Basel 3 News February 2013

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Basel iii Compliance Professionals Association (BiiiCPA)

1200 G Street NW Suite 800 Washington, DC 20005-6705 USA Tel: 202-449-9750 Web: www.basel-iii-association.com
Dear Member, I will lead a Basel III class in London in a few days (March 20-22, 2013). We have ensured that not only the course, but also the venue is great: Four Seasons Hotel, Canary Wharf, London. The view and the food there is fantastic. Yes, this is very important too. I want to spend 3 great days, not simply lead a class. You can call Ross Fenwick after visiting: http://www.baseliiitraining.com/book_course.php?InstanceID=174
I look forward to meeting some of you.

Today we will start with the monitoring of the impact of the Basel frameworks. Yes, we still have Basel iii monitoring with Basel i figures
Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com
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Basel III monitoring Questionnaire and instructions

The Basel Committee on Banking Supervision is monitoring the impact of Basel III: A global
regulatory framework for more resilient banks and banking systems and Basel III: International framework for liquidity risk measurement, standards and monitoring on a sample of banks.
The exercise will be repeated semi-annually with end-December and end-June reporting dates.
Scope of the exercise

Participation in the monitoring exercise is voluntary. The Committee expects both large internationally active banks and smaller institutions to participate in the study, as all of them will be materially affected by some or all of the revisions of the various standards. Where applicable and unless noted otherwise, data should be reported for consolidated groups. The monitoring exercise is targeted at both banks under the Basel II/III frameworks and at those still subject to Basel I. However, as outlined in the remainder of these instructions some parts of the questionnaire are only relevant for banks subject to Basel II or to banks applying a particular approach. If Basel I figures are used, they should be calculated based on the national implementation, referred to as Basel I in this document. In some countries supervisors may have implemented additional rules beyond the 1988 Accord or may have made modifications to the Accord in
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their national implementation, and these should be considered in the calculation of Basel I capital requirements for the purposes of this exercise. If a bank has implemented Basel II at a particular reporting date, it should calculate capital requirements based on the national implementation of the Basel II framework, referred to as Basel II in this document. Unless stated otherwise, the changes to the risk weighted asset calculation of the Basel II framework introduced in 2009 which are collectively referred to as Basel 2.5 (Revisions to the Basel II market risk framework (the Revisions) and Enhancements to the Basel II framework (the Enhancements)) and through the Basel III framework should only be reflected if they are part of the applicable regulatory framework at the reporting date. When providing data on Basel III, banks should also take into account the frequently asked questions on capital, counterparty risk and liquidity published by the Committee. This data collection exercise should be completed on a best-efforts basis. Ideally, banks should include all their assets in this exercise. However, due to data limitations, inclusion of some assets (for example the portfolio of a minor subsidiary) may turn out to be an unsurpassable hurdle. In these cases, banks should consult their relevant national supervisor to determine how to proceed.
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Finance and Economics Discussion Series, Divisions of Research & Statistics and Monetary Affairs, Federal Reserve Board, Washington, D.C.
Lessons from the Historical Use of Reserve Requirements in the United States to Promote Bank Liquidity
Mark A. Carlson NOTE: Staff working papers in the Finance and Economics Discussion Series (FEDS) are preliminary materials circulated to stimulate discussion and critical comment. The analysis and conclusions set forth are those of the authors and do not indicate concurrence by other members of the research staff or the Board of Governors. References in publications to the Finance and Economics Discussion Series (other than acknowledgement) should be cleared with the author(s) to protect the tentative character of these papers. *** Shortly after the Panic of 1837, states began instituting reserve requirements which mandated that banks had to hold liquid assets representing at least some minimum fraction of their liabilities. When Congress passed the National Bank Acts in the 1860s, banks receiving National Bank charters also faced a minimum reserve requirement. These rules were part of an effort to promote liquidity and soundness by ensuring that each individual bank had a pool of liquid assets that it could draw on during times of stress.
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Despite these efforts, as well as some efforts from within the banking sector to provide liquidity support, the banking system remained vulnerable to banking panics and suspensions of convertibility in which banks temporarily stopped or restricted withdrawals of funds (Calomiris and Gorton 1991, Sprague 1910, Wicker 2000). These panics were quite disruptive to economic activity and demonstrated that the reserve requirements were not sufficient to ensure that the financial system remained liquid during periods of stress (Grossman 1993, James, Weiman, and McAndrews 2012). In part to address these concerns, Congress established the Federal Reserve to create an elastic currency that could add liquidity to the banking system and serve as a lender of last resort. This paper reviews the historical experience of the United States with reserve requirements to provide insights for policymakers today regarding efforts to promote individual bank liquidity and the relation of those efforts with a lender of last resort.
(Some proposals, such as the, liquidity coverage ratio proposed by the Basel Committee on Banking Supervision, are quite similar to these historical reserve requirements.)
The insights discussed here draw importantly on the active discussions among academics, policymakers, and bankers during the 1800s and early 1900s about the value of reserve requirements. Other lessons are based on contemporary discussions and some data analysis regarding the dynamics within the banking system during panics and the impact of reserve requirements. While this paper reviews the historical experience of the United States with reserve requirements starting in the 1830s, there is a bit more emphasis on material from the National Banking Era (1863-1913).
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The empirical parts of the paper also draw on data from this period. The focus on the National Banking Era reflects the fact that it was in this period that use of reserve requirements was most prominent and that the experiences during this period ultimately resulted in the creation of the Federal Reserve and a shift away from the use of reserve requirements to regulate liquidity. One key lesson that can be drawn from historical experience is that central banks are important during panics for multiple reasons. One description of a panic is a situation where extraordinary demand for liquid assets exceeds the available supply of those liquid assets (as evidenced by the suspensions of convertibility that occurred during panics and by the spikes in short-term interest rates). A central bank can help ease a panic by rapidly expanding the supply of liquid assets. Relatedly, banks often depend on other banks for liquidity. During a panic, the ability of other banks to furnish that liquidity support is likely to become impaired. Without access to this usual source of liquidity, and in the absence of a lender of last resort, banks may face increased incentives to hoard liquidity during stress events. This dynamic may exacerbate the severity of the stress episode. Thus, during a crisis, the liquidity of an individual bank is intricately connected to central bank liquidity policy and optimal liquidity regulation should consider these jointly. There are other pertinent lessons as well.
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The liquidity reserves mandated by reserve requirements are generally intended to be used when liquidity demand spikes. Nevertheless, banks are often reluctant to draw down their stores of liquid assets during panics. Historical experience suggests that if the rules regarding the instances when the reserve should be used are unclear, the lack of clarity may exacerbate banks reluctance. On a related note, the regulations and penalties associated with monitoring and enforcing the reserve requirement during normal times that were in place during the late 1800s and early 1900s do not appear to have been particularly effective which indicates the importance of considering these aspects of liquidity requirements as well. Additionally, historical experience suggests that when certain assets are designated as stores of liquidity, institutions will seek to accumulate those assets during a crisis to demonstrate their strength; Uunless the pool of liquid assets can be expanded at those times, there is some risk that the functioning of the market for those assets expected to provide liquidity can deteriorate. This paper is organized as follows. Section 2 describes the introduction of reserve requirements, reviews the arguments for and against such requirements during the 19th and early 20th centuries, and provides some stylized facts on reserves held by banks. Section 3 reviews mechanisms within the system designed to address the stresses associated with banking panics and presents some evidence on how holdings of reserves changed shortly after a panic.
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Section 4 briefly recounts events from the Panic of 1907 and discusses some reasons why the reserve requirements alone were not sufficient to stop banking panics. This section also reports on the subsequent debate about the need for a central bank to provide liquidity support to the banking system. Section 5 describes reserve requirements in the presence of a central bank and the decline in the use of reserve requirements as a tool for regulating liquidity following the establishment of the Federal Reserve. A general review of the lessons from the historical experience and concluding thoughts are provided in Section 6.
Section 2. Reserve requirements prior to the Federal Reserve

This section briefly reviews the history of the laws regarding reserve requirements. It also describes some of the reasons given by policymakers for having reserve requirements, the differences in requirements across states, and the enforcement of the reserve requirements. Additionally, this section provides some basic empirical information on the levels of reserves held by individual national banks.
Section 2.1 Introduction of reserve requirements

The first reserve requirements were introduced in the United States shortly following the Panic of 1837 by the states of Virginia, Georgia, and New York (Rodkey 1934). These requirements were generally intended to ensure that banks had ready access to resources that would enable them to meet their liability obligations.
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The adoption of reserve requirements by other states occurred slowly; only 10 states had such laws by 1860. Although after the Panic of 1857 there were a number of journal articles and pamphlets advocating in favor of reserve requirements. When reserve requirements were first enacted the main bank liability was bank notes, which were privately issued currency that the bank promised to redeem for specie (gold or silver coin), and state laws referred to those liabilities as the base for determining the appropriate reserve. As the liability base of banks shifted toward deposits, the reference point for the reserve requirements shifted as well. In 1842, Louisiana passed a law requiring banks to maintain a reserve in specie equal to one-third of its liabilities to the public, which included both notes and deposits (White 1893). By 1895, 21 states had reserve requirements for commercial banks; at this time, all such laws included deposits in liability base (Comptroller 1895). For states that enacted reserve requirements, the laws regarding the ratio of reserves that had to be held relative to the liability base ranged from between 10 percent and 33 percent. State laws also differed with respect to what could be included in the reserve. Some states allowed deposits in other banks to count as part of the reserve. This feature likely owed to the fact that many banks in smaller communities maintained balances at banks in larger cities to clear payments.
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As many bank notes, and later checks, were redeemed at these clearing banks, interbank deposits played an important part in a banks liquidity profile (James 1978, White 1983). Other states required that that the entire reserve be carried as specie in the banks vault. A few states allowed short-term loans to count as part of the reserve. There were some further debates about the type of deposits should be included in the base for the reserve. Some policymakers argued that banks ought to maintain a greater reserve against more volatile deposits. As a result, some states only required a reserve against demand deposits (Comptroller 1895, Welldon 1910). A handful of states mandated reserves against both demand and time deposits, but specified that the amount of liquid resources that needed to be held against each dollar of time deposits was smaller than that required for demand deposits. Nevertheless, a majority of states required the reserve to be calculated against all deposits. When the U.S. Congress passed the National Banking Acts in the early 1860s and provided for National Bank charters, the legislation included reserve requirements for National Banks. These reserve requirements were tiered depending on the location of the banks. For much of the National Banking Era, banks located outside major citiesreferred to as country bankswere required to hold reserves equal to 15 percent of deposits, three-fifths of which could be held as deposits in banks of reserve cities while the rest was required to be held as vault cash.
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Banks in reserve citiesgenerally larger citieswere required to hold reserves equal to 25 percent of deposits, half of which could be carried as balances in central reserve cities. Banks in central reserve citiesat first just New York but later also Chicago and St. Louisheld significant amounts of interbank deposits. These banks were required to maintain a reserve equal to 25 percent of deposits which needed to be held in gold or in Treasury notes. One reason that banks in reserve and central reserve cities were expected to hold a higher portion of their assets as reserves was that they held more interbank deposits; these deposits were seen as more volatile and, in particular, more likely to be withdrawn during banking panics (Federal Reserve 1927).
Section 2.2 The purpose of the reserve

As noted above, reserve requirements were a prudential requirement meant to ensure that banks maintained the resources to meet their obligations. This goal is quite broad and has aspects of both solvency and liquidity. Indeed proponents of reserve requirements often blended the two or spoke of the benefits both in terms of the safety of the banks and the promptness with which banks could meet withdrawals, though there was perhaps a bit more frequent mention of the liquidity benefits. An example of arguments framing the reserve as a tool for supplying liquidity comes from the 1873 report of the Comptroller of the Currency (Comptroller)the chief regulator of the National Bankswho noted that the question is not whether a reserve shall be held which shall insure the payment, merely, of the note, for that is unnecessary, but what
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amount of reserve shall be held by the banks to insure the prompt payment of all their liabilities? (p.19) Among the arguments pointing to solvency benefits, Tucker (1858) suggested that bank failures, such as during the Panic of 1857, were the result of imprudence as banks overextended themselves and did not maintain a reserve of at least one-third of their liabilities. Most advocates tended to blend these extremes. Hooper (1860) provided one of the most interesting blends. He maintained that a bank could reduce its riskiness by adjusting either its capital or its reserve and that for a given level of capital, a bank could extend more loans if it held greater reserve. Having a strong reserve meant that the bank would be able to avoid being forced to access emergency funds from other banks or rapidly call in their loans (or presumably be forced to sell assets in firesales) and thus be stronger overall. While much of the discussion focused on the microprudential benefits to the individual banks of requiring a minimum level of reserves, some commentators did suggest that there were systemic benefits of ensuring banks retained sufficient liquid resources on hand. Opdyke (1858) argued that excessive credit growth led to a boom and bust cycle and that a reserve requirement could be useful in restraining credit growth. More concrete systemic benefits were described by Hooper (1860) and Coe (1873) who suggested that there were collective action reasons to mandate minimum reserves, especially for banks in the main money center of New York City.
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Hooper noted that the reserve of banks in New York was a common good benefitting all the banks in the city as well as the rest of the country and that the management of those banks might not internalize the social benefit they provided. As a consequence, he argued that the law needed to require them to hold a larger reserve than the banks would otherwise have chosen. It is out of the question for the banks of the city of New York to hold that relation of the entire confidence through the country, so long as the action of each bank, in regard to the amount of its reserve of specie, is dependent upon the peculiar views or character of its board of managers. The law must secure the uniform ability of the banks to meet their engagements by making it imperative upon each one of them to hold the requisite amount of specie as a condition of their power to discount (p.44). Coe noted that banks in New York City were linked both through their general dependence on the call loan market for liquidity (described in detail below) and that interior banks tended to react to troubles at one bank as a signal of troubles at all the banks. Thus, during a panic the strong banks needed to support the weak to contain liquidity drains and prevent problems from cascading. This linkage, Coe argued, was a reason that all banks needed to hold a strong reserve and was a motivation for the New York Clearinghouse to establish a reserve requirement in 1857.
Section 2.3 Enforcing the reserve requirement

The debate about how to ensure that banks met the reserve requirement started soon after the requirements were introduced.
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Tucker (1839) advocated enforcing the requirement using a moderate penalty proportional to any deficiency of the reserve. He maintained that the penalty should be high enough to dissuade banks from running below the reserve in good times but not so high that banks were unwilling to use the reserve during a crisis. Opdyke (1858) argued for requiring a minimum reserve somewhat below what was desired as he maintained that banks would hold a buffer stock above the requirement and that the buffer could then be used: A legal minimum of 20 per cent will, it is believed, give a practical minimum of not less than 25 to 30 per cent, for no prudent bank will voluntarily occupy a position on the verge of legal death (p.15-16). In the National Banking Era, the law provided that in the event the Comptroller found that a National bank was deficient in its reserve, the bank could be required to cease making loans and stop paying dividends until the amount of the reserve was restored. The Comptroller (1893) stated that in the event that the bank had loaned out too great a portion of its funds or depositors had withdrawn a significant amount of funds, the only safe and prudent course for the bank to pursue is to cease paying out money in any direction except to depositors until either through the collection of demand or maturing loans on the one hand, or the receipt of deposits on the other, the required portion has been restored (p.18). If the reserve was not restored within 30 days, the Comptroller could, with the concurrence of the Secretary of the Treasury, appoint a receiver for the bank. It was well noted that both the finding by the Comptroller that the bank was deficient and the decision to seek a receiver were discretionary on the part of the Comptroller.
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Moreover, the Comptroller stated that he only had the opportunity to learn about the banks balance sheet from one of the biannual bank examinations or the report of condition filed five times a year (1893). The actual ability to monitor was slightly more complicated. In their examination reports, examiners were asked to look through the banks books and calculate and comment on the adequacy of banks reserve for the past 30 days (or more if deemed appropriate). Thus the examination reports allowed the Comptroller more just than a single days observation. Carter Glass (1913) asserted that this particular penalty regime was reportedly not very successful. In the debates related to Federal Reserve Act, he maintained that the penalties for holding inadequate reserves for an extended period were so severe that they had the never been applied and that in some cases banks had been allowed by regulators to have deficient reserves for periods of several years. Looking at examination reports for a sample of banks indicates that the examiners took note of the condition of the banks reserves and used this information, along with other aspects of the banks condition, to make recommendations about whether the bank should be allowed to pay dividends or make other changes to its capital account. This indicates that the condition of the reserve did matter to the examiners. There were no suggestions in this sample of examination reports that a bank ought not make new loans due to a deficit reserve.
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Information from Welldon (1910) suggests that, as of 1909, many states had similar, though perhaps slightly less severe, penalties for banks falling short of their reserve. Out of the 39 states that had reserve requirements at that time, Welldon mentions a penalty for failing to meet that reserve for 25 states. In every case, that penalty involved a prohibition on extending new loans. In 15 cases, there was also a prohibition on issuing dividends. For only one state, Arizona, does Welldon mention an explicit provision that failure to restore the reserve could result in a bank being declared insolvent. For one other state, Welldon notes that it had removed a previous provision allowing a bank to be declared insolvent if the bank failed to restore the reserve.
Section 2.3 Use of interbank deposits in the reserve

Whether or not to allow interbank deposits to count as part of the reserve was a subject of considerable debate. The National Bank Act allowed country and reserve city banks to count interbank deposits for up to two-fifths and one-half of their reserve respectively. Most states allowed interbank deposits to count as well; only 3 out of the 21 states that had reserve requirements in 1895 required that all reserves be held at the bank. Interbank deposits were allowed partly as recognition of the way banks operated.
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As noted earlier, smaller banks had historically maintained deposits at correspondent banks in larger cities to clear payments or facilitate the redemption of their bank notes. As liability holders would seek to redeem the notes in the larger cities, it made some sense to include part of the balance held there to meet those obligations as part of the banks liquidity reserve. However, during a panic these interbank deposits were generally not an effective source of liquidity. Noyes (1894) notes that when demand during a panic was for physical currency, reserves held elsewhere were not particularly useful. More fundamentally, it was also noted that allowing interbank deposits to count as reserves created a pyramid structure. A bank could deposit cash in another bank and count that deposit in its reserve while the second bank counted the cash in its reserve. The second bank could then deposit the cash in a third bank and compound the process. A withdrawal of reserves by the bottom of the pyramid during a panic could thus result in a rapid depletion of reserves within the banking system (Bankers Magazine 1907, July). The Comptroller noted in 1900 that reserves held in other banks had been ineffective in protecting depositors during the panics of 1873 and 1893 and encouraged Congress to increase the portion of the reserve that banks had to carry as money in their vaults (see pages 25-27).
Section 2.4 Some empirical observations on reserve holdings

Looking at the status of reserves for a sample of 208 banks in both reserve cities (82 banks) and larger country towns (126 banks) using data from the
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September 1892 Call Report provides some further information about the level of bank reserves. Most banks appear to have held reserve in excess of the required reserve; the average reserve ratio was around 29 percent and quite similar for both country banks and those in reserve cities. (These ratios are similar to those found by the Comptroller in 1887.) Moreover, the ratio of reserves to deposits exceeded the legal requirement (15 percent for country banks 25 percent for reserve city banks) by 10 or more percentage points for three-fifths of country banks and almost one-fourth of reserve city banks. Banks may have preferred to hold reserve ratios in excess of what was required simply because they preferred being more liquid, as is suggested by the Bankers Magazine (1908, November), or because they viewed the required reserve ratio as a minimum they did not want to breach and desired to maintain a buffer. Reserves held in the bank (as opposed to with reserve agents) accounted for about half the total reserve. Relative to deposits, reserves at the bank averaged about 14 percent for both groups; also well above the legal requirements of 6 percent for country banks and 12.5 percent for reserve city banks. The finding that about half the reserve was held in cash matches similar findings by the Comptroller a decade or so later (Comptroller 1907). While many banks appear to have preferred to hold reserve well in excess of what was legally required, some banks had deficiencies in their reserve ratios. Of the banks in the sample, 10 percent of the country banks had a deficient reserve and 25 percent of reserve city banks did.
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That banks had deficient reserves suggests that they did not see the reserve ratio as something that had to be met at all times (perhaps especially as they had 30 days to restore it upon notice by the Comptroller). Nevertheless, most of these banks did not sink too far below the legal limitmany of them being within 3 percentage points of the limitperhaps indicating the rule did have some influence on their behavior.
Section 3. Reserve requirements and liquidity during panics

It was understood that banking panics were stressful periods in which the liquidity of the banking system would be tested. In the absence of a central bank, there were two primary mechanisms for provide liquidity during the panics: using the reserve and issuance of Clearinghouse loan certificates. This section considers these two mechanisms.
Section 3.1 Usability of the reserve during a panic

There are two aspects of the debate about the usability of the bank reserve. One is whether the law allowed banks to use their reserve, and the other is whether banks would use their reserve to support other institutions. The concern that legally required reserves held by banks would not be helpful if the banks had to maintain these reserve at all times and could not use them was stated clearly early on. In 1848, Kettell argued that This keeping of 15 per cent. of specie on hand has been tried in New York, in Alabama, and elsewhere, and its
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gross absurdity always made manifest. Of what use is it that a bank has the gold and silver, if the law forbids it to part with it? The debate about whether banks could legally use their reserves continued during the National Banking Era. In his annual report for 1894, the Secretary of the Treasury argued against the reserve requirement for National Banks as then written saying that, as the law was silent on when the National banks could use their reserves, the law created a situation in which they were unusable: Among these are the requirementsthat a fixed reserve, which cannot be lawfully diminished, shall be held on account of deposits. The consequence of this last requirement is that when a bank stands most in need of all its resources it cannot use them without violating the law (reprinted in Rodkey 1934). Proponents of reserve requirements responded that the reserve was established with the intent that it be used during stress periods. As noted above, the decision to find a bank deficient in its reserve was discretionary on the part of the Comptroller. This discretion allowed the Comptroller to effectively waive the requirement during a panic and allow banks time to rebuild their reserves subsequently (Comptroller 1893). Others viewed the vagueness of the law regarding the use of the reserve to be a notable impediment to banks willingness to use the reserve. The Bankers Magazine (1907, August) argued that the vagueness of the law regarding when the reserve could be drawn meant that many bankers felt that the reserve could not be used during a crisis.
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The President of the American Bankers Association expressed similar sentiments in 1908 (see Bankers Magazine 1908, November). Providing certainty about when the reserve could be used was seen as inherently difficult. Coe (1873) argued that it is very challenging to prescribe rules regarding the circumstances or timing in which the reserve should be allowed to be used or rebuilt. Concerns that the rules were preventing banks from running down their reserve were sufficiently great that in at least one instance, Congress introduced legislation in which one goal to make the reserve more clearly usable. In 1897, Representative Walker, Chair of the House Committee on Banking and Currency, argued that the currency legislation forbids, under severe penalties, the banks under any circumstances to use their reserves for the very purpose for which the banks are required to keep such reserves and proposed legislation to allow the banks to use their reserves in any legitimate way for the purpose for which they are required to keep a reserve (Committee on Banking and Currency, 1897 p. 28). This claim was strenuously denied by the Comptroller (Eckels 1897, pp. 320 and 324). The reserve and its potential use also created tension between banks subject to the reserve requirements and those not subject to them. The Bankers Magazine (1894, April) indicated that there was some expectation that the National Banks would use their reserves to provide liquidity and support to state and trust companies not subject to the reserve requirements, even if this support was only provided by the National Banks to protect themselves.
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The article indicated that this expectation was the source of some tension among bankers and resulted in some lack of cooperation during the panic. One might also speculate that some state banks or trust companies may have held lower reserves than they would have if they had not expected the National Banks to provide support. Hooper (1860) suggested that confidence about the reserve also likely affected banks willingness to use it. In particular, he argued that banks in New Orleans were required by law to maintain a higher reserve than those in Boston and that the populace of New Orleans, knowing the strength of the reserve, had greater confidence in their banks and thus the New Orleans banks were more able to use their reserve times of financial trouble.
Section 3.2 Evidence on Use of the Reserve During a Panic

