place over time. Premiums are accumulated over years, and claims payments are usually paid out over the course of months or sometimes years. Graph 4 (left-hand panel) shows the average payout profile for CatXL contracts. Statistics on reinsurance payments show that claims are typically settled over an extended period. On average, 63% of the ultimate obligations are paid within a year and 82% within two years, and it takes more than five years after a natural disaster strikes for the cumulative payout to reach 100%. The premium inflows not immediately used for paying out claims are invested in various assets held for meeting expected future claims. In this way, reinsurers build specific reserves called technical provisions.

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These constitute the largest block of reinsurers‘ on-balance sheet liabilities (Graph 4, right-hand panel).
Insured losses are met by running down assets in line with these technical reserves. Losses in any one year typically lead to loss ratios (incurred losses as a share of earned premium) of between 70 and 90%. To determine whether a reinsurer can withstand severe and unprecedented (yet plausible) reinsured events, regulators look for sufficient technical provisions and capital on the reinsurer‘s balance sheet. The occurrence of a major natural catastrophe dents reinsurers‘ underwriting profitability, as reflected in the combined ratio. This indicator sets costs against premium income. A combined ratio above 100% is not sustainable for an extended period. By contrast, temporary spikes in the combined ratio are indicative of one off extreme events which can be absorbed by an intertemporal transfer of risk. The combined ratio spiked in the years featuring the most costly natural catastrophes to date (Graph 5, blue line): 2005, the year of major hurricanes in the US, and 2011, following earthquakes and flooding in Asia and Oceania. Both occasions also reduced the stock of assets reserved for meeting claims. Yet these temporary spikes in the combined ratio did not cut through to shareholder equity to any significant extent. Catastrophes affect equity only if losses exceed the catastrophe reserve.

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Recent market developments caused shareholder equity to decrease more than insurers‘ core underwriting business ever has.
During the global financial crisis of 2008–09, shareholder equity (book value) declined by 15% (Graph 5, red line), and insurance companies‘ share prices dropped by 59% (yellow line), more than after any natural catastrophe to date. In contrast, shareholder equity remained resilient in 2005 and 2011, when reinsurers weathered record high catastrophe losses.

In dealing with the consequences of peak catastrophe risks, the industry has gravitated towards a distinctive market structure.
One important element is the size of reinsurance companies. Assessing and pricing a large number of different potential physical events involves risk management capabilities and transaction costs on a large scale. Balance sheet size is therefore an important tool for a reinsurer to attain meaningful physical diversification on a global scale. Partly as a result, the 10 largest reinsurance companies account for more than 40% of the global non-life reinsurance market (Graph 6, right-hand panel).

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In spite of the reinsurance market‘s size and concentration, failures of reinsurance companies have remained limited in scope.
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The largest failures to date, comprising two bankruptcies in 2003, led to an essentially inconsequential reduction in available reinsurance capacity of 0.4% (Graph 6, left-hand panel).
That said, any failure of a reinsurer leads to a loss of reinsurance recoverables by primary insurers, and could cause broader market tensions in the event of a disorderly liquidation of large portfolios. In this respect, the degree of connectedness within the global insurance market plays an important role.

Based on their business model, reinsurers enter into contracts with a large number of primary insurance companies, giving rise to numerous vertical links (Graph 3).
In addition, risk transfer between reinsurers leads to horizontal linkages. We estimate that 12% of natural catastrophe-related risk accepted by reinsurers is transferred within the reinsurance industry, which implies that the industry as a whole retains most of the risks it contracts. In 2011, reinsurers paid 3% of earned premiums to cede catastrophe risk to entities outside the insurance sector. Judging by premium volume, the global insurance market transfers a similarly small share of accepted risk to other financial institutions and the wider financial markets.

Linkages with financial markets
Arrangements designed to transfer risk out of the insurance sector create linkages with other financial market participants. Retrocession to other financial institutions uses contractual arrangements similar to those between reinsurers, and commits banks and other financial institutions to pay out if the retroceded risk materialises.