Evidence on use of the reserve during panics situations provides a mixed picture of whether banks were willing to use their reserve. As their reserves were depleted during banking panics, banks in the central reserve city of New York would suspend or curtail shipments of currency to other parts of the country. Sprague (1913) argued that the New York banks tended to do so well before they had exhausted their reserve. In 1907, the Wall Street Journal noted that reserves were around 21 percent of deposits around the time of suspension, below the legal requirement but still fairly high. It was noted in the Journal that use of the reserve during the panic was appropriate: [T]here is a deficit of the bank reserve of $38,838,825. It should be
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remembered, however, that a reserve is for use. There is no wisdom in locking up immense sums of money in bank vaults unless they can be employed in times of emergencyalthough the deficit is very large, yet there is still left in the banks a reserve amounting to over 21 percent of deposits (Wall Street Journal, Nov. 4, 1907). Detailed information on bank balance sheets and reserves are available at a time shortly after the panic from the October 3, 1893 call report. Comparing reserves in 1893 for banks in the same cities as in 1892 suggests that reserve rates declined slightly for country banks and increased a bit for reserve city banks. There also appears to be a shift toward holding the reserves in cash at the bank rather than as deposits with reserve agents. Shifts in the size of the total reserve ratio appear to due largely to shifts in which banks are reporting. When the sample is restricted to banks reporting in both 1892 and 1893, for the median bank the total reserve ratios is higher in 1893 by less than one percentage point higher. By contrast, the shift toward cash is evident even when looking at the same banks. Again looking at the median bank for banks reporting in both 1892 and 1893, the ratio of cash to liabilities subject to the reserve requirement rose by over 5 percentage points, while the ratio of deposits at reserve agents to liabilities subject to reserve requirements decreased by over 5 percentage points. This shift was observable at both county and reserve city banks.
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Moreover, the number (and share) of banks reporting a reserve ratio below the legal requirement decreased relative to what was observed in 1892. Overall, these figures give the impression that banks not under such pressure tended not use their reserves to support the general liquidity of the financial system. Given the pyramiding of reserves that occurred through interbank deposits, the shift toward use of cash in reserves likely had a detrimental impact on overall system liquidity. Looking at how the reserves in 1894 compare to those in 1892 provides some information about longer-term changes to reserve holdings following a panic. Reserve ratios at country banks continued to average 29 percent, but the average reserve ratio for reserve city banks increased to 33 percent. Considering only banks that reported in both years, reserve ratios increased 1 percentage point for banks in country towns and 2 percentage points for banks in reserve cities. (The changes are strongly statistically significant for reserve city banks and moderately so for country banks.) These changes took place entirely from increases in cash holdings at the banks as ratios of reserves held with agents relative to deposits were little changed. These changes suggest that some of the increased preference for cash evident in 1893 persisted for some time.
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Section 3.3 Private sector mechanisms for promoting liquidity during banking panics
Commercial banks did have some mechanisms for responding to panics and trying to expand the supply of liquid assets. Banks in New York, and other large cities, formed clearinghouses to facilitate the settlement of payments between members. The clearinghouses also provided a way to supply liquidity to their members during a panic. In particular, the clearinghouses established procedures to allow banks to deposit securities with the clearinghouse and receive clearinghouse loan certificates that could be used to make payments to other members of the clearinghouse. Using clearinghouse notes allowed specie or other forms of cash to be used to satisfy the heightened demand from others for liquid assets (Comptroller 1873 and 1890, Nash 1908). The clearinghouse notes worked for interbank and sometimes local transactions, but not well for interregional payments. Clearinghouse notes were issued extensively in the Panic of 1907. In New York these notes continued to be large denomination notes, but in many smaller cities small denomination notes were issued and circulated with other currency in the general public market. Banks appear to have been fairly willing to use these loan certificates when the need arose. Tallman and Moen (2012) report that the majority of the loan certificates issued by the New York Clearinghouse Association during the Panic of 1907 went to the six largest banks.
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Nevertheless, there appears to have been some concern about the possibility of a negative reaction to the issuance of clearinghouse certificates. Coincident with the issuance of clearinghouse loan certificates, the New York Clearinghouse Association halted its normal practice of issuing a weekly statement that provided information on the balance sheet of each individual bank and instead reported only aggregate figures for all clearinghouse members. This shift was reportedly done in part to protect members receiving the loan certificates and whose reserves might otherwise appear to be depleted (Bankers Magazine 1907, November). Media reaction to the issuance of loan certificates was also mixed. Shortly after the issuance of the loan certificates in 1907, the Wall Street Journal noted: Although the issue of these certificates is a confession of weakness nevertheless it is also an assurance of strength, and the situation at the end of the week is all the better for the action taken by the Clearing House Association (Oct. 28, 1907, p.1).
Section 3.4 Discussion

The two mechanisms did provide some additional liquidity during a banking panic. Nevertheless, as evidenced by the widespread suspension of convertibility during the major banking panics that occurred between 1865 and 1910, these mechanisms were clearly insufficient to provide the necessary liquidity during times of stress.
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The reserve does not appear to have been used to the degree that proponents might have hoped, perhaps because the degree of regulator discretion and rules for its use and restoration were unclear. Clearinghouse certificates also helped, but, as they could not facilitate distance transactions, also proved insufficient.
Section 4. The Panic of 1907

This section very briefly describes the events of the Panic of 1907, which provides a useful illustration of the dynamics of bank liquidity during a crisis. The section also discusses the lessons of the crisis and the resulting impetus for a central bank.
Section 4.1 Brief history of the Panic of 1907

Two pieces of background information are useful for understanding the panic. First, in the years prior to the panic, there had been considerable growth in the size of the trust companies of New York City. These institutions took deposits and were similar to banks but the state laws allowed them to operate with smaller reserve requirements and without some other restrictions faced by banks. Indeed, these institutions established themselves as trust companies partly to avoid capital and reserve requirements. Trust companies were not members of the New York Clearinghouse Association, but relied on members of the association as clearing agents for payment processing.
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A second piece of background information is that, at both banks and trust companies, a significant portion of liquid assets consisted of call loans. Both banks and trusts depended on the call loan market as a secondary source of reserves, and most of the funding for the call loan market came from the banks and trusts. (Call loans were short-term loans to stock brokers to finance stock purchases and were collateralized by the purchased stocks. These loans could be called by the bank when funds were needed and it was assumed the stock brokers would be easily able to sell the stock to repay the loan.) The Panic of 1907 started when an attempt to corner the copper market collapsed. A number of banks were implicated, but runs on these institutions were quelled following a statement of support from the Clearinghouse Association. Shortly thereafter, a National Bank announced that it would no longer provide clearing services for the Knickerbocker Trust company. When it became clear that the Clearinghouse Association would not support the trust companies, a number of trusts experienced runs. The call loan market quickly came under immense pressure and borrowers in that market that were unable to find alternative funding and faced the prospect of selling their stocks in a firesale and possibly defaulting. Consequently, banks were not able to tap the call loan market as a secondary source of liquidity as they might normally do and the functioning of that market deteriorated significantly.
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Although the banks had held reserves in excess of what was required by law prior to the crisis, such reserves were not sufficient to prevent the New York banks from being forced to restrict payments to outoftown banks. Since they held large quantities of interbank deposits, these restrictions affected bank liquidity throughout the country. The interbank market for reserveson a national level and at the city level for many regional financial centersbroke down as many banks feared deposit withdrawals and hoarded cash and maintained reserves well in excess of what was required (Yates 1908). The panic ended when J.P. Morgan and a consortium of bankers agreed to serve as a de facto lender of last resort to the financial sector.
Section 4.2 Impetus from the Panic of 1907 for establishing a central bank
There were several lessons that policymakers took from the Panic of 1907 that prompted them to work toward establishing a central bank. One lesson was that when the instrument used as a reserve and primary source of supply liquidityin this case the supply of gold and Treasury noteswas fairly inelastic in the short run, demand for that instrument would exceed the available supply during a panic. The subsequent scramble for liquidity would cause short-term funding markets to freeze. (Gold could, and did, flow into the US from abroad in response to rising interest rates. These inflows boosted liquidity, but did take some time to arrive in quantities sufficient to meet demand.)
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As a result, many policy makers concluded that an elastic currency that could increase in quantity was required (Vanderlip 1908). The notion that an elastic currency was needed was not new; as early as 1868, the Comptroller argued in favor of providing some elasticity to the currency for use during times of stress. In particular, the Comptroller argued that The treasury of the United States could hold in reserve a certain amount of legal tender notes in excess of the amount of money in regular circulation, to be advanced to banking institutions at a specified rate of interest upon the deposit of United States bonds as collateral security, a source of relief would be established which would effectually prevent a monetary pressure from being carried to any ruinous extent (1868, p.27). Similar arguments in favor of making available additional currency backed by bonds to add elasticity to the currency and relieve seasonal and other financial pressures were made by the Comptroller in his Annual Report in 1899 (pp. 11-17) and 1902 (pp. 61-63). Various bankers also argued for an elastic currency (See for instance Pugsley (1902) and Hamilton (1906). White (1983) describes various other initiatives.) Nevertheless, following the Panic of 1907, legislative action seemed considerably more likely. Some proposals provided for an emergency currency that could be issued by a central authority only during a crisis; as a temporary palliative such a currency was included in the Aldrich-Vreeland Act of 1908. Under this Act the Secretary of the Treasury could, during a crisis, authorize the issuance of currency backed by any securities held by banks instead of the usual requirement that the currency be backed by U.S. government bonds.
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Ultimately, policymakers chose instead to create the Federal Reserve as a permanent solution where the discount window could be used to turn bank assets into central bank reserves and would thus provide an elastic currency that could be used to respond to changing stringencies in money markets more flexibly and continuously than could the issuance of emergency currency. A closely related argument made by advocates of a central bank was that only central bank notes or reserves are certain to be liquid during a financial crisis (Sprague 1911). Other assets were argued to be liquid only to the extent that they could be converted into central bank reserves: In countries where these notes of the central banks are generally accepted in settlement of debts by business men and banks, the banking reserves of the stock banks may safely consist of the central bank currency, or of a balance kept with the central bank, convertible into such currency. These form the first line of banking reserves. The second line consists of those assets which, with certainty and promptness, may be converted into credit balances with the central bank (Warburg 1916, p. 9). Central bank reserves also have the advantage of being able to be expanded by the central bank during a stress episode. Moulton (1918) notes that the expansion of liquidity is essential during a crisis as banks are expected to be the source of liquidity for their non-financial customers during a crisis and if banks are required to bolster their own liquidity to support their reserve by demanding repayment of, or even refusing to renew, loans during a crisis then financial strains can be significantly exacerbated.
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(Moulton also cautions that, at least at that time, securities holdings were unlikely to be effective as a secondary reserve during a crisis as banks could only sell their securities to other banks. If all banks were seeking to sell their securities holdings at the same time, those securities would be not function as a source of liquidity. This implies that to function as a source of liquidity during a crisis, a security must have ready purchasers from outside the banking system.) Another lesson was that behavioral dynamics could be affected by the absence or presence of a central bank. During a panic, individual banks would pull their funds out of the banks in the reserve cities and bolster their liquid resources (Bankers Magazine 1908, November); several observers, such as the Comptroller (1907) and Herrick (1908), reported that declines in interbank deposits contributed at least as much to the panic as the actions of individual depositors. Banks were argued to have acted out of self preservation because there was no guarantee that their regular source of liquidity, the reserve city banks, would be able to furnish liquidity should the crisis intensity (Roberts 1908, Sprague 1913). Indeed, the banks in New York had suspended payments to out-oftown banks during several prior banking panics. As a central bank would be able to provide a guaranteed liquidity backstop, individual banks would not need to hoard liquidity at the first sign of stress because they would know that the backstop would still be available in a crisis; Warburg (1914) goes a bit further and argues that to prevent hoarding the backstop and ability to turn supply cash must have absolute credibility which only a central bank could provide.
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It was expected that the existence of the central bank would prompt a change in behavior during a panic and would stop minor stresses from escalating into full blown crises (Warburg 1916). A third lesson was that the liquidity requirements that tried to strike a balance between ensuring that the liquidity of the banking system was maintained yet not hampering banks in providing credit were likely to be overwhelmed during a panic. Even critics of central banks sought ways to allow private market participants to expand the supply of liquid assets during a panic. One other aspect of the panic that was not lost on policymakers was that institutions outside the normal banking system, in this case the Trust companies, could precipitate a run on the banking system. The realization that these outside institutions could threaten the stability of the system may have prompted some large influential Clearinghouse Association members to support a central bank (see White 1983, Moen and Tallman 1999).
Section 5. Reserve requirements after the founding of the Federal Reserve

With the establishment of the Federal Reserve, required reserves were reduced as it was expected that the liquidity backstop from the central bank provided individual commercial banks with a ready means of meeting extraordinary liquidity demands. As noted by Rodkey (1934): With the advent of the Federal Reserve System in 1914, we entered upon an era of central banking...
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The central bank is thus placed in position to make advances, either directly or indirectly, to the individual member banks as the replenishment of their reserves becomes necessary... It is clear that the presence of a central bank, prepared to make advances on eligible assets, places the individual bank in a less vulnerable position with respect to demands of its depositors. It tends to lessen the need for primary reserves. The Federal Reserve Act recognized this fact by reducing materially the percentage of required reserves (p.64). Westerfield (1921) noted that the reduction in reserves was appropriate for several reasons including that the reserve because they were concentrated (as opposed to dispersed across banks throughout the system), because the reserves were located in a central bank which feels its responsibility and because their availability is now unquestioned. Lunt (1922), who provided instructions to insurers on how to assess the quality of a bank from its balance sheet, noted that prior to the founding of the Federal Reserve the statement of cash and cash items was regarded as extremely important, and banks that habitually carried larger reserves than those required by law were thought to be exceptionally safe (p.217). However, with the Federal Reserve, the point seems far less important now, since any bank that has a proper loan account can replenish its reserve at will by the simple process of rediscounting . While reserve requirements continued to be viewed as a tool to promote bank liquidity for some time, there was a gradual shift away from this view. Indeed, by the late 1930s, reserve requirements were no longer seen as playing an important role in providing liquidity.
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The committee [Federal Reserve System Committee on Bank Reserves] takes the position that it is no longer the case that the primary function of legal reserve requirements is to assure or preserve the liquidity of the individual member bank. The maintenance of liquidity is necessarily the responsibility of bank management and is achieved by the individual bank when an adequate proportion of its portfolio consists of assets that can be readily converted into cash. Since the establishment of the Federal Reserve System, the liquidity of an individual bank is more adequately safeguarded by the presence of the Federal Reserve banks, which were organized for the purpose, among others, of increasing the liquidity of member banks by providing for the rediscount of their eligible paper, than by the possession of legal reserves (Federal Reserve 1938). It is useful to note that during this period, the Federal Reserve was important as a lender to the banking system. Burgess (1936) notes that in a typical month during the mid-1920s about one-third of member banks obtained at least one loan or advance from their Reserve Bank. As a regular lender to the system, it would be fairly easy for the Federal Reserve to provide additional liquidity to individual banks. The discount window was seen by Federal Reserve staff as the primary source of emergency liquidity for the banking system, especially after the range of eligible collateral was significantly expanded in 1932.29 As they shifted away from being seen as promoting individual bank liquidity, reserve requirements were increasingly seen as a tool to manage credit growth and facilitate the use of monetary policy.
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This development occurred as the Federal Reserve began to use open market operations to adjust available reserves in the banking system as its primary monetary policy tool; it was seen as impractical to have reserves both serve as a source of liquidity and be manipulated for monetary policy purposes. The two main functions of legal requirements for member bank reserves under our present banking structure are, first, to operate in the direction of sound credit conditions by exerting an influence on changes in the volume of bank credit, and secondly, to provide the Federal Reserve banks with sufficient resources to enable them to pursue an effective banking and credit policy (Federal Reserve 1938).
Section 6. Lessons and concluding remarks

From the late 1830s until 1913, regulatory efforts aimed at promoting bank liquidity consisted primarily of reserve requirements that mandated that individual institutions hold liquid assets. However, these reserves were not sufficient to provide liquidity and prevent banks from suspending deposit withdrawals during banking panics. To provide for an elastic currency that could be expanded to meet the extraordinary liquidity demands experienced during a crisis, the Federal Reserve was established. Several lessons from the historical reserve requirement experience are apparent. One of the most important lessons is that individual bank liquidity is intricately connected to central bank liquidity policy. For instance, in the absence of a lender-of-last-resort backstop, banks have more incentive to hoard liquidity which could exacerbate stress episodes.
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Second, the historical debates point out that a known and understood regulatory response to shortfalls in the reserve is an important factor for whether the reserve will be used in times of stress (and for how binding the reserve requirement will be during ordinary times). Third, historical experience indicates that when certain assets are designated as stores of liquidity, institutions will seek to accumulate those during a crisis. Unless the pool of designated assets is large or can be expanded at those times, there is some risk that the functioning of the market for those assets can deteriorate. Further, if non-regulated institutions also use the designated assets as a source of liquidity, then problems at those institutions can spill over and affect the liquidity of the banking sector. Policymakers today are considering various liquidity requirements for banks. For instance, under the Basel III requirements, banks will be subject to a liquidity coverage ratio (LCR). Under this requirement, banks will be required to maintain a stock of high quality and liquid assets as a buffer that is sufficient to cover potential net cumulative cash outflows at all times during a 30-day period. To a large degree, the LCR is similar to a reserve requirement in that it effectively requires liquid assets to be held against certain classes of liabilities (and lines of credit). The historical experience with reserve requirements offers valuable lessons for policymakers as they implement the LCR and other liquidity regulations.
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Bank for International Settlements
International financial markets and bank funding in the euro area: dynamics and participants
Jaime Caruana, General Manager Adrian Van Rixtel, Senior Economist
1. Introduction
Financial markets are undergoing major and at times very rapid changes, mostly as a result of the financial crisis that began in 2007. It is still too early to say for certain which of these changes will endure and which will disappear and to what degree when a new balance is reached. However, we must analyse them in order to be able to design appropriate policies. Among the many forces driving these market developments, we would like to focus on three which have their roots in the crisis. First are changes in market participants perception and management of risk. Counterparty and liquidity risk, for example, were undervalued in the years preceding the crisis but are now major concerns for financial institutions. In addition, systemic risk, stemming from the interconnections between the financial system and the real economy, must be internalised.
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Second, imbalances accumulated on public and private balance sheets over many years must be corrected. These imbalances are reflected on financial institutions balance sheets in the form of excessive leverage and excessive maturity and liquidity transformation. While deleveraging is part of the adjustment needed to restore the soundness of the banking sector, at the same time it burdens financial markets with asset sales and contractions in credit, giving rise to vicious cycles that increase systemic risk. Policies to reduce risk and provide protection against contagion are leading to a renationalisation of financial flows and to market fragmentation. Cross-border lending has contracted more rapidly than domestic lending. In particular, markets in the euro area have been segmented increasingly along national borders. As they attempt to protect themselves against the effects of the crisis, some national authorities are building barriers against cross-national liquidity movements that threaten further segmentation along national lines. Third are regulatory changes. Financial markets are undergoing regulatory changes aimed at making them sounder and more stable. These changes seek to apply the lessons learned from the crisis while preventing collective behaviour from leading to a watering-down of regulations.
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Much emphasis is being placed on consistency in the adoption of the regulations in different countries and on analysing the unwanted negative effects these measures might have. These drivers and their effects on the financial system can be clearly seen in the unfolding crisis in the euro area, particularly in the strains and changes in bank financing. At the most critical points in the crisis, risk aversion and volatility in euro area financial markets increased sharply, with severe contagion effects to international financial markets. The recent tensions in some countries were driven by the increasing interaction between concerns about the sustainability of public finances and the fragility of financial systems in an atmosphere of low growth. Concerns about government deficits and debts in various peripheral European countries, especially when accompanied by external imbalances, spilled over to euro area banks. And financial systems fragility generated contingent liabilities in public finances, thus making the fragilities of sovereign debt become increasingly intertwined with the financial crisis, and creating difficulties for bank funding. In addition to this vicious circle, lower economic growth and the inability to provide stimulus due to the lack of fiscal space make deleveraging even more difficult and weaken bank asset quality. Bank funding had already seen major changes in the years prior to the euro area crisis. During the past few decades, banks loosened the constraints of deposit growth and raised funds from institutional investors in global financial markets.
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They tapped new sources of funding, such as securitisation. The business model of investment banks relied on wholesale funding from institutional investors, especially at short maturities (Merck et al (2012)). Financial globalisation allowed banks to tap institutional investors beyond national borders, which expanded traditional international funding to international interbank markets (CGFS (2010a), McGuire and von Peter (2009), Fender and McGuire (2010)). This greater reliance on funding provided through financial markets experienced unprecedented dislocations during the 200709 global financial crisis. It set off major adjustments in banks business and funding models, which in many cases were later reinforced by the euro area financial crisis. In both crises, some banks access to funding was limited, predominantly because of a deterioration of the quality of their assets, eg mortgage related financial instruments in the case of the global crisis and sovereign debt in the euro crisis. This article investigates how bank funding in the euro area in recent years reflected these market developments. In fact, bank funding can be seen as the area where important issues related to the crisis and financial markets come together. It should be emphasised that this analysis simplifies a very complex reality, with profound differences among different financial institutions and countries. First, adverse feedback effects between the weaknesses of sovereigns and banks disrupted funding markets severely.
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During episodes of severe sovereign strains, access to short- and longer-term wholesale funding markets became problematic even for euro area banks with the highest credit ratings, forcing them to resort to alternative funding sources and to shrink the size of their balance sheets. Second, BIS data show that international interbank funding for euro area banks has collapsed from the high levels observed in 2008. This renationalisation applies especially to funding provided by euro area banks to other euro area banks. As a result, a banks country of origin largely determines its access to various funding instruments and their costs instead of its financial strength. These difficulties have been most pronounced for banks from peripheral countries, which have suffered the most severely from fiscal imbalances. Third, a particular class of international institutional investors, US money market mutual funds, has on balance over the past year withdrawn large sums of short-term funding from euro area banks. For these institutional investors, however, it is not so much a case of a return to home bias as a shift from euro area and UK banks to other foreign banks. Fourth, the crisis has led to a growing recourse to funding secured by collateral, such as covered bonds. This development adds to the already growing demand for assets with high liquidity and low credit risk, in the aftermath of the 200709 global financial crisis. Meanwhile, changes in regulation are adding to demand for such assets even as the loss of creditworthiness of sovereigns is reducing the number of suppliers.
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This has raised concerns about a potential scarcity of safe assets that can be used as collateral. In addition, the fact that a larger part of bank assets is used as collateral for covered bonds (BIS (2012)) tends to raise the riskiness of unsecured debt, leading investors all the more to demand that debt be collateralised. Finally, the renationalisation of bank funding has intensified the dependence on ECB liquidity, which has substituted for lost access to euro area cross-border interbank and bond funding. In what follows, we analyse some of these market trends: first we sketch the adverse feedback between sovereigns and banks. Then we concentrate on the dynamics of several main sources of funding, namely international interbank markets (mostly for loans but also for bond holdings), US money market funds, bond markets and ECB liquidity. The final section concludes.
2. Link between sovereigns and banks