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Securitisation, on the other hand, involves the issuance of insurance liabilities to the wider financial market.
The counterparties are typically other financial institutions, such as hedge funds, banks, pension funds and mutual funds. Among insurance-linked securities, catastrophe bonds are the main instrument for transferring reinsured disaster risks to financial markets. The exogenous nature of the underlying risks supports the view that catastrophe bonds provide effective diversification unrelated to financial market risk. For these reasons, industry experts had high expectations for the expansion of the catastrophe bond market (eg Jaffee and Russell (1997), Froot (2001)). The issuance of catastrophe bonds involves financial transactions with a number of parties (Graph 7). At the centre is a special purpose vehicle (SPV) which funds itself by issuing notes to financial market participants. The SPV invests the proceeds in securities, mostly government bonds which are held in a collateral trust. The sponsoring reinsurer receives these assets in case a natural disaster materializes as specified in the contract. Verifiable physical events, such as storm intensity measured on the Beaufort scale, serve as parametric triggers for catastrophe bonds. Investors recoup the full principal only if no catastrophe occurs. In contrast to other bonds, the possibility of total loss is part of the arrangement from inception, and is compensated ex ante by a higher coupon.

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Despite experts‘ high expectations, the catastrophe bond market has remained relatively small.
Bond issuance has never exceeded $7 billion per year, limiting the outstanding capital at risk to $14 billion (Graph 8). Very few catastrophe bonds have been triggered to date. The 2005 Gulf Coast hurricanes activated payouts from only one of nine catastrophe bonds outstanding at the time (IAIS (2009)).

Likewise, the 2011 Japan earthquake and tsunami triggered one known catastrophe bond, resulting in a payout of less than $300 million.
Payouts to reinsurers from these bonds are small when compared to the sum of insured losses ($116 billion in 2005 and $110 billion in 2011). The global financial crisis has also dealt a blow to this market. The year 2008 saw a rapid decline in catastrophe bond issuance, reflecting generalised funding pressure and investor concern over the vulnerability of insurance entities. The crisis also demonstrated that securitisation structures introduce additional risk through linkages between financial entities. A case in point was the Lehman Brothers bankruptcy in September 2008. Four catastrophe bonds were impaired – not due to natural catastrophes, but because they included a total return swap with Lehman Brothers acting as a counterparty. Following Lehman‘s failure, these securitization arrangements were no longer fully funded, and their market value plunged. Investors thus learned that catastrophe bonds are not immune to ―unnatural‖ disasters such as major institutional failures.

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A further set of financial linkages arises with other financial institutions through cross-holdings of debt and equity.
Insurance companies hold large positions in fixed income instruments, including bank bonds. At the same time, other financial entities own bonds and stocks in insurance companies. For instance, the two largest reinsurance companies stated in their latest (2011) annual reports that Warren Buffett and his companies (Berkshire Hathaway Inc, OBH LLC, National I ndemnity Company) own voting rights in excess of the disclosure threshold (10% in one case and 3.10% in another). Additional shareholders with direct linkages to the financial sector have been disclosed by a number of reinsurance companies. The ramifications of such linkages in this part of the market are difficult to assess.

Conclusion
The upward trend in overall economic losses in recent decades highlights the global economy‘s increasing exposure to natural catastrophes. This development has led to unprecedented losses for the global insurance market, where they cascade from the policyholders via primary insurers to reinsurance companies. Reinsurers cope with these peak risks through diversification, prefunding and risk-sharing with other financial institutions. This global risk transfer creates linkages within the insurance industry and between insurers and financial markets.

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While securitisation to financial markets remains relatively small, linkages between financial institutions arising from retrocession have not been fully assessed.
It is important for regulators to have access to the data needed for monitoring the relevant linkages in the entire risk transfer cascade, as no comprehensive international statistics exist in this area.

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Morten Bech, Todd Keister

On the liquidity coverage ratio and monetary policy implementation
(Important Parts) Basel I I I introduces the first global framework for bank liquidity regulation. As monetary policy typically involves targeting the interest rate on interbank loans of the most liquid asset – central bank reserves – it is important to understand how this new requirement will impact the efficacy of current operational frameworks. We extend a standard model of monetary policy implementation in a corridor system to include the new liquidity regulation. Based on this model, we find that the regulation does not impair central banks‘ ability to implement monetary policy, but operational frameworks may need to adjust. In response to the recent global financial crisis, the Basel Committee on Bank Supervision (BCBS) published a new international regulatory framework, known as Basel I I I , in December 2010 (BCBS (2010)). In addition to strengthening the existing bank capital rules, Basel I I I introduces – for the first time – a global framework for liquidity regulation. A key part of the framework is the liquidity coverage ratio (LCR), which requires banks to hold a sufficient stock of highly liquid assets to survive a 30-day period of market stress. The LCR is scheduled to be implemented in January 2015.
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The new liquidity regulation is likely to impact the process through which central banks implement monetary policy.
In many jurisdictions, this process involves setting a target for the interest rate at which banks lend central bank reserves to one another, typically overnight and on an unsecured basis. Because these reserves are part of banks‘ portfolio of highly liquid assets, the regulations will potentially alter banks‘ demand for reserves, changing the relationship between market conditions and the resulting interest rate.