Since the first quarter of 2010, sovereign debt tensions and their spillover to banks in general and their funding in particular have dominated, in various stages and to different extents, financial and economic developments in the euro area. These sovereign debt strains came before many European banks had really cleaned their balance sheets of assets that were impaired during the global financial crisis. In the event, government finances and banks funding interacted strongly (Caruana (2011), Caruana and Avdjiev (2012)). In particular, sovereign risk affects bank funding through several channels (CGFS (2011)).
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Many banks hold significant amounts of predominantly domestic sovereign bonds on their balance sheets, which can lead to valuation losses and credit risk concerns when sovereign yields rise sharply. Moreover, sovereign debt serves as collateral for various financial transactions, including private repos. Sovereign tensions result in lower collateral values, owing to larger haircuts or margin requirements, which effectively reduce the ability of banks to obtain funding. In addition, sovereign downgrades spill over to banks, worsening both their cost of and access to funding, while reducing the funding benefits they derive from implicit and explicit government guarantees.
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Signs of the strong link between sovereigns and banks started to become more pronounced early in 2010. Tensions in international financial markets were driven by growing concerns about the sustainability of public finances in view of persistent government deficits and high levels of public debt in peripheral European countries in general and in Greece in particular. Specifically, this was the case when the tensions were compounded by countries extensive reliance on foreign funding and that funding had to compete with the refinancing of high public debt.
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These concerns spilled over to banks and, in most euro area countries and most periods, were reflected in marked increases in bank CDS spreads in parallel to the sovereign ones (Graph 1). In this context, interbank funding costs, not only for euro borrowing but also for that in US dollars and sterling, increased sharply (Graph 2, left-hand panel). Again, euro area banks experienced strains in US dollar short-term funding markets (Fender and McGuire (2010)). International spillovers of the euro area financial crisis were also visible in the frequent and often sharp declines in stock prices of US and UK banks in parallel to those of euro area banks (Graph 2, right-hand panel). Weak economic growth and loss of competitiveness pointed to lower government revenues and loan losses, and the anticipation of these feedback effects pressured banks further.
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The significance of the strong interconnection between sovereigns and banks in the euro area financial crisis is shown by the overall increasing trend in the predominantly positive 90-day moving correlations between sovereign and bank CDS spreads for most countries (Graph 3). The co-movement between these spreads increased across euro area countries after the nationalisation of Allied Irish Bank in January 2009, which subsequently contributed to a more pronounced transmission of sovereign risks to banks (Mody and Sandri (2011)). It was particularly high for most euro area countries during crisis periods involving various peripheral countries, such as Greece, Ireland and Portugal, joined later in the crisis by Spain and Italy. At the same time, correlations between sovereign and bank CDS spreads of these countries declined sharply after they received supranational support. [Greece, Ireland and Portugal received support through joint EU-IMF programmes in May 2010/March 2012, November 2010 and April 2011, respectively; the ECB re-activated its Securities Markets Programme (SMP) for Italian and Spanish sovereign debt in August 2011; Spain received limited official funding to support the recapitalisation of its banking sector in June 2012.]
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Cross-border holdings of government debt by banks have played an important role in the development of the euro area financial crisis. Traditionally, domestic banks in key euro area countries held a larger share of their respective governments debt than banks in the US or UK (but a smaller one when compared with Japanese banks). The introduction of the euro reduced this home bias by fostering portfolio diversification, which led to a significant increase in cross-border euro area sovereign bond holdings among euro area countries. In fact, owing to EMU, euro area investors increased the share of their investments in debt securities issued by euro area countries more than investors from all other countries (De Santis and Grard (2009)). Still in 2007, the share of sovereign debt held by domestic banks remained large, particularly for the peripheral countries (Greece, Ireland, Italy, Portugal and Spain).
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Moreover, there are indications that during more recent crisis periods the home bias of banks from peripheral countries increased again (Merler and Pisani-Ferry (2012)). Holdings by euro area monetary financial institutions (MFIs) of other euro area countries sovereign debt as a ratio of their total bond holdings have been on a declining trend since 2006 and have now returned to levels observed in 1998 (ECB (2012b)). All in all, the euro area crisis has demonstrated that sovereign debt holdings can impede banks efforts to regain the trust of their peers and market participants at large. The high degree of international integration between government debt markets and banking systems in the euro area has played an important role in the propagation of the crisis (Bolton and Jeanne (2011)). Exposures to sovereigns in the euro areas periphery spread bank distress to countries with stronger state finances. And for many banks headquartered in the periphery countries, exposures to own governments are much higher than common equity. They are also sizeable in the case of large national banking sectors in other euro area countries. Thus, getting sovereign finances in order is a necessary condition for a healthy banking system.
3. International interbank lending

Since the onset of the financial crisis in August 2007, euro area banks have seen their access to international interbank funding reduced, in some cases substantially. This has been mainly concentrated in intra-euro area interbank markets: international lending by euro area banks to other euro area banks has
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declined sharply, as funding within the euro area has again become segmented along national lines. Overall, between end-2008 and end-2011, international interbank lending from one euro area bank to another shrank drastically, thereby reversing an equally dramatic surge between 2003 and 2008 (Graph 4). This withdrawal of international funds from intra-euro area interbank markets was not offset by an increase in funding provided by non-euro area banks. The decline in international interbank lending within the euro area was concentrated in funds provided through both loans and deposits and debt securities (Graph 5). Debt securities contracted most in proportional terms, but international loans and deposits also fell sharply from the historic high recorded at end-June 2008. The dynamics of the movement in international funds provided between banks in the euro area followed the development of the euro area crisis closely. For both loans and deposits and debt securities, it fell sharply during episodes of severe market stress, such as the first half of 2010 and the second half of 2011, while it recovered during periods of subdued tensions, most notably the first half of 2011. The recent measures taken by the ECB, the expansion of the range of acceptable collateral and the new sovereign bond-buying programme (Outright Monetary Transactions, OMT) have reduced redenomination risk, one factor that had increasingly been contributing to market fragmentation. Sustaining the improvements achieved with regard to risk premia will
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require swift progress both at the country level and through institutional advances in the euro area.
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4. The role of US money market funds

So-called prime US money market funds (MMFs) are important participants in international financial markets, as they channel funds from US households and firms to non-US banks. These funds invest in short-term instruments and try to offer more attractive returns to retail and corporate investors than bank deposits do. Before the crisis, US MMFs became one of the main funding sources of the shadow banking system, by purchasing asset-backed commercial paper (ABCP) from structured finance vehicles and other short-term debt issued by US investment banks and non-bank mortgage lenders. Competition to offer investors higher yields has long led MMFs to hold short-term debt and certificates of deposit issued by European and other banks headquartered outside the United States. US MMFs became the largest single supplier of dollar funding to non-US banks, providing around one trillion US dollars to European banks in mid-2008 (Baba et al (2009)). In the aftermath of the 200709 global financial crisis, they increased their exposures to euro area banks further, while those to US banks fell strongly (Graph 6, left-hand panel) as US banks were downgraded, and changed their funding models. Since early 2010, following the intensification of the euro area financial crisis, however, US MMFs have sharply reduced their exposures to euro area banks in general and to peripheral countries banks in particular (Graph 6, right-hand panel). This has been driven not only by heighted assessment of underlying risk, but also by managers of MMFs seeking to reassure uninsured investors. After the run by institutional investors on prime MMFs in September
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October 2008 and amid ongoing discussion of whether the systemic threat of such runs had been removed by subsequent Securities and Exchange Commission reforms, such funds appear to have been particularly quick to reduce exposures to euro area banks. With the intensification of the crisis in the summer of 2011, the joint exposures of US MMFs to the five peripheral euro area countries, which were never large, became negligible. Strikingly, they also reduced their short-term investments in core euro area banks, which were large. This reduction was the most pronounced for French banks, driven by concerns about their exposures to peripheral sovereign debt, but also affected German, Dutch and Belgian banks (Graph 6, right-hand panel). In the first half of 2012, euro area exposures of US MMFs stabilised but remained at very low levels. Rather than retreating from international exposures, these funds increased their investment in debt instruments issued by Canadian, Japanese and Swiss banks, as well as Scandinavian banks (not shown in Graph 6).
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5. Bond markets: preference for secured funding can lead to scarcity of Collateral
Institutional investors in bank bonds have reduced holdings of euro area bank bonds as well. The euro area financial crisis has impaired access to these markets, most notably during episodes of rapidly increasing market tensions and for banks from peripheral countries. Banks from Greece, Ireland and Portugal have been virtually shut out of primary bond markets, while those from Italy and Spain have enjoyed only intermittent and unreliable access to them (Graph 7). At the same time, funding stress frequently affected core countries banks as well. Banks from Germany, France and the Netherlands issued very modest amounts of bonds in months of severe market turmoil linked to the euro area crisis.
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Moreover, during these episodes, market strains spilled over to banks outside the euro area, such as UK banks (Graph 7). Overall, gross bond issuance by euro area banks has declined with the worsening of the crisis, by 15% in 2011 from 2010 and by 22% in the first half of 2012 from the same period one year earlier.
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The crisis has led to major changes in the composition of gross bond issuance by instrument, especially for banks from peripheral countries. The euro area financial crisis has reinforced the trend towards greater recourse to secured longer-term funding, such as covered bonds (Romo Gonzlez and Van Rixtel (2011), ECB (2012a)). The share of covered bonds in total gross bond issuance by euro area banks has increased from 26% in the first half of 2007 to 40% and 45% in the first half of 2010 and 2012, respectively. For many banks from peripheral countries, most notably from Spain and Italy, this instrument has become the main source of long-term wholesale
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funding, as their access to unsecured markets has been partially or fully closed (Graph 7). Covered bond issuance has been spurred as well by more structural factors, such as favourable regulatory treatment, for example under Basel III and Solvency II and in various bail-in proposals, and legislative initiatives in several countries. Growing issuance of covered bonds has added to the concerns about the scarcity of collateral, or more precisely of safe assets that can be used as collateral. Covered bond issuance by banks results in a balance sheet in which a substantial proportion of their assets is encumbered, ie pledged with priority to investors in covered bonds. The intensification of the crisis has led banks to overcollateralise to a larger degree, which has reduced even more the unencumbered assets available to serve as collateral for new covered bonds. Asset encumbrance also reduces access to unsecured senior debt issuance, because as the pool of encumbered assets underlying covered bonds grows, holders of unsecured bank debt have a claim on fewer assets in the event of the banks insolvency. This substantially reduces their attractiveness as investments (Oliver-Wyman (2011), BIS (2012), ECBC (2012), ECB (2012a)). Concerns about collateral scarcity seem to be an important driver of the increasing trend of so-called retained issuance by peripheral countries banks. As the access of many of these banks to primary bond markets has become impaired, they have started to retain larger parts of their gross bond issuance instead.
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These banks mainly use this paper as collateral in ECB liquidity operations. In the first half of 2012, significantly larger shares of gross bond issuance by Italian, Portuguese and Spanish banks were retained (Graph 7). In contrast, issuance by German, French and Dutch banks has remained targeted to primary public markets and thereby to outside investors. This difference in bond issuance patterns between peripheral and core countries again underscores the renationalisation of funding markets. Strained access to bond financing has led to a revival of the issuance of government guaranteed bonds. The intensification of the crisis in the second half of 2011 propelled the re-activation or prolongation of programmes in all peripheral countries, as well as in Germany. Government guaranteed issuance had become a very important source of longerterm bank funding in 2008 and 2009 at the height of the global financial crisis, and generally has been assessed positively, although not as being without some costs (CGFS (2011), Muller et al (2011)). The reactivation of the programmes in Italy and Spain allowed solid positions had not reduced the value of these explicit guarantees substantially.
6. The provision of ECB liquidity

With the development of the crisis, some euro area banks have resorted to central bank funding on a massive scale. The ECB has conducted a wide range of open market operations, amounting to an unprecedented 1.1 trillion at the end of June 2012.
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This liquidity was absorbed predominantly by banks from countries either under joint EU-IMF programmes or experiencing severe sovereign tensions, showing the distinct segmentation of bank funding according to bank nationality. It was augmented by Emergency Liquidity Assistance (ELA) especially in Greece and Ireland, where national central banks took on the risk of funding local banks through their lender of last resort function. All in all, the worsening euro area financial crisis has substantially increased the dependence of several national banking systems on central bank liquidity, as a result of the increasing renationalisation of market-based bank funding. This trend has been the clearest for Greece, with almost 30% of total bank assets financed by ECB liquidity, while for Ireland and Portugal the proportion has reached about 10% (Graph 8, left-hand panel). The sharp deterioration of the crisis from March 2012 onwards that was concentrated on Spain and spilled over to Italy led to significant increases in the dependence of their banking systems on ECB liquidity as well (Graph 8, right-hand panel).
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7. Policy implications
The severe funding dislocations that were observed during the most intense episodes of the euro area crisis led to unprecedented challenges for policymakers and forced them to take exceptional measures on a large scale. Although the dynamics of the crisis are still evolving, we would like to emphasise several implications for policy. First, recent experience has again demonstrated how quickly and profoundly bank funding can dry up when there is a lack of confidence in the markets. Funding structures that seem stable in normal times can turn highly unstable during episodes of financial market stress. Financing obtained from foreign sources tends to be particularly unstable, and may be especially sensitive to shocks in recipient countries. A case in point is the sharp reduction in international interbank exposures within the euro area in recent years. This has demonstrated again the benefits of stable funding structures, which facilitate the lengthening of maturities, and of considerable diversification between domestic and foreign sources based mainly on deposits and equity and less on short-term wholesale funding.
The Basel III Framework promotes the latter shift.

It ensures that banks rely on their own capacity to build liquidity buffers and raise stable funding, thereby reducing funding liquidity risk. Banks with strong capital and liquidity buffers are much better equipped to withstand disruptions in funding.
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Second, the strong link between sovereigns and banks has underscored the importance of fiscal prudence and, in the European case, the need for greater financial integration in the euro area. This is particularly true for those dependent for funding on foreign capital, which can suddenly leave, shifting the burden to domestic banks and investors. It is easier to build up fiscal buffers in good times than to restore confidence in a crisis. Financial cycles are longer and more difficult to assess than normal business cycles, and more room for manoeuvre is required to deal with them. Third, because recourse to secured funding encumbers a larger part of a banks assets, in the event the bank fails fewer assets are available to holders of the banks unsecured debt, which reduces its attractiveness to investors. Thus, heavier asset encumbrance may increase concerns of collateral scarcity and potentially may impair both the access to and cost of unsecured funding. Scarcity of collateral is worsened if formerly safe assets that could be used as collateral become seen as risky assets. Quite apart from the usual macroeconomic reasons for appropriate fiscal policy, financial markets require sovereigns that are considered practically risk-free. For this reason, in financial systems that tend to operate on the basis of collateral, confidence in the sustainability of public debt has an added value.
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Its absence leads to difficulties and higher funding costs for the economy as a whole. Finally, the increased fragmentation of financial markets, especially in the euro area, and the reliance of peripheral banking systems in the euro area on ECB liquidity require action on several fronts. Within each country, public debt must be made more sustainable, structural reforms must facilitate growth and the financial system must be repaired. For the euro area as a whole, institutional improvements must continue, and there must be greater financial and fiscal integration, mainly with regard to the three aspects of the banking union: common supervision, system-wide deposit insurance and a single resolution system. The recent ECB measures provide more time for these reforms to be implemented, but they are not a substitute for the reforms, so swift progress is still needed.
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Countercyclical loans for the management of exogenous shocks in small vulnerable economies (SVEs) and non traditional sources of development finance
Opening remarks by Mr Jwala Rambarran, Governor of the Central Bank of Trinidad and Tobago, at the Joint Commonwealth Secretariat and United Nations Development Program workshop on Countercyclical loans for the management of exogenous shocks in small vulnerable economies (SVEs) and non-traditional sources of development finance, Port of Spain Ladies and Gentlemen, I thank the Commonwealth Secretariat and the United Nations Development Program (UNDP) for the invitation to deliver opening remarks at this joint workshop on what I consider to be one of the more critical issues facing small vulnerable economies, but which ten years after the Monterrey Consensus on Financing for Development has been largely ignored by the international policy community. While developing countries have made much progress in meeting the 8 Millennium Development Goals (MDGs) to free humanity from extreme poverty, hunger, illiteracy and disease by 2015, substantial challenges still remain, especially in reaching the most vulnerable. Multiple financial, food, energy and economic crises, which often respect no borders, further aggravate matters. As the deadline approaches, we have the opportunity to design a post-2015 framework that builds on successes, learn from past shortcomings, and addresses the gaps in the current MDGs.
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Jeffrey Sachs, Professor of Sustainable Development at Columbia University, warns us in his January 24th 2013 article entitled Writing the Future that humanity faces no greater challenge than to ensure a world of prosperity rather than a world of ruins. Professor Sachs strikes a prescient note when he states Like a novel with two possible endings, ours is a story yet to be written in this new century. There is nothing inevitable about the spread or the collapse of prosperity. More than we know (or perhaps care to admit), the future is a matter of human choice, not mere prediction. I therefore commend the Commonwealth Secretariat and the UNDP for mounting this first of three workshops here in the Caribbean, with the other two to be held in the African and Pacific regions. Perhaps this will be the first chapter on the post-2015 development story of new financing arrangements for small vulnerable Caribbean economies, whose future might be partly based on the choices you make at this workshop. I certainly look forward to the outcomes of all three workshops, and hope that the shared positions will help to influence African, Caribbean and Pacific governments in their advocacy for innovative sources of development finance to be a front-burner issue on the international economic agenda. Ladies and Gentlemen, it is no secret that small vulnerable economies in the Caribbean have grappled with external shocks of varying magnitudes and duration over the past two decades. These shocks include a compression of aid flows, dismantling of preferential trade arrangements for sugar and bananas, interventions
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related to anti-money laundering and combating the financing of terrorism. More recently, the Caribbean has been gradually recovering from the shock of the global financial crisis, which originated in the United States and spread to Europe, the regions two closest trading and investment partners. The untold story, however, is that the combined influence of these multiple shocks has led to a dramatic and fundamental shift in the composition of external financing flows to the Caribbean. In my respectful view, the most significant change in the regional pattern of external resource flows stemmed from the sharp compression in Official Development Assistance (ODA). Flows of ODA to many Caribbean countries began falling in the 1990s, as donors redirected their aid priorities to the newly emerging Commonwealth of Independent States and the Least Developed Countries. This is certainly ironic because the eighth MDG recognizes that developing countries require more generous development aid to have the best chances of reducing poverty and accelerating development within the stipulated 15 year timeframe. Faced with declining aid resources, many Caribbean governments resorted to more expensive commercial borrowing to bridge their funding gaps. This, combined with the growing inability of regional governments to generate high enough primary fiscal surpluses for debt servicing, contributed to a large public debt overhang.
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Gross public debt in the Caribbean climbed rapidly from 65 percent of GDP in 1998 to a peak of almost 100 percent of GDP in 2002, before falling to a still elevated 80 percent of GDP in 2012. The accumulation of public debt was even faster in the Eastern Caribbean, moving from just over 60 percent of GDP in 1998 to a high of almost 120 percent of GDP in 2004, before falling to 95 percent of GDP in 2012. Generally, a public debt ratio of over 90 percent of GDP is considered exceptionally high. By this measure, four countries in the Caribbean are projected to hold exceptionally high public debt in 2013: Jamaica (140 percent), St. Kitts & Nevis (139 percent), Grenada (109 percent), and Antigua & Barbuda (93 percent). Another six countries are projected to have heightened debt vulnerabilities, averaging in the range of 50 to 90 percent of GDP, in 2013. These are the Bahamas, Belize, Dominica, Guyana, St. Lucia and St. Vincent and the Grenadines. Ladies and Gentlemen, the magnitude of the fiscal adjustment required to stabilize and eventually reduce the Caribbeans public debt overhang is neither socially nor politically feasible. Only two small island developing states in the Caribbean Guyana and Haiti have been able to access comprehensive debt relief under the enhanced Heavily Indebted Poor Country (HIPC) Initiative and under the Multilateral Debt Relief Initiative (MDRI). Other small vulnerable Caribbean economies are considered not poor enough and/or not severely indebted enough to benefit from similar international debt relief measures.
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In the meantime, a few Caribbean small island developing states have engaged in debt restructuring operations, sometimes more than once, but debt problems persist. The sombre picture, Ladies and Gentlemen, is one of wide external current account deficits, heavy public debt and slowing capital flows which are placing undue pressure on the regions international reserves and predominantly fixed exchange rate regimes (inclusive of a currency board arrangement in the Eastern Caribbean). Caribbean countries are unwilling to devalue their currencies to support their weaker external positions. Barbados, in particular, remains vehemently opposed to devaluation, which it considers ill-conceived and unsuccessful at correcting the low growth, high debt dilemma facing small, vulnerable Caribbean economies. An appropriate balance is yet to be struck between adjustment and financing. Since September 2008, nine small island developing states in the Caribbean have turned to the IMF for increased financial support under various lending facilities. These are Antigua and Barbuda, Belize, Dominica, Grenada, Haiti, Jamaica, St. Kitts/Nevis, St. Lucia and St.Vincent and the Grenadines. Yet, it is arguable whether the current lending facilities of the IMF, the World Bank and other international financial institutions are sufficient enough to help mitigate the impact of large, unforeseen external shocks on Caribbean and other small vulnerable economies. Over the past decade, the international community has championed several initiatives to help mobilize more resources for development or to make them more effective.
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Well known examples include the International Finance Facility for Immunization, debt conversions, emissions trading, a financial transactions tax and use of the IMFs Special Drawing Rights (SDRs). The jury is still out on whether these major schemes have created additional financial flows for development. For many Caribbean countries, remittances have become an important and promising source of non-traditional external financing. In fact, the Caribbean is among the larger recipient of remittances in proportion to its GDP. For countries such as Haiti, Jamaica and Guyana, remittances represent a lifeline, contributing to smoothing household consumption, easing balance of payments pressures, and financing domestic investments. In effect, the Caribbean has created its very own large, highly educated diaspora pool that represents a potential alternative source of long-term funding. The stock of the Caribbean diaspora is estimated to be around 3.5 million people or more than one-fifth of the regions population. Preliminary estimates place the annual savings of the Caribbean diaspora at over 15 percent of the regions GDP. Despite this impressive potential market, regional governments are yet to adopt innovative financing solutions such as diaspora bonds to tap into the wealth of its diaspora. Ladies and Gentlemen, I have noted the wide scope of this workshop agenda, which ranges from exploring the feasibility of countercyclical loan instruments from the IMF and World Bank to identifying new sources of revenues including new regional financing mechanisms for small vulnerable economies.
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I am also most impressed with the caliber of the presenters. I have no doubt that you have the right ingredients for stimulating and fruitful discussions over the next two days. But we must be realistic. There is no silver-bullet solution to the deep-rooted, financing challenges facing small vulnerable economies. Stabilizing the Caribbeans debt overhang as a priority is only a start. Putting in place the policies and institutions to allow pro-poor growth and achievement of the MDGs in the Caribbean will require persistent action from governments across the region. In this regard, I see both the Commonwealth Secretariat and UNDP continuing to play an active role.
Conclusion
In closing, Ladies and Gentlemen, I must remind our foreign participants that even as you devote attention to the rigors of the workshop, you have come to Trinidad and Tobago during the Carnival season, a most opportune time to witness the creativity, energy and passion of our people. So do take time if only to experience Super Blues Fantastic Friday. Let me assure you all of the continued support and collaboration of the Central Bank of Trinidad and Tobago in helping to move development finance issues facing small vulnerable economies onto the international agenda. I thank you.
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FSB publishes peer review on risk governance