Central banks will need to take these changes into account when deciding on monetary policy operations.
In this special feature, we study the interactions that may arise between liquidity regulation and monetary policy implementation. Our discussion is based on a standard economic model for analysing the process of implementing monetary policy, which we extend to incorporate a liquidity requirement in the form of an LCR.

The key takeaway from our analysis is that, while the LCR will not impair central banks‘ ability to implement monetary policy, the process whereby this is done may need to adjust.
Once the LCR is in place, central banks will need to consider not only how the size of an open market operation affects interest rates, but also how the structure of the operation affects bank balance sheets. In certain circumstances, central banks may choose to adjust their operational frameworks to better fit the new environment.

At a minimum, they will need to monitor developments that materially affect the LCR of the banking system – just as they have traditionally monitored other factors that affect reserve markets.

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We begin with a short primer on the LCR – including its definition and a brief discussion of how far the banking system currently is from meeting the regulatory threshold.
We also touch on how both interbank and lending facility borrowings affect a bank‘s LCR. We then present a simple version of the textbook model of monetary policy implementation, followed by an extended version that includes an LCR requirement.

Finally, we discuss how different types of open market operations affect bank balance sheets and the LCR calculations before offering some concluding remarks.

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

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

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

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EIOPA – Risk Dashboard

Systemic risks and vulnerabilities
On the basis of observed market conditions, data gathered from undertakings, and expert judgment, E IOPA assesses the main systemic risks and vulnerabilities faced by the European insurance industry over the coming quarters to be:

• Macro risks:
Recessionary pressure in a number of economies in the EU exemplify the macro-economic risks which are still at an elevated level. Although several important steps have been taken recently both at the European and national level, uncertainty remains with regard to any remaining implementation risks.
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In addition, the combination of austerity measures, rising unemployment and a prolonged period of subdued growth could have negative effects on insurance demand.

• Credit and market risk:
The trend of decreasing CDS spreads has continued. However, this development certainly is also driven by excess liquidity, the difficult global financial investment environment and investors‘ risk appetite striving for an appropriate balance of yield versus risk. Recent changes in asset allocation of European insurers rather hint at a reduced risk appetite concerning credit investments. They tend to shift investments towards less riskier counterparties, reducing their European sovereign and banking exposure. This indicates a continuation of a negative outlook/ perception on that credit category. Market risks are still dominated by the low yield environment with 10 year swap rates in Western Europe having again reached new lows in the past months.

• Stabilisation in life insurance business:
The declining trend in life gross written premiums has been reversed, however growth rates are still rather subdued. Lapse rates in the sample have improved from their peak in Q4 2011 and remained stable since last quarter.

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Use of expert judgment Use of expert judgment after the mechanical aggregation:
• Macro risk:
Slightly upwards due to high heterogeneity in growth figures across EU countries and general uncertainty about the medium term growth potential and its implications for the demand of insurance products.

In addition, implementation risks around the various crisis management tools used in the sovereign debt crisis are non negligible.

• Credit risk:
Slightly upwards as the observed decrease of the mechanistic score is considered too large given the uncertain macro outlook, potentially distorted bond prices as a result of excess liquidity while at the same time investors have limited alternatives to substantially reduce their credit risk exposure.
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• Market risk:
Slightly upwards due to the severe consequences a prolonged low yield environment could have on the profitability and solvency of the insurance sector. Improvements in other indicators, e.g. equity risk, are not considered to make up the effects of recently observed new historic lows in 10_year swap rates, given the on average small equity investments of insurers.

• Liquidity&funding:
Slightly downwards as the increase of the mechanistic score is solely driven by low issuance volume of cat bonds in Q3 which is seasonally driven and is already picking up substantially in October and November. Other indicators remained stable.