The Financial Stability Board (FSB) published today a thematic peer review on risk governance. The report takes stock of risk governance practices at both national authorities and firms, notes progress made since the financial crisis, identifies sound practices and offers recommendations to support further improvements. The recent global financial crisis exposed a number of risk governance weaknesses in major financial institutions, relating to the roles and responsibilities of corporate boards of directors (the board), the firm-wide risk management function, and the independent assessment of risk governance. Without the appropriate checks and balances provided by the board and these functions, a culture of excessive risk-taking and leverage was allowed to permeate in many of these firms. The peer review found that, since the crisis, national authorities have taken several measures to improve regulatory and supervisory oversight of risk governance at financial institutions. These measures include developing or strengthening existing regulation or guidance, raising supervisory expectations for the risk management function, engaging more frequently with the board and management, and assessing the accuracy and usefulness of the information provided to the board to enable effective discharge of their responsibilities. Nonetheless, more work is necessary.
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In particular, national authorities need to better assess the effectiveness of a firms risk governance framework, and more specifically its risk culture, to help ensure the sound management of risk through the economic cycle. Supervisors will need to strengthen their assessment of risk governance frameworks to encompass an integrated view across all aspects of the framework. The peer review also surveyed 36 banks and broker-dealers that FSB members deemed as significant for the purpose of the review. The evaluation of their responses indicates that many of the best risk governance practices at surveyed firms are now more advanced than national supervisory guidance, an outcome that may have been motivated by firms need to regain market confidence. Despite these considerable strides, significant gaps remain in a number of areas, particularly in the risk management function. At the core of strong risk management is an effective risk appetite framework, and firms progress to date is uneven in its development, comprehensiveness and implementation. Very few firms were able to identify clear examples of how they used their risk appetite framework in strategic decision-making processes. Drawing from the findings of the review, the report identifies a list of sound risk governance practices that would help firms continue to improve their risk governance and national authorities to assess its effectiveness. The review also sets out several recommendations targeting areas where more substantial work is needed, in particular:
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1. National authorities should strengthen their regulatory and supervisory guidance for financial institutions and devote adequate resources to assess the effectiveness of risk governance frameworks. 2. Standard setting bodies should review their principles for governance, taking into consideration the sound risk governance practices set out in the report. 3. The FSB should explore ways to formally assess risk culture at financial institutions. 4. The FSB should provide general guidance on the key elements that should be included in risk appetite frameworks and establish a common nomenclature for terms used in risk appetite statements. Tiff Macklem, Chairman of the FSBs Standing Committee on Standards Implementation (SCSI), said: The review usefully pulls together good risk governance practices and identifies follow-up work that needs to be done by national authorities to strengthen their ability to assess the effectiveness of firms risk governance frameworks. Recent headline events surrounding activities at some large financial institutions underscore the importance of promoting and implementing a sound risk culture. Swee Lian Teo, Chair of the peer review team on risk governance, said: While measures have been taken to improve risk governance, the review showed that there are still gaps that need to be addressed by both firms and supervisors. The report sets out recommendations that will help supervisors everywhere raise the bar on their expectations for risk governance so that firms practices continue to improve through changing environments.
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Notes
The FSB has been established to coordinate at the international level the work of national financial authorities and international standard setting bodies and to develop and promote the implementation of effective regulatory, supervisory and other financial sector policies in the interest of financial stability. It brings together national authorities responsible for financial stability in 24 countries and jurisdictions, international financial institutions, sector-specific international groupings of regulators and supervisors, and committees of central bank experts. The FSB also conducts outreach with 65 other jurisdictions through its six regional consultative groups. The peer review on risk governance is the the sixth thematic peer review conducted by the FSB and the first thematic review using the revised objectives and guidelines for the conduct of peer reviews set forth in the December 2011 Handbook for FSB Peer Reviews. Thematic reviews focus on the implementation and effectiveness across the FSB membership of international financial standards developed by standard-setting bodies and policies agreed within the FSB in a particular area important for global financial stability. Thematic reviews may also analyse other areas important for global financial stability where international standards or policies do not yet exist. The objectives of the reviews are to encourage consistent cross-country and cross-sector implementation; to evaluate (where possible) the extent to which standards and policies have had their intended results; and to identify gaps and weaknesses in reviewed areas and to make recommendations for potential follow-up (including via the development of new standards) by FSB members.
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Thematic Review on Risk Governance Peer Review Report Foreword

Financial Stability Board (FSB) member jurisdictions have committed, under the FSB Charter and in the FSB Framework for Strengthening Adherence to International Standards, to undergo periodic peer reviews. To fulfil this responsibility, the FSB has established a regular programme of country and thematic peer reviews of its member jurisdictions. Thematic reviews focus on the implementation and effectiveness across the FSB membership of international financial standards developed by standard-setting bodies and policies agreed within the FSB in a particular area important for global financial stability. Thematic reviews may also analyse other areas important for global financial stability where international standards or policies do not yet exist. The objectives of the reviews are to encourage consistent cross-country and cross-sector implementation; to evaluate (where possible) the extent to which standards and policies have had their intended results; and to identify gaps and weaknesses in reviewed areas and to make recommendations for potential follow-up (including via the development of new standards) by FSB members. This report describes the findings of the thematic peer review on risk governance, including the key elements of the discussion in the FSB Standing Committee on Standards Implementation (SCSI).
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Executive summary
The recent global financial crisis exposed a number of governance weaknesses that resulted in firms failure to understand the risks they were taking. In the wake of the crisis, numerous reports painted a fairly bleak picture of risk governance frameworks at financial institutions, which consists of the three key functions: the board, the firm-wide risk management function, and the independent assessment of risk governance. The crisis highlighted that many boards had directors with little financial industry experience and limited understanding of the rapidly increasing complexity of the institutions they were leading. Too often, directors were unable to dedicate sufficient time to understand the firms business model and too deferential to senior management. In addition, many boards did not pay sufficient attention to risk management or set up effective structures, such as a dedicated risk committee, to facilitate meaningful analysis of the firms risk exposures and to constructively challenge managements proposals and decisions. The risk committees that did exist were often staffed by directors short on both experience and independence from management. The information provided to the board was voluminous and not easily understood which hampered the ability of directors to fulfil their responsibilities. Moreover, most firms lacked a formal process to independently assess the propriety of their risk governance frameworks. Without the appropriate checks and balances provided by the board, the risk management function, and independent assessment functions, a
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culture of excessive risk-taking and leverage was allowed to permeate in these weakly governed firms. Further, with the risk management function lacking the authority, stature and independence to rein in the firms risk-taking, the ability to address any weaknesses in risk governance identified by internal control assessment and testing processes was obstructed. The peer review found that, since the crisis, national authorities have taken several measures to improve regulatory and supervisory oversight of risk governance at financial institutions. These measures include developing or strengthening existing regulation or guidance, raising supervisory expectations for the risk management function, engaging more frequently with the board and management, and assessing the accuracy and usefulness of the information provided to the board to enable effective discharge of their responsibilities. Nonetheless, more work remains; national authorities need to strengthen their ability to assess the effectiveness of a firms risk governance, and more specifically its risk culture to help ensure sound risk governance through changing environments. Supervisors will need to undergo a substantial change in approach since assessing risk governance frameworks entails forming an integrated view across all aspects of the framework. The peer review also asked supervisors to evaluate progress made by their surveyed firm(s) toward enhanced risk governance in seven areas. To provide some consistency to this exercise, the review team developed high-level criteria to assist supervisory evaluations of firms progress, drawing from a compilation of relevant principles, recommendations and supervisory guidance.
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The high-level criteria were viewed as fundamental prerequisites for risk governance frameworks. This evaluation found that many of the best risk governance practices at surveyed firms are now more advanced than national guidance. This outcome may have been motivated by firms need to regain market confidence rather than regulatory requirements. Firms have made particular progress in: assessing the collective skills and qualifications of the board as well as the boards effectiveness either through self-evaluations or through the use of third parties; instituting a stand-alone risk committee that is composed only of independent directors and having a clear definition of independence; establishing a group-wide chief risk officer (CRO) and risk management function that is independent from revenue-generating responsibilities and has the stature, authority and independence to challenge decisions on risk made by management and business lines; and integrating the discussions among the risk and audit committees through joint meetings or cross-membership. Although many surveyed firms have made progress in the last few years, significant gaps remain, relative to the criteria developed, particularly in risk management. There were also differences in progress across regions with firms in advanced economies having adopted more of the desirable risk governance practices. The results of the supervisory evaluations were grouped by:
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(i) all surveyed firms; (ii) firms identified by the FSB and Basel Committee on Banking Supervision (BCBS) as global systemically important financial institutions, or G-SIFIs; and (iii) firms that reside in advanced economies (AEs) or emerging market and developing economies (EMDEs). In summary, across the seven areas evaluated, firms have made the most progress in defining the boards role and responsibilities, and reasonable progress in their approach to risk governance and the independent assessment of risk governance. The supervisory evaluations, however, indicate that surveyed firms should continue to work toward defining the responsibilities of the risk committee and strengthening their risk management functions as nearly 50 per cent of surveyed firms did not meet all of the evaluation criteria in these areas. By type of institution, surveyed G-SIFIs are more advanced than other financial institutions in defining the responsibilities of the board and risk committee, conducting independent assessments of risk governance, providing relevant information to the board and risk committee, and to some extent more advanced in the risk management function. These results support the finding that the firms in the regions hardest hit by the financial crisis have made the most progress. Meanwhile, supervisory evaluations of firms that reside in EMDEs show that nearly 65 per cent did not meet all of the criteria for the risk management function. These gaps need immediate attention by both supervisors and firms. Other significant findings coming out of the review include the following:
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National authorities do not engage on a sufficiently regular and frequent basis with the board, risk committee and audit committee. Several jurisdictions hold such meetings only once a year or on an as-needed basis. Good progress has been made toward elevating the CROs stature, authority, and independence. In many firms, the CRO has a direct reporting line to the chief executive officer (CEO) and a role that is distinct from other executive functions and business line responsibilities (e.g., no dual-hatting). This elevation, however, needs to be supported by the involvement of the risk committee in reviewing the performance and setting the objectives of the CRO, ensuring that the CRO has access to the board and risk committee without impediment (including reporting directly to the board/risk committee), and facilitating periodic meetings with directors without the presence of executive directors or other management. More work is needed on the part of both national authorities and firms on establishing an effective risk appetite framework (RAF). Assessing a firms RAF is a challenging task that requires greater clarity and an elevated level of consistency among national authorities. Supervisory expectations for the independent assessment of internal control systems by internal audit or other independent function were well-established prior to the crisis. As such, this is an area that demonstrated relatively sound practices across the FSB membership at both national authorities and firms. However, no jurisdiction had specific expectations for internal audit to periodically provide a firm-wide assessment of risk management or risk governance processes.
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Nearly all firms have an independent chief audit executive (CAE) who reports administratively to the CEO and the audit committee chair and who directly reports audit findings to a permanent audit committee. However, there is still room for improving the CAEs access to directors beyond those on the audit committee. Drawing from the findings of the review, including discussions with industry organisations as well as risk committee directors and CROs of several firms that participated in the review, the report identifies some of the better practices exemplified by national authorities and firms to collectively form a list of sound risk governance practices (see Section V). It also draws on some of the relevant principles and recommendations for risk governance published by other organisations and standard setting bodies. No one single authority or firm, however, demonstrated all of these sound practices. This integrated and coherent list of sound practices aims to help national authorities take a more holistic approach to risk governance, rather than looking at each facet in isolation, and may provide a basis for consideration by authorities and standard setting bodies as they review their guidance and standards for strengthening risk governance practices. The review sets out several recommendations to ensure the effectiveness of risk governance frameworks continue to improve by targeting areas where more substantial work is needed. While the review focused on banks and broker-dealers that are systemically important, these recommendations apply to other types of financial institutions, including insurers and financial conglomerates.
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Recommendations:
1. To ensure that firms risk governance practices continue to improve, FSB member jurisdictions should strengthen their regulatory and supervisory guidance for financial institutions, in particular for SIFIs, and devote adequate resources (both in skills and quantity) to assess the effectiveness of risk governance frameworks. In particular, national authorities should consider the following sound risk governance practices: i. Set requirements on the independence and composition of boards, including requirements on relevant types of skills that the board, collectively, should have (e.g., risk management, financial industry expertise) as well as the time commitment expected. ii. Hold the board accountable for its oversight of the firms risk governance and assess if the level and types of risk information provided to the board enable effective discharge of board responsibilities. Boards should satisfy themselves that the information they receive from management and the control functions is comprehensive, accurate, complete and timely to enable effective decision-making on the firms strategy, risk profile and emerging risks. This includes establishing communication procedures between the risk committee and the board and across other board committees, most importantly the audit and finance committees. iii. Set requirements to elevate the CROs stature, authority, and independence in the firm. This includes requiring the risk committee to review the performance and objectives of the CRO, ensuring the CRO has unfettered access to the board and risk committee (including a direct reporting line to the board
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and/or risk committee), and expecting the CRO to meet periodically with directors without executive directors and management present. The CRO should have a direct reporting line to the CEO and a distinct role from other executive functions and business line responsibilities (e.g., no dual-hatting). Further, the CRO should be involved in activities and decisions (from a risk perspective) that may affect the firms prospective risk profile (e.g., strategic business plans, new products, mergers and acquisitions, internal capital adequacy assessment process, or ICAAP). iv. Require the board (or audit committee) to obtain an independent assessment of the design and effectiveness of the risk governance framework on an annual basis. v. Engage more frequently with the board, risk committee, audit committee, CEO, CRO, and other relevant functions, such as the CFO, to assess the firms risk culture (e.g., the tone at the top), whether directors provide effective challenge to managements proposals and decisions, and whether the risk management function has the appropriate authority to influence decisions that affect the firms risk exposures. 2. The relevant standard setting bodies (e.g., BCBS, IAIS, IOSCO, OECD) should review their principles for governance, taking into consideration the sound risk governance practices listed in Section V. 3. Risk culture plays a critical role in ensuring effective risk governance endures through changing environments. The FSB Supervisory Intensity and Effectiveness group has agreed to implement the recommendation from the 2012 FSB progress report on enhanced supervision to explore ways to formally assess risk culture, particularly at G-SIFIs. This work should be completed by September 2013.
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4. To improve their ability to assess firms progress toward more effective risk management, national authorities should provide guidance on the key elements that are incorporated in effective risk appetite frameworks. To enable firms to define frameworks with a minimum amount of comparability despite their firm-specific nature, a common nomenclature for terms used in risk appetite statements (e.g., risk appetite, risk capacity, risk limits) should be established. The FSB Supervisory Intensity and Effectiveness group, in collaboration with relevant standard setters, has agreed to finalise this work by the end of 2013. 5. The FSB should consider launching a follow-up review on risk governance after 2016 (i.e., after the G-SIFI policy measures begin to be phased in), to assess national authorities implementation of the recommendations to strengthen their supervisory guidance and oversight of risk governance. The review also should include the G-SIFIs identified in 2014 by the FSB in collaboration with the BCBS and IAIS.
(Important Part)
Increasing the intensity and effectiveness of supervision to reduce the moral hazard posed by SIFIs is a key component of the FSBs policy measures, endorsed by G20 Leaders. Since the onset of the global crisis, supervisors have intensified their oversight of financial institutions, particularly SIFIs, so as to reduce the probability of their failure. Specifically, supervisory expectations of risk management functions and overall risk governance frameworks have increased, as this was an area that exhibited significant weaknesses in many financial institutions during the global financial crisis.
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While supervisors are responsible for assessing whether a firms risk governance framework and processes are adequate, appropriate and effective for managing the firms risk profile, the firms management is responsible for identifying and managing the firms risk. In October 2011, the FSB agreed to conduct a thematic peer review on risk governance to assess progress toward enhancing practices at national authorities and firms (banks and broker-dealers). For purposes of this review, risk governance collectively refers to the role and responsibilities of the board, the firm-wide CRO and risk management function, and the independent assessment of the risk governance framework (see Chart 2).
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- Board responsibilities and practices: The board is responsible for ensuring that the firm has an appropriate risk governance framework given the firms business model, complexity and size which is embedded into the firms risk culture. How boards assume such responsibilities varies across jurisdictions. - Firm-wide risk management function: The CRO and risk management function are responsible for the firms risk management across the entire organisation, ensuring that the firms risk profile remains within the risk appetite statement (RAS) as approved by the board. The risk management function is responsible for identifying, measuring, monitoring, and recommending strategies to control or mitigate risks, and reporting on risk exposures on an aggregated and disaggregated basis. - Independent assessment of the risk governance framework: The independent assessment of the firms risk governance framework plays a crucial role in the ongoing maintenance of a firms internal controls, risk management and risk governance. It helps a firm accomplish its objectives by bringing a disciplined approach to evaluate and improve the effectiveness of risk management, control and governance processes. This may involve internal parties, such as internal audit, or external resources such as third-party reviewers (e.g., audit firms, consultants).
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Supervisory guidance for managing risks associated with the settlement of foreign exchange transactions
The purpose of this guidance is to provide updated guidance to supervisors and the banks they supervise on approaches to managing the risks associated with the settlement of FX transactions. This guidance expands on, and replaces, the BCBS's Supervisory guidance for managing settlement risk in foreign exchange transactions published in September 2000. Since the BCBS's Supervisory guidance for managing settlement risk in foreign exchange transactions (2000) was published, the foreign exchange market has made significant strides in reducing the risks associated with the settlement of FX transactions. Substantial FX settlement-related risks remain, however, not least because of the rapid growth in FX trading activities. The document provides a more comprehensive and detailed view on governance arrangements and the management of principal risk, replacement cost risk and all other FX settlement-related risks. In addition, it promotes the use of payment-versus-payment arrangements, where practicable, to reduce principal risk. The guidance is organized into seven "guidelines" that address governance, principal risk, replacement cost risk, liquidity risk, operational risk, legal risk, and capital for FX transactions. The key recommendations emphasize the following:
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A bank should ensure that all FX settlement-related risks are effectively managed and that its practices are consistent with those used for managing other counterparty exposures of similar size and duration. A bank should reduce its principal risk as much as practicable by settling FX transactions through the use of FMIs that provide PVP arrangements. Where PVP settlement is not practicable, a bank should properly identify, measure, control and reduce the size and duration of its remaining principal risk. A bank should ensure that when analysing capital needs, all FX settlement-related risks should be considered, including principal risk and replacement cost risk and that sufficient capital is held against these potential exposures, as appropriate. A bank should use netting arrangements and collateral arrangements to reduce its replacement cost risk and should fully collateralise its mark-to-market exposure on physically settling FX swaps and forwards with counterparties that are financial institutions and systemically important non-financial entities.
Annex FX settlement-related risks and how they arise

1. In the period between FX trade execution and final settlement, a bank is exposed to a number of different risks. The risks vary depending on the type of pre-settlement and settlement arrangements. A bank needs to understand the risks associated with FX transactions in order to adequately manage them.
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2. Section A describes principal risk, replacement cost risk and liquidity risk. Section B identifies and describes the presence of operational and legal risks between trade execution and final settlement. Finally, Section C discusses the various pre-settlement and settlement arrangements and their impact on risks. 3. For the purposes of exposition, the risks are described from the point of view of a bank and a failed FX counterparty of that bank. Section A describes the risks relating to a single FX trade between a bank and its counterparty. This is generalised to multiple trades in Sections B and C.
A. Risks relating to counterparty failure to deliver the expected currency

4. The three main risks associated with FX transactions are principal risk, replacement cost risk and liquidity risk, which arise due to the possibility that a counterparty may fail to settle an FX trade. This failure may be temporary (eg operational or liquidity problems of the counterparty) or permanent (eg counterpartys insolvency). A bank may become aware of a potential failure at any time between trading and the completion of settlement, particularly if the problem is due to insolvency. However, sometimes, a bank may only know that a problem has occurred on or after settlement day when it does not receive the currency that the counterparty was expected to deliver. Initially, a bank may not be able to identify the cause of the failure, nor determine whether the failure is temporary or permanent.
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5. A bank is exposed to principal risk, replacement cost risk and liquidity risk until it receives the bought currency with finality.
Principal risk
6. Principal risk is the risk that a bank pays away the currency being sold, but fails to receive the currency being bought. Principal risk can be the most serious risk because the amount at risk can be equal to the full value of the trade. 7. Principal risk exists when a bank is no longer guaranteed that it can unilaterally cancel the payment of the currency it sold (the unilateral cancellation deadline). Given that a banks unilateral payment cancellation deadline may be one or more business days before the settlement date, this risk can last for a significant period of time.
Replacement cost risk

8. Replacement cost risk is the risk that an FX counterparty will default before a trade has settled and that the bank must replace it with a new trade and a different counterparty at current market prices (potentially less favourable exchange rate). As such, the bank may incur a loss relative to the original trade. Replacement cost risk exists throughout the period between trade execution and final settlement.
Liquidity risk
9. Liquidity risk is the risk that a counterparty will not settle an obligation for full value when due.
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Liquidity risk does not imply that a counterparty is insolvent since it may be able to settle the required debit obligations at some unspecified later time. 10. Liquidity risk exists in addition to replacement cost risk. Whether a default is just a replacement cost problem or turns into a liquidity shortage depends on whether a bank can replace the failed trade in time to meet its obligations or, at least, to borrow the necessary currency until it can replace the trade. In principle, liquidity risk can exist throughout the period between trade execution and final settlement. In practice, the probability of the problem materialising as a liquidity shortage and a replacement cost depends on many factors, including: The timing of the default. The closer the default is to the settlement date, the less time a bank has to make other arrangements. Whether a bank has already irrevocably paid away the currency it is selling. If so, the bank may have fewer liquid assets available to pay for the replacement trade or to use as collateral to borrow the currency it needs. The nature of the trade. The less liquid the currency being purchased and/or the larger the value of the trade, the harder it may be to replace. 11. A bank may find it hard to predict the probability of a liquidity shortage, as it cannot make a sound judgment based solely on normal market conditions. However, there is a strong positive correlation between a counterparty default and illiquid markets (ie the default may be the cause of the market illiquidity or an effect of it).
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In addition, trades that are easy to replace in normal conditions may be impossible to replace when markets are less liquid and experiencing stressed conditions.
B. Operational and legal risks