• Insurance risk:
Slightly upwards due to reduced buffers of reinsurers for catastrophe losses after Hurricane Sandy and potential price hikes in upcoming renewals, which are not reflected in Q3 figures yet. In addition, insurers‘ business model might be impacted in a low yield environment when lower investment returns cannot counter balance potential underwriting losses.

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

Why did the default premium suddenly emerge?
Evidently, even though everyone understood the rules, no such pricing-in occurred for the first decade of the Eurosystem (Figure 1). Risk appetite was high for much of that period, but the market‘s perception of sovereign risk must also have remained low. (Perhaps, despite Treaty prohibitions, market participants assumed that any sovereign that got into trouble would be bailed-out). Indeed, sovereign spreads in the euro area were almost totally insensitive to credit ratings before the crisis (Figure 2). One often-heard interpretation of what happened during that decade is that the complacent market environment relaxed the budget constraint on euro-area sovereigns and led them to borrow recklessly. Actually this story doesn‘t fit the facts very well. After all, although sovereign debt ratios in most of the Eurosystem did not fall as much as they could and should have on the good years, at least they did not increase dramatically before the crisis (Figure 4). (Private debt ratios, and in particular the size of the bank and near-bank systems did increase, but that is a somewhat different story, to which I will turn shortly). It‘s possible alternatively that there was a multiple equilibrium here, with the ―good‖ or low interest equilibrium (with a self-fulfilling degree of confidence in the creditworthiness of all the sovereigns) being selected by the market at the start of the euro, and events during the financial crisis – not least those associated with Greece – having tripped the system into the ―bad‖ or high interest equilibrium with default risk premia moving a number of sovereigns into a more challenging debt sustainability position.
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Most likely, what we have seen is a combination of factors:
(i)a sharp reduction in risk appetite resulting in even little-changed debt ratios, as in I taly, looking more challenging and in need of a risk-premium; and in addition (for most countries) (ii)a sharp increase in debt ratios as governments reacted to the crisis (including, but not at all confined to, the socialisation in most countries of some private banking losses through their assumption by governments) (Figure 4 again).

The increased sensitivity of sovereign spreads to ratings, and the increased range of ratings themselves – both illustrated in Figure 2 – suggest that both factors are at work.
(As spreads widened in stressed countries, their fluctuations – which would not concern hold-to-maturity investors – added a risk factor for others and probably ratcheted up the average level of the spreads.) In the specific case of Ireland, the depth of the recession and the remarkably high elasticity of tax revenues and the Government deficit to the downturn, combined with the unfortunate decision to lock-in a very comprehensive bank guarantee before the potential scale of the banking losses could at all be appreciated, meant that I reland‘s actual and prospective general government debt made a shocking turnaround from about 25 per cent of GDP in 2007 to 1 17 per cent just five years later. Historians will debate the exact triggers for the market‘s loss of confidence in the I rish sovereign. Even as late as April 2010, after the first sampling indicated the scale of the banking losses, sovereign spreads were little more than 1 per cent. By November of that year (just a few weeks after the Deauville statement which persuaded the markets that private sector holders of euro sovereign debt would not be immune from loss-sharing) large banking outflows and spreads exceeding five per cent made recourse to official assistance inevitable.
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(Figure 3 shows the plot with some relevant news stories flagged). Perhaps the most significant take-away from the sequence of spikes and troughs is the fact that some of them clearly relate to news that is country-specific, some of them to euro area general news.
The same is doubtless true for all of the stressed sovereigns.

Default risk vs. devaluation risk vs. redenomination risk
It‘s worth pausing to recall that raw sovereign spreads such as we are seeing today in the euro area are not remotely unprecedented in pre-euro history. On the contrary, they were the norm as is illustrated by Figure 1. The difference is that these spreads reflected a combination of default risk and currency risk. During the last fiscal crisis of the 1980s I rish sovereign spreads ballooned out also.

But that was for local currency denominated debt.
Eurobond borrowing by the Irish Government remained at fairly tight spreads despite the high overall debt ratio (higher than today), and the fact that almost half of the national debt was denominated in foreign currency. The high spreads reflected devaluation expectations and currency risk generally. And there were devaluations, though less than was baked into the spreads – by between 250 and 300 basis points on average during the last ten years of that ill-fated regime, the narrow-band EMS. It is not that default and devaluation are close substitutes; not at all, and for several reasons.
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For one thing, default has potential reputational consequences for the issuer qualitatively different to those of devaluation.
In addition, though, devaluation affects not only the international value of the Government‘s debt promises, but also that of all other contracts denominated in local currency; as a result, depending on the speed of price-resetting (pass-through) it can affect competitiveness throughout the economy. These differences have not been sufficiently emphasised, I feel, in recent discussion.

As an example, I could mention the I rish devaluation of August 1986.
The main goal of this important action was restoration of wage competitiveness, not a lowering of the real value of the local currency-denominated debt. (Indeed, I recall that some domestic policymakers were confused on this point and thought that the debt burden would actually increase as a result of translation effect on the foreign currency debt!) Such currency risk can be so extreme as to make it impossible for the sovereign to issue any sizable amount of local-currency denominated debt to international lenders. In the literature, such countries – all in the developing world (and not including I reland, cf. Figure 5) – were said to suffer from ―Original Sin‖. Happily, the number of countries suffering ―Original Sin‖ has been diminishing in recent years.

Instead, we have to acknowledge the emergence in market pricing of a new phenomenon, ―redenomination risk‖.
How can we recognise redenomination risk?

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This is not straightforward, not least because the term could refer to a number of different scenarios.
One suggested way of approaching the question is to use econometric estimates of the cross-sectional determinants of sovereign spreads for foreign currency-denominated borrowing to predict current spreads in stressed euro area countries: a positive residual might suggest a redenomination risk premium. Comparisons of current spreads of euro area sovereigns in euro and in foreign currency-denominated borrowings provides for an alternative approach. My own favourite approach is to look at the co-movement in the time series of euro area country spreads. Some of this co-movement can be attributed to fluctuations in market risk-appetite; the remainder could be interpreted as a system-wide redenomination premium. This brief summary already suggests the complexity and ambiguity of some of the concepts involved and their measurement. Evidently, redenomination risk, as imagined by market commentators, combines default and currency risk in a novel way not contemplated by the Treaty that established the euro area. The ECB has made clear its determination to do what is necessary to preserve the euro and remove unfounded euro break-up premia in sovereign yields. The OMT, designed as a backstop to inhibit negative self-fulfilling market dynamics, provides the necessary tools to deliver on that commitment. The programme does not go overboard in the direction of removing the incentive for governments to manage their finances in such a way as to recover and retain the confidence of the market, but it will ensure that
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disciplined governments will not have to pay spreads that could only reflect market concerns about a system break-up.
As announced, the ECB will only buy bonds at the shorter end of the maturity spectrum, but the OMT can be expected to have an influence transmitted by market forces throughout the yield curve, and indeed spreads have tightened right across all maturities since the OMT was announced. Still, it is not to be expected that the OMT will by itself restore the tight uniformity of spreads that prevailed for the first decade of the euro. Forcing such a tight uniformity would not be generally considered safe absent more reliable alternative mechanisms for ensuring disciplined fiscal policy in the countries concerned. More likely would be a potentially extended period of sovereign spreads that, albeit narrower than at their worst, remain material.

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

Very sizable capital injections (about 50 per cent of GN P from the Irish Government alone – a sum which proved too great to be financed without the protection of an IM F programme) have ensured that the Irish banks more than satisfy regulatory requirements once again, but their future profitability is constrained by the emergence and likely persistence of the sovereign spreads, and the knock-on effect of the spreads on the banks‘ funding costs.
Euro-area risk-free rates are not now the most relevant indicator of the marginal cost of funds to the I rish banking sector.

It is, of course, true that the I rish banks (like those in other stressed countries) have been drawing heavily on ECB refinancing facilities during the crisis, especially following the huge outflow of funds that occurred in early 2009 and again in the last few months of 2010.
This access to refinancing has been vital to the continuing operation
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of the banking system, and it has come at the policy rate.
(Let me mention as an aside a curious feature of the current monetary policy environment in the euro area. The two key ECB rates – the main refinancing operations rate and the deposit rate – are 75 basis points and zero, respectively. Access to both the refinancing and deposit facilities are both close to all-time highs.