12. A bank may also face FX settlement-related risks caused by weaknesses in its own operations and weaknesses in the legal enforceability of contractual terms and the governing law applicable to its transactions. If a bank has inadequate operational capabilities or if there are weaknesses in the legal basis for the pre-settlement and settlement arrangements, it can face increased principal risk, replacement cost risk and liquidity risk relating to counterparty failure. 13. Operational risk is the risk of loss due to external events or inadequate or failed internal processes, people and systems. This definition includes legal risk and excludes strategic and reputational risk. 14. Inadequate skills and insufficient processing capacity may increase potential exposures. These weaknesses can cause operational delays, inaccurate confirmation and reconciliation, or an inability to quickly correct or cancel payment instructions. 15. Legal risk occurs when a counterpartys contractual FX obligations are non-binding, unenforceable and subject to loss because: (i) The underlying transaction documentation is inadequate; (ii) The counterparty lacks the requisite authority or is subject to legal transaction restrictions;
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(iii) The underlying transaction or contractual terms are impermissible and/or conflict with applicable law or regulatory policies; or (iv) Applicable bankruptcy or insolvency laws limit or alter contractual remedies. 16. Legal problems may affect settlement of a foreign exchange transaction. Legal issues may compromise the legal robustness of netting, the enforceability of unilateral cancellation times or certainty about the finality of the receipt of currency.
C. Impact of pre-settlement and settlement arrangements on risks

17. FX settlement-related risks may be affected by the type of pre-settlement and settlement arrangements used by a bank. Risk implications for the most common arrangements are described below. This section focuses on the implications for the risks related to counterparty failure described in Section A. Different pre-settlement and settlement arrangements can also impact the operational and legal risks described in Section B some arrangements may be operationally more complex, require more demanding risk management or create different legal risks. However, since these implications can vary from bank to bank and depend on specific circumstances, they are not covered in this section.
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Close-out netting
18. Legally robust and enforceable netting arrangements can be a safe and efficient method for reducing settlement exposures. In the context of bilateral FX transactions, close-out netting is a specific type of netting that establishes a close-out payment based on the net present value of future cash flows between a bank and a defaulting counterparty. This involves two counterparties entering into a formal bilateral agreement stipulating that, if there is a defined event of default (eg insolvency of one of the counterparties), the unpaid obligations covered by the netting agreement are netted. The value of those future obligations is calculated to a net present value, usually in a single-base currency. Thus, a series of future dated cash flows is typically reduced to one single payment due to, or from, the closed-out counterparty. 19. Legally enforceable close-out netting reduces principal risk, replacement cost risk, liquidity risk and operational risk for unsettled future obligations. Without close-out netting, a bank may be required to make principal payments to a defaulted counterparty. This risk is particularly relevant in jurisdictions without statutory provision or with weak or ineffective provision for offset of obligations with a defaulted counterparty. Thus, a bank may face gross principal risk, replacement cost risk and liquidity risk on transactions not covered by a legally enforceable netting agreement.
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Bilateral obligation netting

20. Under bilateral obligation netting, FX transactions between two counterparties due to settle on a certain date are netted to produce a single obligation to pay in each currency on that date (ie each counterparty has an obligation to pay a single amount in those currencies in which it is a bilateral net seller). Those net amounts are likely to be smaller than the original gross amounts, reducing principal and liquidity risks. Obligation netting can take different forms (eg netting by novation) and may vary by jurisdiction. Their effectiveness depends on the legal soundness of the contractual terms.
Collateral arrangements
21. If netting is accompanied by a collateral arrangement, replacement cost risk can be reduced further. A collateral arrangement is where the counterparty with the negative net position provides financial assets to the other counterparty in order to secure that obligation. Collateral could be taken to cover only price movements that have already occurred. However, in this case, if there is a counterparty default, a bank is still exposed to further movements that may occur between the time collateral was last taken and the time that the bank succeeds in replacing the trade (potential future exposure).
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Further protection can be achieved if collateral is also taken to cover the potential future exposure. Since the actual size of this exposure cannot be determined until after the event, the degree of additional protection depends on the assumptions made when calculating the collateral amount. Note that such collateral arrangements are typically not used to provide protection against liquidity or principal risk.
Settlement via traditional correspondent banking

22. Under this settlement method, each counterparty to an FX trade transfers to the other counterparty the currency it is selling, typically using their correspondent banks for the currencies concerned. Once a payment instruction is irrevocable, the full amount being transferred is subject to principal risk, and some portion may be subject to replacement cost risk and liquidity risk.
On-us settlement
23. On-us settlement is where both legs of an FX transaction are settled across the books of a single institution. On-us settlement can occur either where one counterparty to a transaction provides accounts in both currencies to the other counterparty, or where one institution provides accounts to both counterparties to an FX transaction in both currencies. The account provider debits one of its customers accounts and credits the other, while making opposite debits and credits to its own account.
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Those credits can be made simultaneously (via PVP) or at different times, in which case one counterparty may be exposed to principal risk from the other counterparty. Irrespective of whether principal risk exists, normal correspondent credit risks are also likely to exist.
Payment-versus-payment settlement
24. Payment-versus-payment (PVP) settlement is a mechanism that ensures the final transfer of a payment in one currency if, and only if, a final transfer of a payment in another currency occurs, thereby removing principal risk. There are various forms of PVP settlement arrangements, including the type offered by CLS Bank International (CLS Bank). Another form consists of a link between payment systems in the two currencies, where a payment is made in one system if, and only if, payment is made in the other system. PVP arrangements do not guarantee settlement. In a basic PVP arrangement, a trade will settle only if a bank and its counterparty pay in the correct amount. If the counterparty fails to pay in, a bank will receive back the currency it was selling, thus providing protection against principal risk. However, it will still be short on the currency that it was buying and face liquidity risk equal to the full amount of that currency, as well as the replacement cost risk on that amount.
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Central clearing
25. A central counterparty (CCP) is an entity that interposes itself between counterparties to trades in a financial market, thus, becoming the buyer to every seller and the seller to every buyer. In this way, a form of multilateral obligation netting is achieved among the original counterparties. Currently, CCPs for FX trades involving an exchange of payments at settlement are rare, but they may become more widespread in the future.
Indirect participation in settlement or CCP arrangements

26. A bank may choose to be an indirect participant of a settlement or CCP arrangement (ie a customer of a direct participant). In this case, the FX settlement-related risks a bank faces will depend, in part, on the exact terms of the service provided by the direct participant. Thus, the risks associated with indirect participation may not be the same as those associated with direct participation.
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Overview of Guidelines Guideline 1: Governance

A bank should have strong governance arrangements over its FX settlement-related risks, including a comprehensive risk management process and active engagement by the board of directors.
Guideline 2: Principal risk

A bank should use FMIs that provide PVP settlement to eliminate principal risk when settling FX transactions. Where PVP settlement is not practicable, a bank should properly identify, measure, control and reduce the size and duration of its remaining principal risk.
Guideline 3: Replacement cost risk

A bank should employ prudent risk mitigation regimes to properly identify, measure, monitor and control replacement cost risk for FX transactions until settlement has been confirmed and reconciled.
Guideline 4: Liquidity risk

A bank should properly identify, measure, monitor and control its liquidity needs and risks in each currency when settling FX transactions.
Guideline 5: Operational risk

A bank should properly identify, assess, monitor and control its operational risks.
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A bank should ensure that its systems support appropriate risk management controls, and have sufficient capacity, scalability and resiliency to handle FX volumes under normal and stressed conditions.
Guideline 6: Legal risk

A bank should ensure that agreements and contracts are legally enforceable for each aspect of its activities in all relevant jurisdictions.
Guideline 7: Capital for FX transactions

When analysing capital needs, a bank should consider all FX settlement-related risks, including principal risk and replacement cost risk. A bank should ensure that sufficient capital is held against these potential exposures, as appropriate.
Executive summary
Since the previous supervisory guidance was published in 2000, the foreign exchange (FX) market has made significant strides in reducing the risks associated with the settlement of FX transactions. These risks include principal risk, replacement cost risk, liquidity risk, operational risk and legal risk. Such FX settlement-related risks have been mitigated by the implementation of payment-versus-payment (PVP) arrangements and the increasing use of close-out netting and collateralisation. However, substantial FX settlement-related risks remain due to rapid growth in FX trading activities. In addition, many banks underestimate their principal risk2 and other associated risks by not taking into full account the duration of exposure between trade execution and final settlement.
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While such risks may have a relatively low impact during normal market conditions, they may create disproportionately larger concerns during times of market stress. Therefore, it is crucial that banks and their supervisors continue efforts to reduce or manage the risks arising from FX settlement. In particular, the efforts should concentrate on increasing the scope of currencies, products and counterparties that are eligible for settlement through PVP arrangements. This guidance expands on, and replaces, the Supervisory guidance for managing settlement risk in foreign exchange transactions published in September 2000 by the Basel Committee on Banking Supervision (BCBS). The revised guidance provides a more comprehensive and detailed view on governance arrangements and the management of principal risk, replacement cost risk and all other FX settlement-related risks. It also promotes the use of PVP arrangements, where practicable, to reduce principal risk. The BCBS expects banks and national supervisors to implement the revised guidance in their jurisdictions, taking into consideration the size, nature, complexity and risk profile of their banks FX activities. This guidance is organised into seven guidelines that address governance, principal risk, replacement cost risk, liquidity risk, operational risk, legal risk, and capital for FX transactions. The key recommendations emphasise the following: A bank should ensure that all FX settlement-related risks are effectively managed and that its practices are consistent with those used for managing other counterparty exposures of similar size and duration.
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A bank should reduce its principal risk as much as practicable by settling FX transactions through the use of FMIs that provide PVP arrangements. Where PVP settlement is not practicable, a bank should properly identify, measure, control and reduce the size and duration of its remaining principal risk. A bank should ensure that when analysing capital needs, all FX settlement-related risks should be considered, including principal risk and replacement cost risk and that sufficient capital is held against these potential exposures, as appropriate. A bank should use netting arrangements where netting is legally enforceable and collateral arrangements to reduce its replacement cost risk and should fully collateralise its mark-to-market exposure on physically settling FX swaps and forwards with counterparties that are financial institutions and systemically important non-financial entities.
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Speech by Andrew Bailey, Managing Director, Prudential Business Unit at the Chartered Institutes Nicholas Barbon Lectures, London
Thank you for inviting me to give this Nicholas Barbon Lecture. And, thank you for giving me the opportunity to remind myself of the career of Nicholas Barbon I say remind myself because a long time ago I was an economic historian. Barbon is certainly one of the founders if not the founder of the insurance industry in London in the late seventeenth century. He was first a builder, indeed, he wrote a tract called an apology for the builder in which he defended new construction in London on the grounds that cities created employment and wealth. Barbon was probably the leading builder of the time and he offered an integrated service because he pioneered house insurance. Indeed there are observations that Barbons business was to build, insure, and re-build your house when it fell down.
These days you would be in FSA enforcement if you tried that one.
But Barbon was also one of the early economic theorists in a period at the end of the seventeenth century when economic theory flourished, before it went into abeyance until Adam Smith and David Hume came onto the scene.
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Barbon developed the argument that wealth creates demand and he extolled conspicuous consumption: he wrote that a poor man wants a Pound; a rich man a Hundred. Clearly, Barbon never quite imagined that one day investment bankers would take his idea to a whole new level. And, finally on Barbon, he was around at the time of the founding of the Bank of England. Indeed, the records suggest that he very much wanted the Bank of England not to be founded, and instead that his own idea of a national Land Bank should have received the favour of the Crown and Parliament. That did not happen, and so I guess that Barbon would not be happy on finding out that the Bank of England will, over three hundred years later, take on regulating his industry of insurance. But then his writings suggest that Barbon was no fan of regulation. From my perspective this is a very exciting time because after nearly three years of work on a wide range of subjects covering the legislation, the new model of prudential supervision, our staff, property, IT and other things, we can see the new Prudential Regulation Authority starting to take shape for real. We are in the process of moving into our new home at 20 Moorgate. There were several reasons why we chose a City location. One consequence is that it will bring us closer to the insurance industry, which for the most part resisted the appeal of Canary Wharf and stayed close to the roots that date back to Barbon. He would have approved, providing he could have built, insured, and rebuilt your building.
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Time will tell whether you will welcome having your prudential regulator near to your doorsteps, and as far as we know located in the City for the first time. I want to tackle a number of large issues today, which are closely connected. First, why do we think it makes sense to place prudential supervision of insurance in the PRA alongside banks and major investment firms? Second, what style of supervision will the PRA adopt and how will it affect insurers? And third, how do we think about the issue of systemic risk, and systemically important status for insurers? There are over 700 insurers in this country which will be subject to prudential supervision by the PRA and conduct supervision by the FCA (in addition, insurance brokers will be entirely supervised by the FCA). Why place prudential supervision of insurers in the PRA alongside banks? I am tempted to make one point here and conclude, namely that we asked to have one industry that caused us less trouble than banks. Of course, that would be on the basis of please keep it that way. Its tempting to stop there, but in all honesty it would not be the full story. Banks and insurers have one crucial thing in common which distinguishes them from other financial services providers, namely that they bring the funds customers deposit or invest directly onto their balance sheets and therefore expose customers directly to the risk inherent in those balance sheets.
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We did not, however, place insurers under the PRA because they are like banks, even though there are important similarities in the prudential approach we apply to both sectors. Why then? For me, the logic has to do with what we have learned about our role during the crisis. The traditional model of supervision has been quite industry specific. The FSA regime introduced in 1997 created a single authority, but within the FSA the framework of rules applied to insurance supervision is unique to the industry. It is true that in the run-up to the start of the crisis, and for some time thereafter, the FSA mingled insurance and bank supervision in terms of its operating units, but I think that did not work effectively and we have moved to a clear distinction with an insurance supervision directorate headed by Julian Adams. Insurance supervision is a skill of its own, and while our supervisors do move roles between insurance and banking in both directions, we want to ensure that we have groups of truly expert insurance and banking supervisors. The reason for locating insurance and banking in the PRA is in my view that we have learned during the crisis that our job as prudential supervisors is to ensure that the public and users of financial services, including the corporate sector, can be assured of continuous access to the critical services on which they depend. Many financial services may be regarded as critical by their users, but some are distinctive because it is hard for consumers to replace their provider with a substitute without accepting unacceptable cost and loss.
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Insurers provide critical services to the public in terms of risk transfer and very long-lived savings contracts. This last point draws out that insurance is not a single homogenous industry general and life insurance are very different activities - and we recognise that in our supervision. It would be unacceptable to the public to have access to risk transfer through, say home or car insurance, or professional indemnity insurance, to name but a few, withdrawn in a disruptive and unannounced way. In the same way, savings contracts that are long-lived and provided by life insurers, and are often an individuals primary pension provision, are critical financial services that are difficult to replace without unacceptable cost. For me, there is therefore a common feature of banking and insurance in terms of continuity of access to critical financial services. This is not, however, the end of the story on the issue of why the PRA will regulate banks and insurers. What I have started to describe is the first objective that the new legislation gives to the PRA, namely the safety and soundness of the firms we will supervise. But there is another important leg to the definition of the objective, namely that the underlying objective of our pursuit of safety and soundness is the stability of the financial system. For banks, this had led us to emphasise that we will be a proportionate supervisor, putting more emphasis on the large firms that have more scope to damage the stability of the system. We think we can do this for banks because the depositor is protected by the deposit insurance arrangements on the first 85,000 of deposits
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provided by the FSCS for all banks except branches from other EU countries (where the insurance comes from the home country), and because as a consequence of the crisis the resolution regime is now set down in statute, though we clearly have work to do to make the larger banks resolvable using those resolution powers, supplemented we expect by future EU legislation. For insurers, the legislation gives the PRA a second objective, namely the protection of policyholders.
We do not have a comparable objective for depositors.

Policyholder protection means in effect that our approach of proportionality in supervision cannot be the same for insurers. Why? This is a good question because the FSCS is set up to cover insurance. For me, the reason is that we have more work to do to develop the best tools to ensure continuity of access to critical insurance services. Why do I think we are short of tools? To explain my view on this requires some background on the resolution of banks. Statutory special resolution regimes for banks like the one adopted in the UK in 2009 have at their heart the power to alter property rights, the power to separate the business of a company from its owners, albeit with safeguards against unfair expropriation. It is a very powerful tool, and one that should be used carefully for that reason.
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For banks a typical use of the resolution regime is because depositors can lose confidence in their ability to have access to their funds, and thus a run can start which brings down the bank. A resolution regime can bring order to that process. For insurers, policyholders are less likely run in the sense that they can withdraw their contract and take it somewhere else, though it is possible for some life contracts to be surrendered without penalty. Unlike money, insurance contracts are not fungible because the cover is specific to the contract. In the limit, a bank depositor can exchange their claim on the bank (commercial bank money) for a risk-free claim on the central bank (by requesting bank notes). An insurance policyholder cannot do this. Work is under way to determine whether insurance would benefit from a special resolution regime that overrides normal insolvency rules in order to enhance the ability to ensure continuity of critical contacts through, say, the transfer to business to another firm. I will return to this subject later in this lecture because it is one that we should consider carefully. My general view is that the policyholder protection objective for insurance points to the need for a resolution regime for insurers, but the important issue is to be clear on what sort of regime. There is one further area of insurance that for me clinches the case for the policyholder protection objective in the PRA. I almost mention With Profits with trepidation, but I am afraid I must do so at this stage.
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With about 350bn of policy values outstanding, and policy maturities that can run into decades hence, With Profits is clearly a legacy that will be very much with us for a good while yet. Consequently, I do think that the industry and the authorities need to be alert to its inherent risks and complexities. In thinking about the implications of With Profits, let me step back for a moment. In broad terms, I can see two distinct types of financial contract involving deposits and savings. A deposit contract with a bank has at its core the promise that the bank will return the full value of the deposit at any time when it is contractually obliged to do so. Loss of confidence in a bank sets in when depositors fear that this may not happen. An asset management contract is quite different because the promise is at its simplest to return the proceeds of the investment strategy, which may be more or less than the amount invested. It is cruel to remember the Woody Allen jibe at this point that a stockbroker is someone who invests your money until it is all gone. Economists might call the deposit and asset management contract corner solutions in that they have a robust definition and lie at opposite ends of a range. If so, With Profits falls in between, and it is in this ground that issues can arise. The proposition was essentially to offer investors a blended exposure to cash, bond, property and equity return with some degree of smoothing of overall returns, essentially at managements discretion, to reduce market timing risk.
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The marketing tended to make much of these products potential to earn above cash returns without the volatility of pure equity exposure; and this in turn conditioned policy holders expectations, a fact first acknowledged explicitly in the UKs prudential solvency regime for insurers in 1967 (bear in mind that this was not the original prudential regime, which was introduced in 1870). The essence of the With Profits contact as I understand it is that the provider offers a guaranteed minimum return, variously structured, plus the prospect of additional returns derived from the return earned on a pooled fund that combines many contracts including over different generations of policyholders. There is of course a logic to pooling returns, but for the policyholder the return can be complicated, and sometimes made opaque, by the practice of pooling different generations of policyholders who may have different expectations on their returns (conditioned, for instance, on changes in the external environment); and by the practices of smoothing returns and of charging differentially for the economic value of the guarantees. Additionally, problems have arisen because the funds are made up of many different groups of policyholders with different guarantees, some of which, essentially on the annuity side, became increasingly valuable as nominal interest rates fell from the mid 1990s. The existence of these guarantees was often, at best, unclear or, at worst not disclosed to new joiners to the fund. Bear in mind also that these contracts are long-lived with maturities typically of 25 years of more; and that the With Profits insurers themselves have often built up over many years through the take-over or mergers of many smaller providers, each with their own distinct products, associated policyholder expectations, and administrative legacy systems.
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Suffice to say that in the last two years in which I have been involved with insurance supervision, some of the most difficult issues that I have faced have been in the area of With Profits. For that reason, I think it is appropriate that the PRA should have a policyholder protection objective because I think we have to recognise explicitly the contractual complexity that we inherit and the solvency risks this can generate. I should also add finally that it is not a coincidence that we have found this area to be the most challenging in terms of creating the twin peaks model in which the FCA will have responsibility for reaching judgements, through a formal determination process on fairness to policyholders and the PRA will be responsible for ensuring that those judgements are compatible with the prudential soundness of firms. We have reached a satisfactory conclusion, with specific language in the legislation, and a special With Profits MoU between the FCA and PRA; but it has required very careful consideration to ensure that each regulators role and responsibilities has been appropriately defined to avoid any under-laps and that the correct balance has been struck between them. Let me now move on to the second subject what style of supervision will the PRA adopt and how will it affect insurers? Let me start by drawing the distinction between regulation and supervision in our world. Regulation is about the framework of rules and policies against which we operate. Supervision is about how we apply that framework every day. They are not the same thing.
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Rules are for the most part in our world the product of international agreement, eventually. There are good reasons for this in terms of seeking to ensure comparable standards of protection where services can be provided across borders, and where encouraging free trade in services is consistent with open economies. When it comes to supervision the PRA will be applying judgement around the framework of rules. This is important for a number of reasons, but above all against a background of inexorable increases in rule making we must have the determination to be focussed on the key risks that matter to our objectives. One of my commitments is that we must be focussed on the (I hope) small number of big risks that threaten our objectives of safety and soundness and policyholder protection. I dont have any difficulty with intensive and intrusive supervision where it is focussed and justified by the risks. We are not, however, substitute compliance officers that is the job of firms, and one that we will expect to see in place and functioning along with risk and audit functions. Another key aspect of judgemental supervision is that it must be forward-looking to the risks that may arise. This is crucial, and was not properly incorporated into the pre-crisis regime of supervision. Let me give a few current examples of this for insurers.
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We are focussed on the impact of very low interest rates staying with us for a protracted time, and when I say this I am offering no view whatsoever on the likely course of monetary policy. Likewise, we want to know that the prudential position of firms also captures the possible impact of an unexpected upward shift in the slope of the yield curve, and again I am offering no view on monetary policy. My third example is different: we are watching the range of possible outcomes on flood insurance in this country for their prudential implications. Judgment in supervision is not, however, without its challenges when it comes to the practice of supervision. There are two large challenges I see. First, we have to balance the use of sensible judgement against the risk of creating undue uncertainty in our behaviour which damages your ability to do business. This is not easy I accept. It requires us almost constantly to check and test our judgements against a framework of reasonable predictability. Also, it requires a greater degree of transparency from us to you, and I think from both of us to the public and investors. This is important to ensure that we can both be held to account for applying judgement in a way that is consistent with the pursuit of our objectives. I am conscious that achieving accountability in insurance supervision in the current environment is challenging because all the focus is on the banks.
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No visits to the Treasury Select Committee may seem like a blessing, but we have to ensure that the accountability still holds water. On that point, frankly, I think there should have already been more accountability for how the processes of the European Union could have created such a vast cost for an industry for the implementation of a directive which has not even yet been finally agreed, and for which I cannot give you a date. Largely unseen in the banking crisis has been the shocking cost of Solvency II. The second challenge with the use of judgement in supervision is that elsewhere we have seen a preference to have many rules, but often ones which can then be gamed. Paul Volcker put it nicely in his evidence to the Parliamentary Banking Commission. He said that people ask for clear and simple rules so that they can tell when they are in abeyance, but they typically fail to add that they want to know how to get round the rule too, but that is part of the in deal. At the PRA we will apply judgement rigorously; sometimes you will agree with us, and sometimes you wont. We will be clear and transparent in our judgements, and we will be accountable. Finally on the issue of the PRAs approach to supervision, I want to assure you that we will take supervision of insurers just as seriously as we do the other lot. It is not in our nature to do otherwise. And, we are putting more emphasis on senior level contact in the new approach.
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We want to deliver key messages very clearly to senior management and boards, and we want to know how your governance works in practice. I will give one example of this approach in recent months, returning to Solvency II. It was clear to me by the end of last summer that we were facing a long delay in the directive on top of a bill that, as I have said, was indefensible and ever rising. We have had extensive contact with chief executives and the Association of British Insurers in recent months, with the overarching objective that this cannot go on. I think we have reached a sensible conclusion which at least makes the best of where we find ourselves. Where possible and sensible we will use the work done on Solvency II to date to bolster our existing ICAS regime, though I should stress that we are quite comfortable with the core of ICAS and believe that we can use it as the framework to build the PRA approach until such time as Solvency II appears. I hope that this change of approach both alleviates the costs and helps to create a less pressured environment in which we can seek to obtain a better framework for prudential supervision of insurers in the future than would otherwise be the case. There is too much at stake for the industry and the economy to compromise on this objective. Let me turn to the third and final issue, namely how do we think about the issue of systemic risk, and systemically important status, for insurers? This is obviously topical in the context of the IAIS proposed policy measures for globally systemically important insurers.
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First of all, in my view the case for systemic importance for insurers has to be proved. It does not follow that because major banks are systemically important, the same must be true for insurers. And, second, if a case can be made, it does not automatically determine what the response should be; in other words, it does not follow that the same capital treatment of systemic firms and/or a statutory resolution regime are needed as for banks. The calibration of these responses will have to be proven, and the response will need to be consistent with mitigating the cause of the systemic risk. So, lets put banks to one side, but only after making one important point, that whereas systemic risk in banking is dangerous in good part because that it is in the nature of banking that the confidence issue combined with a very high level of inter-connectivity of risk within the system creates systemic risk, this is not true to the same extent in insurance. Over the years, re-insurance has come under the spotlight as a possible cause of intra-system connectivity and risk, but I have not yet seen a convincing demonstration of a major systemic issue for pure reinsurance of idiosyncratic, diversifiable, non-financial risks such as fire, weather, earthquake or liability. It is of course likely that within the insurance industry there are firms which because of some combination of complexity of risk and size pose more risks to the financial system, and as such our supervision should be proportional. Let me develop this theme drawing on, I should say, valuable input from my colleagues Paul Sharma and Julian Adams.
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The resolution challenge for non-life insurance involves ensuring short-term continuity of risk cover. But life insurers make long-term promises to their policyholders which can only be matched imperfectly with available financial instruments (securities and derivatives). This creates a vulnerability to shocks from financial markets such as the impact of the large fall in equity markets in 2002 to 2003. Life insurers do not close down by going into so-called solvent run-off in the same way as non-life insurers, and bear in mind that the term solvent run-off is the expression of a probability of an outcome. A non-life insurer when it enters run-off typically ceases to collect new premiums. The risk in run-off here and there is a risk that needs examination is that near-term claims are paid out to the detriment of unidentified far-term claims, thereby creating an inequality through a form of time subordination. In contrast, a life insurer that enters run-off continues to collect regular premiums on its existing in-force life insurance policies. Moreover, it needs to continue to pay its obligations (e.g. annuities-in-payment) on the exact day contracted whereas a non-life insurer in run-off has some greater flexibility to pay claims to match its cash flow. Finally, a life insurer in run-off needs to honour contractual policy surrender rights. These features of life insurers draw out the difference in economic interest between near-term and far-term policyholders, and one who has a right of surrender and one who does not.
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Moreover as life insurers are making long-term promises to policyholders, they often seek to match those commitments dynamically, using short-term derivatives, and therefore rely on continued access to those derivatives and the willingness of counterparties to take such exposures to a firm in run-off. These derivative positions will not be more idiosyncratic like traditional insurance, but will be determined by the overall direction of financial market prices, giving scope for more system-wide problems. I described earlier the issues I see with more traditional With-Profit contracts. The issues I highlighted were not so much to do with definite features of the contract between the insurer and the policyholder but with the uncertainty around the contract itself arising from the substantial discretion afforded to the insurers management to determine final policy charges and returns. There is an argument that such uncertainty is helpful to the insurer because the promise to the policyholder is cautious in terms of accrued income and gains, and the insurer is in control of the investment strategy for the asset pool. The issue with uncertainty around contractual terms is therefore arguably more of a conduct issue to do with fairness in the operation of the contract, but to be clear it will have prudential consequences if the scale of the fairness problem is large enough, as Equitable demonstrated. Compare this with the newer life insurance products in some jurisdictions which contain much more definitive promises, for example that at each valuation point the policyholder has a commitment such that if their asset-pool is valued higher than the previous guaranteed amount, this new amount will feature in the minimum guaranteed return.
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This reduces uncertainty in one sense relative to With Profits but increases financial risk for the insurer which is further increased where policyholders can switch instruments at each valuation point and thus select against the insurer on the basis of a more definitive promise they have made on future returns. The insurer thus risks adverse selection against them. The risks in this type of contract are therefore more clearly prudential. Globally the scale of all of these promises is very large the full extent is not clear, but it could be well over $1 trillion. In the UK these contracts are marked to market, which provides useful information, but that is not consistently the case globally. There is scope for problems in, for instance, the time-value of liabilities and the valuation of complex derivative positions. All of this tends to my mind to demonstrate that there is at least one part of the insurance industry that is, globally, large and complex, and UK firms are an important part of this sector. That does not, to be clear, lead to a conclusion that therefore the approach and toolkit taken for globally important banks should apply to these insurers. It leads me to two initial conclusions. First, that in a world of proportionate supervision, we should take a more enhanced and intensive approach for these large and complex firms. This is what the PRA will do, and it does not contradict our policyholder protection objective which, as I indicated earlier, gives us in my view a somewhat different objective in respect of small insurers versus small banks.
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Second, this degree of complexity inevitably raises important questions around our resolution tools where we face dealing with large-scale run-downs. In this context, I am aware that the PRA will need to be very clear how it interprets and puts into effect its policyholder protection objective in the context of insurers that enter run-off or require some other means to draw the business to a close. In conclusion, I hope this description has given you a sense of the PRAs intended approach to supervising insurers, and some of the big issues that we see ahead. We have grown all too accustomed to focusing heavily on banks, reflecting their capacity for damaging spillovers and externalities. Whether, or how much, insurers share some of these characteristics is the subject of extensive debate. I am yet to be persuaded that the similarities of insurers and banks are more important that the differences. But I am persuaded that insurance is a critical financial service provided by firms that have considerable complexity in terms of financial risks. This alone demonstrates why we care about the prudential supervision of insurers. I should stress that we are looking forward to the challenge. Thank you.
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From ideas to implementation