But in practice, the bulk of the refinancing is going to banks in the stressed countries, while the bulk of the deposits are placed by banks in non-stressed countries.
To the extent that the stressed countries have tended to have weaker economic performance during the crisis, this pattern might be considered paradoxical. But it is of course a reflection and semi-automatic consequence of the fragmentation which has developed in the euro area. To be sure, the ECB policy rate is clearly below the marginal cost of funds in the stressed countries.) But access to ECB funds at the policy rate is limited by the availability of eligible collateral and the haircuts that are applied to such collateral (despite the relaxation of eligibility criteria). About 20 per cent of the total financing of the three going concern I rish controlled banks comes from this source at present (16 per cent of the balance sheet total). Competition for deposits therefore remains strong and rates high. It‘s not just that higher bank funding costs will now be passed on to new borrowers, adding headwinds to the economic recovery, though that is certainly a factor.
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Indeed, the lower policy interest rates set by the ECB since the crisis began have only been partly transmitted to borrowers in I reland and in the other stressed euro area countries (Figure 6).
(As is seen by the results of a recursive regression exercise, the pass-through from policy rate to Irish residential mortgage SVR rates has halved since the start of the crisis – Figure 7.) Some of this can be rationalised as reflecting a higher credit risk-premium being charged by the banks, but some is also due to the higher marginal cost of funds. Worse still for the health of the banks, and their ability to contribute to the economic recovery, is the fact that they are still coping with the consequences of their marginal cost of funds having delinked so sizably from the ECB policy rate. These consequences arise because of the long-term mortgage contracts the banks made when they assumed that their marginal cost of funds would always remain close to the (risk-free) policy rate. Suffice it to say that a large block of residential mortgages was granted at interest rates which track the ECB policy rate plus a very low spread. These tracker mortgages, many of which have an average remaining maturity of 15–20 years or more, yield less than the marginal cost of funds (Figure 8 which is drawn on the assumption, not strictly valid, that the average spread of the trackers over policy rate was unchanged over time). In effect, by assuming that their cost of funds would not deviate much from the ECB policy rate, the banks exposed themselves to a very large ―basis risk‖. In principle, they could escape this trap if there were a willing purchaser (public or private) with access to funding at a cost that is not contaminated by the sovereign stress.

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Until such a purchaser comes forward, the banks will have to continue to fund this portfolio at a loss, even on performing mortgages, whose effects will spill over onto their customers and their owners (not least the State).

Conclusion
Irish Sovereign spreads may no longer be bloated by redenomination risk, but at 300 basis points at the long-end, they do seem to reflect a credit risk premium that is poor reward, so far, for what has been a sizable fiscal adjustment effort. Reflecting on where we have got to, it seems that there are distinct parallels with the fiscal crisis of the EMS period. As I mentioned, spreads (then reflecting devaluation risk) exceeded what would have been needed ex post to compensate for actual exchange rate movements by almost the same amount (250–300 basis points). Those spreads were transmitted to the banking system then also. The I rish financial situation is relatively extreme, and as such illustrates clearly some of the key problems that have been faced also in other stressed parts of the euro area. While it has delivered a much lower inflation rate, the euro is no longer insulating financial markets from the impact of excessive debt in member countries. The early insulation of the monetary transmission mechanism from fiscal problems of participating countries has worn through. The pernicious feedback loop from banks to sovereign and from sovereign to banks that re-emerged in the crisis remains strong and damaging. Getting back to the ―good‖ equilibrium will require a healing process which removes the market‘s fear of default.
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It is inevitably a protracted process needing not only firm adherence to consistently disciplined policies but also the creation of institutions that can prevent future crises, or at least cope with them better if they cannot be avoided.

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D. The Dodd Frank Act and the new Risk Management Standards (976 slides, included in the 3285 slides)
The US Dodd-Frank Wall Street Reform and Consumer Protection Act is the most significant piece of legislation concerning the financial services industry in about 80 years. What does it mean for risk and compliance management professionals? It means new challenges, new jobs, new careers, and new opportunities. The bill establishes new risk management and corporate governance principles, sets up an early warning system to protect the economy from future threats, and brings more transparency and accountability. It also amends important sections of the Sarbanes Oxley Act. For example, it significantly expands whistleblower protections under the Sarbanes Oxley Act and creates additional anti-retaliation requirements. You will find more information at: www.risk-compliance-association.com/Distance_Learning_and_Cert ification.htm

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