Remarks by Mr Stefan Ingves, Governor of the Sveriges Riksbank and Chairman of the Basel Committee on Banking Supervision, at the 8th High Level Meeting organised by the Basel Committee on Banking Supervision and the Financial Stability Institute and hosted by the South African Reserve Bank, Cape Town
Introduction
Let me begin today by thanking Josef Toovsk, Chairman of the Financial Stability Institute, for organising the latest in its series of High Level Meetings. The Basel Committee continues to view these events as extremely important, as they bring together senior policymakers and supervisors in a forum in which we can share thoughts on critical issues of the moment and reflect on long term challenges. Let me also extend my thanks to the South African Reserve Bank for its superb hospitality as the annual host of this High Level Meeting. Change and reform new ideas and new ways of doing things can be challenging in good times. When all is well, the perceived need is low and the costs including opportunity costs are difficult to justify. Even small ideas can be difficult to implement. Crises, on the other hand, provide a catalyst for fundamentally rethinking past practices.
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Many banks have learnt this as a painful lesson in recent years: when times were good, potential operational, risk management and cultural deficiencies were not examined closely enough. When serious problems emerge, however, there is a demand for new ideas and new ways of doing things: the status quo becomes unacceptable. Of course, the same scenario has applied to the regulatory framework more broadly. Pre crisis, any call for stronger capital and liquidity rules was generally howled down as burdensome and unnecessary. Post-2008, the costs of a weak regulatory framework have been all too obvious and painful for the banking sector, and as a result the demand for new ideas was immediate and forceful. My theme for today is that successful regulatory reform is about ideas and implementation. Certainly, we needed to rethink the regulatory framework in light of what we have learnt from the past five years the status quo was not acceptable. But if we want to be successful, the Committee also needs to make sure that the ideas we developed into Basel III are truly put into practice.
From ideas .
The Basel Committees response to the financial crisis was to recognise that policy weaknesses contributed to the excesses that built up in the financial sector. A substantial overhaul was necessary: minor adjustments to the framework were not going to be enough.
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We needed some big, new far-reaching ideas. In summary, we decided that it was necessary to: require banks to maintain substantially higher levels of capital, with the minimum common equity requirement increasing from 2% to 7% of risk weighted assets; require banks to hold higher quality forms of capital, with common equity at the core of the requirements, and standards to ensure other types of capital instruments are truly loss-absorbing. It is worthwhile emphasising that these reforms also go a long way to simplifying banks capital structures, as well as making them more transparent and comparable; introduce an additional capital buffer (the capital conservation buffer) designed to enforce corrective action when a banks capital ratio deteriorates. The capital conservation buffer allows banks to dip into their capital reserves, while at the same time providing disincentives for banks to do so due to the restrictions it imposes on dividend and bonus payments; add a macroprudential element in the form of the countercyclical buffer, which requires banks to hold more capital in good times to prepare for inevitable downturns in the economy; supplement the risk-based regime with a simple backstop in the form of a (non-risk based) leverage ratio; impose additional capital requirements on systemically important banks both global and domestic to take account of the externalities their failure would impose on society; and
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introduce the first international standards for bank liquidity and funding, designed to promote the resilience of a banks liquidity risk profile to both short term liquidity shocks (the Liquidity Coverage Ratio LCR) and longer-term mismatches in funding (the Net Stable Funding Ratio NSFR). Of course, there are plenty of other big ideas being floated on how the banking industry should be restructured in the aftermath of the crisis, particularly those related to varying models of structural separation (eg the ideas of Volker, Vickers and Liikanen). But for those that fall within the mandate of the Basel Committee, we believe that the ideas produced by Basel Committee thinking translated into the Basel III reforms, and subsequently endorsed by the G20 and Financial Stability Board provide a substantial foundation on which the banking system can be rebuilt to be much more robust and resilient in the future. Basel III capital requirements are probably well known to all of you, so I do not propose to say much more about them today. What I would instead like to focus on is our thinking in relation to liquidity, and particularly the LCR. As an idea, it is simple: a bank should have enough liquid assets to survive a 30-day period of stress. And perhaps to some, it might seem underwhelming. If you tell your spouse that we have implemented a reform that requires banks to have enough cash to last 30 days, more than likely you will get the same response I did when I tried to explain it to my wife: what do
you mean, only 30 days?
Yet this idea has been one of the most fundamental reforms of the crisis.
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It also is a classic example of an idea that had been toyed with for a long time, but took a crisis to bring to fruition. A study of Basel Committee history shows liquidity to have been on the agenda almost for the entire existence of the Committee, but we have never come close to an international standard. Basel III has changed that. So even though the LCR is only 30 days of cash, its significance should not be underestimated. As you would be aware, the focus of the Committee over the past two years has been on refining the formulation of the LCR announced in 2010. Given this is the first time the international community had developed a global liquidity standard, it was agreed that it should be subject to an observation period, during which it could be adjusted as a result of further analysis and assessment. The aim of the observation process was not to further tighten or weaken the standard: the goal was purely to ensure the calibration was more reflective of empirical evidence and appropriate for implementation as a minimum standard, across the Committees 27 member countries and more broadly. The changes agreed to by the Committee focus on three main areas: High quality liquid assets (HQLA): A diverse and sufficiently large stock of HQLA is essential to help banks withstand liquidity stress. The revised definition now provides limited recognition of additional assets such as a broader range of corporate bonds, a selection of listed equities, and some highly-rated residential associated with such assets, their inclusion in the stock of HQLA is subject to a relatively low limit as well as significant haircuts.
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The Committee has tried to balance the benefits of greater diversification of the liquidity pool against the cost of including slightly lower quality assets. We have also changed some of the assumed inflow and outflow rates that determine the size of the pool of liquid assets that a bank is required to hold. As in the case of the capital conservation buffer, the standards now make very clear that liquidity is to be built up and maintained in good times so that it can be used in times of need. In other words, liquidity is not useful if it is frozen. In addition, in light of the considerable stress facing banking systems in some regions of the world, the Committee revised the implementation plan of the LCR by introducing a phase-in arrangement. The LCR will come into force as planned in 2015, although banks now will have until 1 January 2019 to meet the standard in full. Nevertheless, I expect many banks will choose to move to the higher standard more quickly. In announcing the revisions to the LCR, many headline writers categorised it as some kind of win for the banking industry over the regulators. This is simplistic. We had an observation period for good reason: to make sure we got the settings right. There was, I think, legitimate concern that, as a minimum standard, the 2010 formulation of the LCR may have been calibrated too conservatively overall.
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For example, the treatment of traditional retail and commercial banking was probably too harsh, and this has been adjusted. Equally the treatment of derivative-related risks was probably too weak, and so that has been adjusted too. Much has been made of the inclusion of RMBS in the definition of high quality liquid assets, but the eligibility criteria are tight and the initial perception that the Committee had granted carte blanche to the securitisation sector is well wide of the mark. As the Chairman of the Basel Committees governing body, Governor King of the Bank of England, said when announcing the full set of changes, they are designed to make the LCR more realistic. I think this sums it up very well. Of course, the overall impact of the changes is to improve the reported LCR of the banking system. Based on our most recent data (end June 2012), we estimate that the weighted average LCR for a sample of roughly 200 of the worlds largest banks is around 125%, compared with a little over 100% for the previous calibration. This does not mean, however, that all banks are ready and able to meet the standard today. Even though the industry average is well above the minimum, our estimates suggest that roughly one-quarter of our sample could still have an LCR below 100% even with the latest policy changes. So there remains a significant liquidity shortfall that will need to be addressed by a number of banks.
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One also has to bear in mind that favourable terms from central banks have helped to improve bank funding. Central banks serve as lenders of last resort and, as economic conditions improve, banks will need to become more self-reliant. However, the timetable for the gradual introduction of the ratio ensures that the new liquidity standard will in no way hinder the ability of the global banking system to finance a recovery. It has taken a lot of time and effort to reach agreement on the LCR. It is, as I said, a deceptively simple idea, but its implications are big and far-reaching. Unsurprisingly, there is much in the detail that required a lot of careful analysis and thought, not to mention a willingness to find a way through differing national perspectives. It is, however, critical that the new ideas such as the LCR (and the other new features of Basel III such as the capital conservation buffer, countercyclical buffer, leverage ratio and NSFR) are implemented if their benefits are to be realised. Against that background, let me now turn to the work we have started to ensure that the Basel III framework is implemented as intended.
. to implementation
Steady progress is being made. As of January 2013, 11 out of 19 Basel Committee jurisdictions have final Basel III rules in place, including our hosts today, South Africa. A number of non-member countries also implemented Basel III at the beginning of the year, further expanding its coverage.
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While it would be ideal to have much broader coverage at this time (as at today, around one-third of global banking assets are officially subject to the Basel III requirements), the delays should not be interpreted as any lack of commitment by global regulators to implement the agreed reforms. At recent international gatherings, all members have been asked to reaffirm their commitment to implementing the agreed reforms as soon as possible. And they have given that commitment (subject, of course, to the vagaries of domestic rule-making processes that each must follow). Nevertheless, let me be clear: the question being discussed is when the reforms will be implemented, not if. Any setback to implementation is undesirable, since Basel III is a key platform on which to rebuild a stronger global banking system. But the delays are not critical at this point, for two reasons. First, the Basel III capital rules contain a lengthy phase-in period, meaning that in 2013 the new requirements should not be particularly burdensome for banks (eg none of the new deductions from capital are applied this year). Second, many regulators who have been unable to implement the new standards by the beginning of this year are still measuring and monitoring their banks capacity to meet the new requirements. And, of course, markets are applying similar pressure. In other words, the force of the new capital regime is much broader than just those countries that have implemented their domestic regulations.
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Nevertheless, to ensure visibility of the implementation of reforms, the Basel Committee has been regularly publishing information about members adoption of Basel III. We will continue to do this so as to keep all stakeholders and the markets informed, and to maintain peer pressure where necessary. It is especially important that jurisdictions that are home to global systemically important banks (G-SIBs) make every effort to issue final regulations at the earliest possible opportunity. But simply issuing domestic rules is not enough to achieve what the G20 Leaders asked for: full, timely and consistent implementation of Basel III. In response to this call, in 2012 the Committee initiated what has become known as the Regulatory Consistency Assessment Programme (RCAP). The regular progress reports are simply one part of this programme, which assesses domestic regulations compliance with the Basel standards, and examines the outcomes at individual banks. The RCAP process will be fundamental to ensuring confidence in regulatory ratios and promoting a level playing field for internationally-operating banks. It is inevitable that, as the Committee begins to review aspects of the regulatory framework in far more detail than it (or anyone else) has ever done in the past, we will find aspects of implementation that do not meet the G20s aspiration: full, timely and consistent. We are going to find parts of the framework that have been implemented only in part, or late, or inconsistently. The financial crisis identified that, like the standards themselves, implementation of global standards was not as robust as it should have been.
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This could be classed as a failure by global standard setters. To some extent, the criticism can be justified not enough has been done in the past to ensure global agreements have been truly implemented by national authorities. However, just as the Committee has been determined to revise the Basel framework to fix the problems that emerged from the lessons of the crisis, the RCAP should be seen as demonstrating the Committees determination to also find implementation problems and fix them. Committee published recently by Professor Charles Goodhart notes that the Committee has on more than one occasion over the past 35 years considered undertaking more detailed analysis of domestic implementation of global standards, but shied away from this as being too intrusive. However, we have now taken that step, since if we are serious about fixing the problems of the past, then we need to not just look at the policy settings, but also their application. Our efforts on implementation should therefore be seen as an integral part of the reform agenda not just an adjunct to it. When it comes to our country-by-country assessments, thus far the Committee has conducted detailed assessments of the final regulations adopted in Japan, and the draft regulations in the European Union and the United States. Follow-up assessments in the European Union and United States will be conducted once final regulations are available. Assessments under the RCAP are currently underway for Singapore and Switzerland. Later this year will follow China, Australia, Brazil and Canada.
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As with all of the RCAP work, transparency is critical to success all of these reports will, of course, be published in full when complete. It is important to note that, in undertaking this work, the Basel Committee has no enforcement power, so it would be meaningless to think we can force jurisdictions to change their local regulations if we find gaps. Our goal is therefore framed more positively: to deepen the implementation process and to help jurisdictions identify the gaps and address them. Ideally, the assessments provide a roadmap by which identified gaps can be closed. They also provide stakeholders and markets with a much higher degree of transparency about the extent of any local divergence from agreed international standards, and the importance of these. In this way, we believe we will establish the appropriate incentives for local rulemakers to apply the global standards, and for markets and others to apply appropriate pressure where banks may be subject to weaker-then-expected prudential requirements. More consistent domestic regulations will be an improvement. But beyond looking at how local regulators have transposed Basel agreements into domestic regulations, the Committee has also begun examining whether the framework(s) are producing consistent outcomes. Ultimately, what counts is that the capital ratio calculated and reported by individual banks provides a meaningful and comparable representation of their capital strength. Differences in regulation, or their application, can undermine the regulatory framework by making it more difficult for bank depositors,
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counterparties, investors, shareholders and supervisors to have confidence that reported capital ratios serve their intended purpose. In this context, some concerns have been recently voiced that banks are not calculating risk weighted assets consistently. The Committee has, in fact, been investigating this issue for much of the past year. This work has examined the calculation of risk weights in both the banking and the trading books. As with our country assessments, we will publish the results of both studies. The preliminary results of the trading book are most advanced, and will be published very shortly. The analysis is based on two sources of data: public disclosures by banks and a hypothetical test portfolio exercise in which 15 large, internationally active banks have participated from nine Basel Committee jurisdictions. I will not pre-release the detailed results today, but the headline messages are that: there is a material variation in risk weights for trading assets across banks (after adjusting for accounting differences and for differences in the riskiness of different bank portfolios); certain modelling choices seem to be major drivers of the variation in risk weights; and the quality of existing public disclosure is generally insufficient to allow users to determine how much of the variation in reported risk weights is a reflection of underlying risk taking, and how much stems from other factors (eg modeling choices, supervisory discretions).
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In thinking about these results, it needs to be borne in mind that the objective is not to achieve zero variation. If we wished to achieve that outcome, we could simply force all banks onto the standardised approach to capital adequacy and remove any modelling options. But the standardised approach while an ostensibly consistent methodology would not necessarily guarantee a meaningful measure of risk when applied to the worlds largest banks with the biggest and most complex trading portfolios. Modelling necessarily introduces a degree of variability, since Basel standards deliberately allow banks and supervisors flexibility in order to accommodate for differences in risk appetite and local practices, but with the goal of also providing greater accuracy. Further, from a financial stability perspective, it is desirable to have some diversity in risk management practices so as to avoid that all banks act in a similar way. When banks would have identical response functions, economic cyclicality would increase, potentially creating additional instability. At the same time, excessive variation in risk measurement is clearly undesirable. Finding the right balance is the key. The preliminary work suggests we may not have the balance right in the current set-up. But as with all of our work on implementation, it is necessary to identify problems before we can set about correcting them. The on-going analysis has generated a wealth of information about risk modelling by banks.
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This is useful for international policymakers. The Committee has not yet decided what actions it might take in response to the analysis, but some of the possible policy options could comprise improvements in public disclosure practices, limitations in the modeling choices for banks, and further harmonisation of supervisory practices. These ideas will also feed into the current fundamental review of the trading book. In addition, our international study provides national supervisors with a much clearer understanding of how the risk models of their banks compare to those of international peers. This means that national supervisors are much better equipped to discuss the results with their banks and take action where needed. The Committee will be doing further work on the trading book, in addition to the banking book work, to explore the outcomes in more depth. I am confident that it will generate additional insights in the modelling of risk-weighted assets and to explain better why modelling results differ across banks. It will also allow building quantitative benchmarks against which supervisors can test their banks. The Committees work on how banks calculate risk weighted assets also feeds into a broader concern that, in pursuit of risk sensitivity, the Basel III framework has grown too complex. There are many contributory factors to the build-up of complexity, including developments in the financial markets and adoption of sophisticated risk management practices by banks.
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It is nave to think banks utilising complex trading strategies and products, across global markets, can be supervised using simple rules (even if calibrated to penal settings). Indeed, an important driver has been the necessity to address perverse incentives that are created by simple rules. So while seeking appropriate risk sensitivity, care is also being taken to ensure that complexity does not undermine the very benefits it offers. The Basel Committee has also been working during 2012 to review possible areas for simplification, aiming to strike a term, the Committee intends to publish a paper to explain its thinking on the trade-offs that need to be made, and identifying potential ways to make the framework simpler and more comparable.
Conclusion
If there is one message I would like to leave you with it is that, when it comes to reform, ideas and implementation go together. Much of the Basel Committees work on big ideas that respond to the shortcomings in the regulatory framework identified by the financial crisis is reaching the end stage. The capital rules are set (and, in an increasing number of jurisdictions, coming into force), and the revisions to the LCR have recently been agreed. In 2013, we will seek to set out the specification of the backstop leverage ratio, and the NSFR will be refined between now and the end of 2014. Clearly, we still have work to do, but increasingly it is about getting the technical details correct rather than new far-reaching ideas.
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Even when the Committees policy response to the crisis is complete, much more work will still be needed. Implementation needs to be seen as an integral part of the reform agenda, not a sideline activity. As we examine this issue to a depth that it has not previously been examined, we will inevitably find things that need improvement. Turning a blind eye to these, as may have occurred in the past, is not an option we need to persevere and find those areas where additional modifications to the regulatory framework are needed to ensure it is effective. If we do not work to improve implementation, we will not embed the reforms into domestic banking systems in the full, timely and consistent manner that is in everyones interests.
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FSA statement on Basel III rules on capital requirements for exposures to CCPs
In July 2012 the Basel Committee on Banking Supervision (BCBS) agreed a revised Regulatory rules text on the capital requirements for bank exposures to central counterparties. These rules set out the capital treatment for bank exposures to qualifying central counterparties (QCCP). A QCCP is defined as 'an entity that is licensed to operate as a CCP (including a license granted by way of confirming an exemption), and is permitted by the appropriate regulator/overseer to operate as such with respect to the products offered. This is subject to the provision that the CCP is based and prudentially supervised in a jurisdiction where the relevant regulator/overseer has established, and publicly indicated that it applies to the CCP on an ongoing basis, domestic rules and regulations that are consistent with the CPSS-IOSCO Principles for Financial Market Infrastructures'. BCBS FAQs published at the end of 2012 clarified that 'during 2013, if a CCP regulator has not yet implemented the CPSS-IOSCO Principles for Financial Market Infrastructures (PFMIs), but has publicly stated that it is working towards implementing these principles, the CCPs that are regulated by the CCP regulator may be treated as QCCPs. However, a CCP regulator may still declare a specific CCP non-qualifying.' The FSA is working towards implementing the PFMIs. The FSA reserves the right to declare a specific CCP to be non-qualifying.
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However, currently all recognised clearing houses based in the UK and prudentially supervised by the FSA may be treated as QCCPs for a transitional period that, unless extended, expires on 31 December 2013. CCPs in the UK are subject to the Regulation on OTC Derivatives, central counterparties and trade repositories (EMIR), which entered into force across the EU in August 2012. EMIR follows the recommendations developed by CPSS-IOSCO PFMIs as established on 16 April 2012, and directs the European Securities and Markets Authority (ESMA) to consider both the existing principles and their future developments when drawing up or revising the regulatory technical standards, guidelines and recommendations foreseen in EMIR (see recital 90). The FSAs supervision is currently focused on preparing domestic CCPs to meet the requirements of EMIR, and we anticipate that UK CCPs will apply for authorisation under EMIR during 2013. From 1 April 2013, responsibility for the supervision of CCPs will pass to the Bank of England. The Bank of England has made clear in its recent document The Bank of Englands approach to the supervision of financial market infrastructures that 'the UK regulatory framework, and requirements and rules set within it, will be consistent with the minimum standards in the Principles. Lets remember the paper:
Capital requirements for bank exposures to central counterparties July 2012 An overview Regulatory rules text on the capital requirements for bank exposures to central counterparties
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The interim framework for determining capital requirements for bank exposures to central counterparties is being introduced via additions and amendments to the International Convergence of Capital Measurement and Capital Standards: A Revised Framework - Comprehensive Version, June 2006 (hereinafter referred to as Basel II).
General terms and scope of application

Annex 4, Section I, A. General Terms the following terms are added: A central counterparty (CCP) is a clearing house that interposes itself between counterparties to contracts traded in one or more financial markets, becoming the buyer to every seller and the seller to every buyer and thereby ensuring the future performance of open contracts. A CCP becomes counterparty to trades with market participants through novation, an open offer system, or another legally binding arrangement. For the purposes of the capital framework, a CCP is a financial institution. A qualifying central counterparty (QCCP) is an entity that is licensed to operate as a CCP (including a license granted by way of confirming an exemption), and is permitted by the appropriate regulator/overseer to operate as such with respect to the products offered. This is subject to the provision that the CCP is based and prudentially supervised in a jurisdiction where the relevant regulator/overseer has established, and publicly indicated that it applies to the CCP on an ongoing basis, domestic rules and regulations that are consistent with the CPSS-IOSCO Principles for Financial Market Infrastructures. As is the case more generally, banking supervisors still reserve the right to require banks in their jurisdictions to hold additional capital against their exposures to such CCPs via Pillar 2.
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This might be appropriate where, for example, an external assessment such as an FSAP has found material shortcomings in the CCP or the regulation of CCPs, and the CCP and/or the CCP regulator have not since publicly addressed the issues identified. Where the CCP is in a jurisdiction that does not have a CCP regulator applying the Principles to the CCP, then the banking supervisor may make the determination of whether the CCP meets this definition. In addition, for a CCP to be considered a QCCP, the terms defined in paragraphs 122 and 123 of this Annex for the purposes of calculating the capital requirements for default fund exposures must be made available or calculated in accordance with paragraph 124 of this Annex. A clearing member is a member of, or a direct participant in, a CCP that is entitled to enter into a transaction with the CCP, regardless of whether it enters into trades with a CCP for its own hedging, investment or speculative purposes or whether it also enters into trades as a financial intermediary between the CCP and other market participants. A client is a party to a transaction with a CCP through either a clearing member acting as a financial intermediary, or a clearing member guaranteeing the performance of the client to the CCP. Initial margin means a clearing members or clients funded collateral posted to the CCP to mitigate the potential future exposure of the CCP to the clearing member arising from the possible future change in the value of their transactions. For the purposes of this Annex, initial margin does not include contributions to a CCP for mutualised loss sharing arrangements (ie in case a CCP uses initial margin to mutualise losses among the clearing members, it will be treated as a default fund exposure). Variation margin means a clearing members or clients funded collateral posted on a daily or intraday basis to a CCP based upon price movements of their transactions.
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Trade exposures (in section IX) include the current2 and potential future exposure of a clearing member or a client to a CCP arising from OTC derivatives, exchange traded derivatives transactions or SFTs, as well as initial margin. Default funds, also known as clearing deposits or guaranty fund contributions (or any other names), are clearing members funded or unfunded contributions towards, or underwriting of, a CCPs mutualised loss sharing arrangements. The description given by a CCP to its mutualised loss sharing arrangements is not determinative of their status as a default fund; rather, the substance of such arrangements will govern their status. Offsetting transaction means the transaction leg between the clearing member and the CCP when the clearing member acts on behalf of a client (eg when a clearing member clears or novates a clients trade).
Annex 4, Section II. Scope of application.

Paragraph 6 is replaced by the following: 6(i) Exposures to central counterparties arising from OTC derivatives, exchange traded derivatives transactions and SFTs will be subject to the counterparty credit risk treatment laid out in paragraphs 106 to 127 of this Annex. Exposures arising from the settlement of cash transactions (equities, fixed income, spot FX and spot commodities) are not subject to this treatment. The settlement of cash transactions remains subject to the treatment described in Annex 3.
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6(ii) When the clearing member-to-client leg of an exchange traded derivatives transaction is conducted under a bilateral agreement, both the client bank and the clearing member are to capitalise that transaction as an OTC derivative. Annex 4, new section IX on central counterparties is added:
IX. Central Counterparties

106. Regardless of whether a CCP is classified as a QCCP, a bank retains the responsibility to ensure that it maintains adequate capital for its exposures. Under Pillar 2 of Basel II, a bank should consider whether it might need to hold capital in excess of the minimum capital requirements if, for example, (i) its dealings with a CCP give rise to more risky exposures or (ii) where, given the context of that banks dealings, it is unclear that the CCP meets the definition of a QCCP. 107. Where the bank is acting as a clearing member, the bank should assess through appropriate scenario analysis and stress testing whether the level of capital held against exposures to a CCP adequately addresses the inherent risks of those transactions. This assessment will include potential future or contingent exposures resulting from future drawings on default fund commitments, and/or from secondary commitments to take over or replace offsetting transactions from clients of another clearing member in case of this clearing member defaulting or becoming insolvent. 108. A bank must monitor and report to senior management and the appropriate committee of the Board on a regular basis all of its exposures to CCPs, including exposures arising from trading through a CCP and exposures arising from CCP membership obligations such as default fund contributions.
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109. Where a bank is trading with a Qualifying CCP (QCCP) as defined in Annex 4, Section I, A. General Terms, then paragraphs 110 to 125 of this Annex will apply. In the case of non-qualifying CCPs, paragraphs 126 and 127 of this Annex will apply. Within three months of a central counterparty ceasing to qualify as a QCCP, unless a banks national supervisor requires otherwise, the trades with a former QCCP may continue to be capitalised as though they are with a QCCP. After that time, the banks exposures with such a central counterparty must be capitalised according to paragraphs 126 and 127 of this Annex.
Exposures to Qualifying CCPs A. Trade exposures (i) Clearing member exposures to CCPs
110. Where a bank acts as a clearing member of a CCP for its own purposes, a risk weight of 2% must be applied to the banks trade exposure to the CCP in respect of OTC derivatives, exchange traded derivative transactions and SFTs. Where the clearing member offers clearing services to clients, the 2% risk weight also applies to the clearing members trade exposure to the CCP that arises when the clearing member is obligated to reimburse the client for any losses suffered due to changes in the value of its transactions in the event that the CCP defaults. 111. The exposure amount for such trade exposure is to be calculated in accordance with Annex 4 using the IMM, 3 CEM or Standardised Method, as consistently applied by such bank to such an exposure in the ordinary
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course of its business, or Part 2, Section II, D3 together with credit risk mitigation techniques set forth in Basel II for collateralised transactions. Where the respective exposure methodology allows for it, margining can be taken into account. In the case of IMM banks, the 20-day floor for the margin period of risk (MPOR) as established in the first bullet point of Annex 4, paragraph 41(i) will not apply, provided that the netting set does not contain illiquid collateral or exotic trades and provided there are no disputed trades. This refers to exposure calculations under IMM, or the IMM short cut method of Annex 4, paragraph 41, and for the holding periods entering the exposure calculation of repo-style transactions in paragraphs 147 and 181. 112. Where settlement is legally enforceable on a net basis in an event of default and regardless of whether the counterparty is insolvent or bankrupt, the total replacement cost of all contracts relevant to the trade exposure determination can be calculated as a net replacement cost if the applicable close-out netting sets meet the requirements set out in: Paragraphs 173 and, where applicable, also 174 of the main text in the case of repo-style transactions, Paragraphs 96(i) to 96(iii) of this Annex in the case of derivative transactions, Paragraphs 10 to 19 of this Annex in the case of cross-product netting. To the extent that the rules referenced above include the term master netting agreement, this term should be read as including any netting agreement that provides legally enforceable rights of set-off. If the bank cannot demonstrate that netting agreements meet these rules, each single transaction will be regarded as a netting set of its own for the calculation of trade exposure.
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(ii) Clearing member exposures to clients

113. The clearing member will always capitalise its exposure (including potential CVA risk exposure) to clients as bilateral trades, irrespective of whether the clearing member guarantees the trade or acts as an intermediary between the client and the CCP. However, to recognise the shorter close-out period for cleared transactions, clearing members can capitalise the exposure to their clients applying a margin period of risk of at least 5 days (if they adopt the IMM); or multiplying the EAD by a scalar of no less than 0.71 (if they adopt either the CEM or the Standardised Method).
(iii) Client exposures

114. Where a bank is a client of a clearing member, and enters into a transaction with the clearing member acting as a financial intermediary (ie the clearing member completes an offsetting transaction with a CCP), the clients exposures to the clearing member may receive the treatment in paragraphs 110 to 112 of this Annex if the two conditions below are met. Likewise, where a client enters into a transaction with the CCP, with a clearing member guaranteeing its performance, the clients exposures to the CCP may receive the treatment in paragraph 110 to 112 if the following two conditions are met: (a) The offsetting transactions are identified by the CCP as client transactions and collateral to support them is held by the CCP and/or the clearing member, as applicable, under arrangements that prevent any losses to the client due to: (i) the default or insolvency of the clearing member, (ii) the default or insolvency of the clearing members other clients, and
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(iii) the joint default or insolvency of the clearing member and any of its other clients. The client must be in a position to provide to the national supervisor, if requested, an independent, written and reasoned legal opinion that concludes that, in the event of legal challenge, the relevant courts and administrative authorities would find that the client would bear no losses on account of the insolvency of an intermediary clearing member or of any other clients of such intermediary under relevant law: - the law of the jurisdiction(s) of the client, clearing member and CCP; - if the foreign branch of the client, clearing member or CCP are involved, then also under the law of the jurisdiction(s) in which the branch are located; - the law that governs the individual transactions and collateral; and - the law that governs any contract or agreement necessary to meet this condition (a). (b) Relevant laws, regulation, rules, contractual, or administrative arrangements provide that the offsetting transactions with the defaulted or insolvent clearing member are highly likely to continue to be indirectly transacted through the CCP, or by the CCP, should the clearing member default or become insolvent. In such circumstances, the client positions and collateral with the CCP will be transferred at market value unless the client requests to close out the position at market value. 115. Where a client is not protected from losses in the case that the clearing member and another client of the clearing member jointly default or become jointly insolvent, but all other conditions in the preceding paragraph are met, a risk weight of 4% will apply to the clients exposure to the clearing member.
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116. Where the bank is a client of the clearing member and the requirements in paragraphs 114 or 115 above are not met, the bank will capitalise its exposure (including potential CVA risk exposure) to the clearing member as a bilateral trade.
(iv) Treatment of posted collateral

117. In all cases, any assets or collateral posted must, from the perspective of the bank posting such collateral, receive the risk weights that otherwise applies to such assets or collateral under the capital adequacy framework, regardless of the fact that such assets have been posted as collateral. Where assets or collateral of a clearing member or client are posted with a CCP or a clearing member and are not held in a bankruptcy remote manner, the bank posting such assets or collateral must also recognise credit risk based upon the assets or collateral being exposed to risk of loss based on the creditworthiness of the entity holding such assets or collateral. 118. Collateral posted by the clearing member (including cash, securities, other pledged assets, and excess initial or variation margin, also called overcollateralisation), that is held by a custodian, and is bankruptcy remote from the CCP, is not subject to a capital requirement for counterparty credit risk exposure to such bankruptcy remote custodian. 119. Collateral posted by a client, that is held by a custodian, and is bankruptcy remote from the CCP, the clearing member and other clients, is not subject to a capital requirement for counterparty credit risk. If the collateral is held at the CCP on a clients behalf and is not held on a bankruptcy remote basis, a 2% risk-weight must be applied to the collateral if the conditions established in paragraph 114 of this Annex are met; or 4% if the conditions in paragraph 115 of this Annex are met.
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Regulatory consistency assessment programme (RCAP) - Analysis of risk-weighted assets for market risk
The Basel Committee on Banking Supervision has published its report on the regulatory consistency of risk-weighted assets for market risk. This analysis of risk-weighted assets in the trading book is part of the wider Regulatory Consistency Assessment Programme (RCAP)initiated by the Committee in 2012; a similar analysis is currently under way for the banking book. The programme aims to ensure consistent implementation of the Basel framework, which will help strengthen the resilience of the global banking system, maintain market confidence in regulatory ratios and provide a level playing field for banks operating internationally. The report brings together two pieces of analysis. The first is based on an examination of publicly available bank data for a selection of large banks. It also contains the results of a hypothetical test portfolio exercise, in which 15 internationally active banks participated. The Basel Committee plans to conduct a further hypothetical test portfolio exercise later this year. This will include other, more complex, hypothetical test portfolios, with the aim of helping the Committee to deepen its analysis of the variation in risk measurement of trading books across banks.
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Introduction
Consistent implementation of the Basel framework is fundamental to raising the resilience of the global banking system, maintaining market confidence in regulatory ratios and providing a level playing field for internationally operating banks. Against this background, the Basel Committee has initiated the Regulatory Consistency Assessment Programme (RCAP). The assessment programme is conducted on three levels: Level 1: ensuring the timely adoption of Basel III; Level 2: ensuring regulatory consistency with Basel III; and Level 3: ensuring consistency of risk-weighted asset (RWA) outcomes. This report presents the preliminary results of the Committees analysis of RWA outcomes for banks trading book assets (Level 3); a similar analysis is under way for the banking book. At the same time, the Committee is currently working on a fundamental review of the market risk framework. One of the objectives of the fundamental review is to deliver a regulatory framework that can be implemented consistently by supervisors and which achieves comparable levels of capital across jurisdictions. The findings in this report will feed into the fundamental review and will inform the Committee about possible directions for further policy work. Recently, a number of private sector studies using publicly available data have come to mixed conclusions on the variability of risk weighting for trading assets: some indicate that variability reflects genuine differences in business models and is commensurate to actual exposure to risk, while
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others suggest that variability is driven by other factors, such as different modelling approaches. In order to better understand the potential drivers of the variability in the measurement and disclosure of market risk measured by RWAs based on the market risk framework (mRWAs) the Committee undertook (i) An analysis of publicly available data of large globally active banks with significant trading operations and (ii) A hypothetical test portfolio exercise to examine what methodology choices are the greatest potential drivers behind the variability of internal market risk model outcomes. Importantly, the objective of this work was not to judge the correctness of the modelling choices made by banks or to assess the compliance of supervisory approaches taken in different jurisdictions. Rather, the objective was to obtain a preliminary estimate of the potential for variation in mRWAs across banks and to highlight aspects of the Basel standards that contribute to this variation. The review of public disclosures focused on a sample of 16 global banks with significant trading activity. The observation period includes the most recent changes related to Basel 2.5, which had taken effect in some jurisdictions but not all. Despite the asynchronous adoption of Basel 2.5, value was found in comparing mRWAs across pre- and post-Basel 2.5 jurisdictions because many of the issues carry over to the new regime, for example regarding the contribution to mRWAs from internal models and standardised approaches.
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For some banks, the disclosures required under Basel II (Pillar 3) factored into the analysis and provided a chance to evaluate the utility of such disclosures for this type of project. The focus of the hypothetical test portfolio exercise was to discover the design elements of internal models that have the greatest potential impact on the level of variability in mRWAs. Hypothetical test portfolios overcome the limitations encountered when attempting to use public and supervisory data on real portfolios to investigate potential sources of variation because they control for differences in portfolio composition. However, they show only potential and not realised variation in outcome. Moreover, in this case, the exercise focused on a series of simple long and short positions, designed to reveal the impact of model design features. To shed light on the effect of different sources of variation on more realistic portfolios, the Committee plans to conduct a further hypothetical test portfolio exercise later this year. This will include other, more complex, hypothetical test portfolios, with the aim of helping the Committee to deepen its analysis of the variation in risk measurement of trading books across banks.
Executive summary Key findings of the analysis

The analysis of public reports on mRWAs, and the hypothetical test portfolio exercise, provided a clear picture of substantial variation in mRWAs across banks. Based on public reports, the analysis shows considerable variation in average published mRWAs for trading assets and provides some
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indication that differences in the composition and size of trading positions are correlated with banks average mRWAs. However, the quality of disclosures was found to be insufficient to allow investors and other interested parties to assess how much of the variation reflects differing levels of actual risk and how much is a result of other factors. The hypothetical test portfolio exercise indicated that, using a hypothetical diversified portfolio consisting primarily of simple long and short positions, there can be a substantial difference between the bank reporting the lowest mRWAs and the bank reporting the highest. This outcome is attributed to a range of factors: A sizeable portion of the variation is due to supervisory decisions applied either to all banks in a jurisdiction, or to individual banks. An example of the former would be policy decisions to restrict modelling options (eg to disallow any diversification benefit between types of risk). An example of the latter would be the application of supervisory multipliers: around one-quarter of the total variation in the hypothetical diversified portfolio could be attributed to this single factor. These supervisory actions typically result in higher capital requirements than would otherwise be the case but can also increase the variation in mRWA between banks, particularly across jurisdictions. These supervisory actions, particularly at an individual bank level, are often not disclosed. Another important source of variation is due to modelling choices made by banks.
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The exercise found that a small number of key modelling choices are the main drivers of the remaining model-driven variability. It is important pointing out that the Basel standards deliberately allow banks and supervisors some flexibility in measuring risks in order to accommodate for differences in risk appetite and local practices, but with the goal of also providing greater accuracy. Some variation in mRWA should therefore be expected. In addition, from a financial stability perspective, it is desirable to have some diversity in risk management practices so as to avoid that all banks act in a similar way, which potentially could create additional instability. At the same time, excessive variation in risk measurement is undesirable. This study did not seek to determine what the optimal level of variation should be, but the preliminary findings highlight potential policy options that can be considered if the Committee wished to narrow the potential for variation in the future. These policy options complement important policy initiatives that are already under way, including work on disclosures notably as recommended by the Enhanced Disclosure Task Force (EDTF) and the fundamental review of the trading book. Further detail of the above findings and the potential policy options are set out in the report.
Analysis of publicly available data

The analysis of publicly available data shows significant differences across individual banks in the size of regulatory mRWAs relative to trading assets.
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Across the banks in the sample, the average risk weighting of trading assets varies from around 10% to nearly 80%, with most banks between 15% and 45%. Such differences could be justified, provided that they are driven by differences in actual risk taking and business models. In this regard, the public data provides some indication that differences in the composition and size of trading positions are correlated with mRWAs. For example, banks with a greater proportion of illiquid trading assets, including holdings of distressed debt and illiquid equity, tend to report slightly higher average risk weighting of their trading assets. However, this correlation does not fully explain variations across banks and the observations are based on only a small subset of banks. So, while there is some evidence that variations in mRWAs can be explained by actual risk taking, there are indications that a considerable part of the variation cannot be explained by that factor. Instead, the analysis suggests that other factors may also be driving the observed variations across banks and jurisdictions: 1. Differences in supervisory approaches and requirements, contributing to differences in the levels of reliance on the internal models approach, as well as an asynchronous adoption of Basel 2.5. For example, during the period under review, nine out of 16 banks in the sample were subject to Basel 2.5. The remaining seven banks became subject to Basel 2.5 standards on 1 January 2013.
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2. Differences in methodologies and modelling choices for market risk regulatory capital calculations. For example, the current Basel framework allows banks to choose different historical data periods for value-at-risk (VaR) or use different methods to arrive at a regulatory capital figure. Analysing public data requires taking into account differences in accounting regimes to allow for appropriate comparison across jurisdictions. For example, an important difference concerns the netting of derivatives. Netting can lead to material differences in the way trading assets are measured and accounting regimes differ regarding the degree of netting permitted. To the extent possible, the public data used in this report is adjusted for the differences in netting across accounting regimes. Other accounting differences that may play a role, such as the rules for classifying assets into the accounting trading book, could not be corrected for and some of the variation in mRWAs relative to trading assets may stem from these differences. Looking more closely at the findings, and in particular drivers of variation not related to risk, the analysis indicates a significant disparity in reliance on internal models. The portion of mRWAs that is calculated with internal models can range from approximately 10% to nearly 80% for the sample of banks across jurisdictions. Before the implementation of Basel 2.5, the greater use of internal models would tend to result in lower average mRWAs due to the recognition of diversification and netting benefits.
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However, with the implementation of Basel 2.5 this relationship may be reversing as banks with internal models are now required to capitalise for sVaR (stressed value-at-risk), IRC (incremental risk charge) and CRM (comprehensive risk measure) under the new regime, resulting in higher observed levels of modelled capital charges in comparison to prior periods. Other factors that could explain variation in mRWAs include regulatory and internal capital add-ons and the use of regulatory multipliers higher than the minimum of 3, which are applied at the discretion of supervisors as a general incentive to improve models and risk management systems. This information is, however, not transparent in public disclosures and its impact could not be examined using publicly available data. Instead, the hypothetical test portfolio exercise allowed examination of the importance of the regulatory multiplier in more detail, the results of which are presented in Chapter 2. As a second step, the Committee considered using supervisory data, but it was found that the structure and content of periodic supervisory financial reports outlining the condition and income of financial institutions is disparate across jurisdictions. This disparity resulted in deeming the utility of public supervisory data as relatively low when attempting to perform a cross-jurisdictional comparison of mRWAs and the underlying drivers. From the beginning of the analysis, it was understood that public disclosures have historically not provided stakeholders with enough information to appropriately assess and compare mRWAs and regulatory capital across banks and jurisdictions. The observations in this report corroborate that finding, as the full scope of mRWA dispersion across banks could not be fully explained by publicly available information.
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While some banks provide more detailed disclosure than others, in general public disclosures did not provide sufficiently granular information to establish conclusively what is driving the differences.
Hypothetical test portfolio exercise

Due to the limitations encountered when attempting to use public and supervisory data to investigate variability of mRWAs, a hypothetical test portfolio exercise was undertaken to investigate the level of variability of mRWAs stemming from internal models. A total of 15 internationally active banks with significant trading assets participated in this exercise. Following the receipt of the results, nine of the participating banks received an on-site visit by an international team of supervisors. These visits allowed the Committee to better understand the modelling choices and other factors that might underlie the observed differences in results for each portfolio. The modelling of individual positions exhibited wide variations in some cases, but this reduced as portfolios became more diversified (and more realistic). This suggests the wide variation for narrowly-focused portfolios did not compound as additional positions were added, but rather was reduced as idiosyncratic issues became less prominent. Furthermore, from a regulatory capital perspective, the result for the aggregate portfolio is the most important, as it is at the this level that regulatory capital requirements are generally determined. The high-level results of the exercise highlight two main sources of differences in mRWAs:
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(i) Differences in the model choices made by banks, and (ii) Differences in supervisory practices, including the use of supervisory multipliers. These sources of differences were also indicated in the analysis of public data. In the exercise for a hypothetical diversified portfolio there was a substantial difference between the bank reporting the lowest mRWAs and that reporting the highest. Of this, around one-quarter was due to supervisory multiplier alone: Variation caused by banks model choices: The current market risk requirements allow flexibility for banks to make a variety of choices when developing internal models. The hypothetical test portfolio exercise, and subsequent on-site visits, allowed the group to identify the most important model choices that drive variation in mRWAs. One important observation is that there is generally more variability in mRWAs from the new, more complex, IRC models than VaR and sVaR models. Supervisors may also influence outcomes here by determining, within their national frameworks, the extent of modelling options available to banks. Variation caused by differences in supervisory multipliers: When calculating mRWAs from VaR and sVaR models, the results of market risk internal models are converted to a capital requirement by applying a multiplier.
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The multiplier is at least 3, but can be higher at the supervisors discretion. In the exercise, significant variation was observed in the multipliers to be applied to the output of banks models and this variation has a direct impact on variability of reported market risk capital requirements. The multipliers for the participating banks in the exercise showed a considerable range, from 3 to 5.5.
Key modelling choices that drive variability

The test portfolio exercise provided clear evidence that differences in modelling choices can be very important drivers of variability across banks. The group was able to identify the most important modelling choices that drive variation in outcomes: For VaR and sVaR models: 1. Length of data period for calibrating and the weighting scheme applied; 2. Aggregation approach across asset classes and across specific and general risk; 3. The choice of whether to scale a one-day risk estimate to a 10-day measure or estimate risk over 10 days directly; and 4. Approach to choosing stress period (for sVaR) and the resulting stress period calibration. For IRC models:
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1. The overall modelling approach (the use of spread-based models or transition matrix-based models); 2. Calibration of the transition matrix and the initial credit rating assigned to positions; and 3. Correlation assumptions across obligors. In addition to highlighting the level of variation of mRWAs from internal models, and the most important modelling choices driving the variability, the exercise highlighted a direct relationship between complexity of risk metric/product and the associated variability of the metric across banks. The relatively more complex IRC models in the exercise displayed much more variability than VaR and sVaR models, and portfolios containing less simple products also typically showed more variability in results. This suggests considering a second phase of analysis to explore specific methodological issues related to more complex products and CRM models. Whilst the exercise highlighted that some modelling choices are more conservative than others, in most cases this result is due to the nature of the portfolios tested (hypothetical portfolios made of simple long and short positions) and each choice could be aggressive or conservative for different portfolios and market conditions. For example, a short dataset will tend to produce a more conservative outcome in periods of high volatility, but a less conservative outcome during periods of very low volatility. The important result is the highlighting of the areas of flexibility in rules that drive variation rather than which choice is the most prudent.
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Potential policy issues for future consideration

As noted above, the analysis shows there is a considerable variation in average mRWAs for trading assets and that only a part of the differences can be explained by variation in actual risk taking or business models. While some amount of variation in mRWAs is expected in any regime based on internal models and views may differ as to what is an acceptable amount of variationto develop a variation benchmark would require further analysis which was beyond the scope of this reportthe findings in this report suggest a direction for future policy work that could narrow down the potential variation in outcomes. The analysis highlights three potential types of policy options that could be considered in the future: (i) Improvement of public disclosure and regulatory data collection to aid the understanding of mRWAs; (ii) Narrowing down the modelling choices for banks; and (iii) A further harmonisation of supervisory practices with regard to model approvals (to reduce the level of variation in mRWAs). A second phase of analysis may result in exploring further potential types of policy options to address specific methodological issues related to more complex products and CRM models. At this stage, the following suggestions for policy options should not be seen as comprehensive, nor as pre-empting any specific policy measures, but rather as potential directions for future work to be considered by the relevant Basel Committee working groups. Furthermore, the potential policy measures should not be seen as mutually exclusive: some combination of the three could be appropriate going forward.
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It should also be noted that there are important trade-offs between model harmonisation and the use test rule. Strict harmonisation of internal models may make it more difficult to implement the use test rule, ie a requirement for banks to not just develop models to satisfy regulators, but also to use those models in their internal risk management. Furthermore, models harmonisation may have pro-cyclical effects stemming from a high correlation between banks capital adequacy requirements.
Improving public disclosure

Regarding public disclosures, the potential policy options should be seen in the broader context of the regulatory and industry work on public disclosures, notably by the Committees Working Group on Disclosure and the Enhanced Disclosure Task Force (EDTF), which has recently published its report on public disclosure by banks. The findings in this analysis support the recommendations and proposals in the EDTF report to enhance the public disclosure of regulatory RWAs for market risk and promote further work on Pillar 3 disclosure requirements for market risk. Based on the results of this analysis, disclosures could be improved by including more granular information regarding the components of mRWAs, the VaR and other market risk models used for regulatory capital purposes. When performing the cross jurisdictional comparison of mRWAs the Committee found in general that disclosures could be clearer on the drivers of market risk, be outlined more consistently across jurisdictions, be provided on a more timely and consistent basis, and provide more relevant information to their users that is based on information presented
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to management, risk committees and boards of directors for decision making purposes. Suggestions for improving the quality, content and consistency of disclosures related to mRWAs that could be considered include the following: 1. Common standards for the frequency of reporting less than half of the banks in the sample reported information on a quarterly basis; 2. Common standards for explanations of the drivers of the change in mRWAs from period to period; 3. A more granular and consistent segmentation of the components of mRWAs to facilitate a deeper recognition of a banks market risks; 4. Disclosure of key modelling choices, particularly those highlighted by the hypothetical test portfolio exercise as driving the greatest variation in the results of models; and 5. Disclosure of key differences in models used for internal risk management and those used for regulatory capital calculations. It was found that banks seldom directly report the 10-day 99% VaR used in regulatory capital calculations. These suggestions are closely in line with the earlier EDTFs recommendations. Another potential area for future policy work concerns harmonisation and/or consistency of the content and accessibility of supervisory and regulatory reports across jurisdictions.
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Narrowing down banks modelling choices

Future policy work that might consider narrowing down the modelling choices for banks, and therefore reduce variability, needs to consider the broader context of the fundamental review of the trading book, which is currently being undertaken by the Basel Committees Trading Book Group. This work reflects the Committees increased focus on achieving a regulatory framework that can be implemented consistently by supervisors and which achieves comparable levels of capital across jurisdictions. While there may be practical limits to narrowing the modelling choices for banks under an internal models-based approach, the list of modelling choices that were the strongest potential drivers of variability, set out above, provides areas for consideration to directly reduce variability, for example: Closely defining the modelling approach for the IRC model, including the assumptions used for migration and default probabilities and the correlation structure; Reducing the flexibility in choosing the length of historical data to calibrate VaR models; and Defining a single scaling approach to obtain a 10-day VaR and sVaR measure. These areas can be considered in addition to policy options which already form part of the fundamental review of the trading book, namely: Strengthening the relationship between standardised approaches and internal models to be able to benchmark internal model results; Moving from separate VaR and sVaR based measures to a single Expected Shortfall based measure; and
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Enhancing regulatory oversight through a more granular approval process of internal models.
Further harmonising supervisory practices

Another, potentially complementary, approach to address the variability across model outcomes indirectly would be to develop additional supervisory guidance for upholding consistent model standards and approving the use of models, including the use of supervisory multipliers. Other more structural changes could include creating an international team that actively monitors international modelling standards. In this regard, increased supervisory scrutiny of models could address some of the drivers of variation that have been identified. At the same time, it should be noted that the Basel framework in certain areas allows for supervisory discretion to appropriately reflect domestic circumstances.
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From the Public Responses to the 2012 November Consultative Documents
Strengthening Oversight and Regulation of Shadow Banking

The FSB published in November 2012 its Consultative Documents on Strengthening Oversight and Regulation of Shadow Banking, which provided an initial integrated set of policy recommendations to strengthen oversight and regulation of shadow banking. The Consultative Documents include: - A report entitled An integrated Overview of Policy Recommendations which sets out the FSB's overall approach to shadow banking issues and provides an overview of its recommendations across the five specific areas; - A report entitled Policy Framework for Strengthening Oversight and Regulation of Shadow Banking Entities which sets out a high-level policy framework to assess and mitigate bank-like systemic risks posed by shadow banking entities other than money market funds (MMFs); and - A report entitled Policy Recommendations to Address Shadow Banking Risks in Securities Lending and Repos that sets out 13 recommendations to enhance transparency, strengthen regulation of securities financing transactions, and improve market structure. The FSB indicated that it would welcome comments on these Consultative Documents by 14 January 2013. These comments are available below. The FSB wishes to thank those who have taken the time and effort to express their views, which will serve as an input to its work to finalise policy recommendations by September 2013.
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Deutsche Bank Deutsche Bank response to consultation on Strengthening Oversight and Regulation of Shadow Banking Policy: a Framework for Addressing Shadow Banking Risks in Securities Lending and Repos
Dear Sir / Madam, Deutsche Bank welcomes the opportunity to respond to the recommendations proposed by the Financial Stability Board (FSB) for addressing shadow banking risks in securities lending and repurchase agreements (repos). This reports findings, combined with the interim report published earlier this year, represent a thorough and useful analysis with recommendations that strike a balanced tone for the approach to regulation of securities financing markets. However, in translating what are sound principles into concrete measures, more thought should be given to unintended consequences and interactions with other regulation and regulatory proposals. As the report recognises, securities financing markets are an essential component of the financial markets as a whole and, as such, regulatory interventions in this space need to be advanced carefully. The FSB is therefore right to stand by a commitment to proportionate regulation and to identify greater transparency and understanding of the dynamics and risks within this market as a key priority. In order to avoid unintended consequences, we believe it is important that final recommendations capture the following key points:
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Scope -
In developing recommendations to address potential risks arising from securities lending and repo activity, care must be taken to ensure that proposed remedies are appropriate for credit institutions which are already captured within the scope of the Basel III regulations. Duplication or conflict must be avoided and the scope of application of the proposed recommendations needs to be carefully tailored.
Overlap -
Significant work has been advanced in recent years by the Basel Committee to strengthen liquidity and ensure prudent balance sheet risk management within banks. For instance, the Liquidity Coverage Ratio (LCR) accounts for secured lending and repo transactions by ensuring outflows related to these transactions, during a stressed period, are adequately covered by a stock of liquid assets. The proposal to implement mandatory minimum haircuts could lead to significant overlap in this area. Furthermore, the Basel III Leverage Ratio places a limit on banks balance sheets, directly affecting the extent to which secured borrowing can be undertaken. These rules should not be unnecessarily undermined or duplicated by additional measures designed to address the non-bank sector.
Transparency -
We believe that a better understanding of existing interactions within securities financing markets is essential to inform the more detailed work that is required to finalise recommendations in this area. The FSB is right to point out that a number of global reporting initiatives have already been launched, and any further initiatives in this space should take these into account.
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Consistent
final recommendations will be essential if they are to be effective in reducing system-wide risks.
implementation - Global implementation of the FSBs
It is therefore critical that the FSB focuses explicitly on the approach to implementation and ongoing oversight of the application of new rules at this stage. We also have concerns that rules are being developed based on the current environment, without fully determining or understanding how the landscape will change in two to three years time as a result of other regulations (i.e. Basel III, CRD IV and EMIR in the EU, Dodd Frank in the US and forthcoming proposals in relation to the collateralisation of non-centrally cleared derivatives for all market participants) which will rely heavily on participants' ability to finance their positions and significantly affect collateral flows globally. It may be prudent therefore to consider implementation timeframes and monitor this area of focus before applying strict rules. We would be very happy to discuss any of the points raised in this response, or to provide additional information if it would be useful.
Deutsche Bank response to the Financial Stability Boards consultation on Strengthening Oversight and Regulation of Shadow Banking Policy: a Framework for Addressing Shadow Banking Risks in Securities Lending and Repos. A. General remarks
Q1. Does this consultative document, taken together with the earlier interim report, adequately identify the financial stability risks in the securities lending and repo markets?
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Are there additional financial stability risks in the securities lending and repo markets that the FSB should have addressed? If so, please identify any such risks, as well as any potential recommendation(s) for the FSBs consideration.
This consultation, along with the FSBs interim report on securities lending and repo, effectively identifies the potential financial stability risks that could arise from these activities. However, many of these risks will be mitigated by the implementation of the Basel III framework. For instance, the introduction of the Leverage Ratio will significantly curtail the extent to which banks can raise funding against assets, whilst the Liquidity Coverage Ratio (LCR) will ensure that banks hold a sufficient quantity of liquid assets against a potential loss of secured funding during a severe stress scenario. These are developments which will have a clear bearing on the risks that the FSB is seeking to tackle through this paper and as such it is important that they are properly reflected in the final recommendations of the FSB particularly with respect to determining the scope of application for the proposals. Care should also be taken not to create disincentives for secured funding with the introduction of mandatory minimum haircuts. This recommendation, when coupled with the Basel III LCR which already stresses outflows on secured funding transactions, could remove the benefit of secured funding and lead to a higher reliance on unsecured money. Finally, the risk that maturity transformation brings for regulated entities is fully captured within the Liquidity Coverage Ratio (LCR) and will be strengthened by the Net Stable Funding Ratio (NSFR) when it is introduced.
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Therefore attempts to impose limitations on maturity mismatch, outside of this context, would risk duplication.
Q2. Do the policy recommendations in the document adequately address the financial stability risk(s) identified? Are there alternative approaches to risk mitigation (including existing regulatory, industry, or other mitigants) that the FSB should consider to address such risks in the securities lending and repo markets? If so, please describe such mitigants and explain how they address the risks. Are they likely to be adequate under situations of extreme financial stress?
We endorse the overall approach of the FSB which has tried to maintain focus on tailored and proportionate interventions to address risks where appropriate. For the most part specific recommendations meet the test of proportionality; however, we do not believe that this is the case for those relating to mandatory minimum haircuts. We do not believe that the measures proposed around minimum haircuts would be effective in reducing pro-cyclicality and have concerns that they could have significant unintended consequences. They would also duplicate market risk measures in Basel 2.5 and Basel III, which could in turn lead to perverse incentives that would undermine the overarching financial stability aims of the FSB framework. In addition, the cumulative impact when combined with other regulatory proposals should be considered. In particular, the Basel Committee and IOSCO are currently developing proposals regarding the collateralisation of non-centrally cleared
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derivatives and whether re-hypothecation of that collateral would be possible. It is important that the implications of these proposals are taken into account in the FSBs final recommendations for securities lending and repo. More generally, as stated above, we also believe that many of the key risks identified by the FSB are already captured or addressed under capital, liquidity and leverage rules being applied to banks. This should be taken into account in the FSBs final recommendations. For example, restrictions on leverage for regulated entities will be captured under the Basel III international Leverage Ratio. Repo and secured lending are captured within the exposure measure calculation of the proposed Leverage Ratio and collateral price volatility is captured within LCR-prescribed repo haircuts. If the intention is to further capture system leverage rather than institution-specific leverage, the FSB should also take into account that many institutions will be required to hold systemic risk buffers either as global or domestic Systemically Important Financial Institutions, which is a further protection and disincentive against inter-connectedness.
Q3. Please explain the feasibility of implementing the policy recommendations (or any alternative that you believe that would more adequately address any identified financial stability risks) in the jurisdiction(s) on which you would like to comment?
Enhanced monitoring of financial stability risks - for all market participants whether prudentially regulated banks or non-banks - is essential to provide an understanding of where risks lie and to be able to develop appropriate regulatory responses to them.
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Greater transparency will inform regulation and should be prioritised in order to ensure the FSBs view on the precise regulatory tools that are required to address the risks identified are appropriate. Without current data on the functioning of the market, effective impact assessments for individual measures will be impossible to complete. Many of the key data elements are already available to supervisory authorities in a number of jurisdictions. As far as possible these existing data initiatives should form the basis of proposals for enhanced data collection and the FSBs recommendations should focus on ensuring as much global consistency in data requirements as possible. The regulatory reform agenda that is already being delivered will address many of the risks identified by the FSB analysis (i.e. greater transparency via OTC reforms globally; UCITS and MiFID revisions in the EU; liquidity, leverage and capital rules and large exposure limits designed to capture non-banking entities under the revised Basel framework). The FSBs overall approach to regulation of the repo and securities lending sector has quite rightly focussed on the need to ensure proportionality. Ensuring the appropriate scope of application for recommendations should be an essential element of that proportionality.
Q4. Please address any costs and benefits, as well as unintended consequences from implementing the policy recommendations in the jurisdiction(s) on which you would like to comment? Please provide quantitative answers, to the extent possible that would assist the FSB in carrying out a subsequent quantitative impact assessment.
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In our view, the introduction of numerical floors for haircuts on securities against cash transactions would have the unintended consequence of incentivising unsecured funding and/or use of lower quality collateral. Specifically, we think: - The proposals are out of line with Basel III LCR haircuts i.e. 4% for longer-dated sovereign debt securities vs 0% in the LCR. - Imposing floors which are higher than those used in normal market practice could introduce incentives for less vigilant collateral management i.e. two sovereign debt securities are both subject to a 4% floor; one security is issued by a more highly rated sovereign than the other, and therefore receives a low haircut in normal times. If both are subject to a 4% floor, collateral managers are in turn dis-incentivised from utilising the higher quality collateral. - Where floors conflict with those prescribed in the LCR, there will be a net benefit under the LCR for holding the collateral instead of using it in repo markets. For example, if you hold an unencumbered level 1 asset you can count 100% of its value in the liquidity buffer. Alternatively, if you repo that security you will only receive the post-haircut value in cash. Hence, for LCR compliance, it would be advantageous to fund your position unsecured if a mandatory haircut is applied. In this context, we support the FSBs intention to carry out a Quantitative Impact Study on these proposals which we believe will demonstrate that minimum haircuts would be counterproductive.
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When assessing the impact of mandatory minimum haircuts on the regulated banking sector, the FSB should consider the combined impact of these proposals with the Basel III rules on both leverage and liquidity. In addition, the FSB should consider the impact assessment conducted by the Basel Committee and IOSCO when developing proposals for collateralisation of non-cleared derivatives. This will result in significant changes to the availability and use of collateral globally.
Q5. What is the appropriate phase-in period to implement the policy recommendations (or any alternative that you believe would more adequately)
In light of the potential for many of the recommendations set out by the FSB to have significant unintended consequences for financial markets, it is imperative that any regulatory initiatives are preceded by a thorough impact assessment and subject to phase-in - as the FSB suggests. If recommendations are taken forward on minimum haircuts, limits on cash collateral reinvestment and re-hypothecation of client assets, then we would recommend the FSB incorporates a monitoring period to assess the impacts, similar to the approach used in updating the Basel framework. Such a monitoring period would be all the more important given the interaction of recommendations with other regulations still to come into force, such as Basel III and Basel Committee/IOSCO proposals on margin for non-cleared derivatives. Consistent global implementation of any rules is also essential and as such we welcome FSB leadership in this area and would emphasise the importance of the FSB continuing to be closely focused on the implementation of any final recommendations in this area.
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B. Transparency
Overall we agree with the assessment that regulators globally need access to more consistent and granular data on securities lending and repos. We believe that a significant amount of data is already being provided to individual supervisors and strongly endorse the FSBs recommendation that the first step to improved transparency should be to build on existing sources of data. We also welcome the recognition that, to be useful, different levels of data are required for different purposes. It is essential that any data collected should be directly relevant to providing supervisors with a better understanding of specific potential risks arising from securities lending and repo activity. Steps to improve data collection should focus on improving existing sources to allow detection of potential systemic risk and relevant data gaps. If essential, yet currently uncollected data is identified, relevant contractual-level data can then be requested. However, it may be that in most instances aggregated, or information on net positions, will suffice. These additional items should be requested with adequate time for banks to adjust their systems. This point is particularly significant in light of European firms who are currently implementing substantial new reporting requirements (COREP and FINREP).
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A significant amount of information on institutions credit risk exposures through repos and securities financing is already included in banks Pillar 3 disclosure reports under Basel III. The Basel III Quantitative Impact Study is another important source of data, collecting information on banks maturity transformation (Net Stable Funding Ratio) and secured lending activity (Liquidity Coverage Ratio) plus applied haircuts. In addition, a number of national regulatory reports and market surveys already capture much of the data that the FSB indicates may be required to provide the required level of transparency. The consistency and comparability of this information should be reviewed along with any gaps for the purposes of detecting emerging systemic risks. Existing sources include: the International Capital Markets Associations European Repo Councils biannual survey; the Bank of Englands quarterly money market survey; reports generated for clients under the UK Financial Services Authority Client Assets sourcebook regime; and the FSA hedge fund survey. The FSB considers that the time lag and granularity around regulatory reporting and surveys is a downside to relying solely on these tools. However, before proposing entirely new frameworks for collecting data, the scope for reducing time lags or extracting more data from existing reports in a cost efficient manner should be fully explored. For example, inclusion of monthly delta changes alongside existing reports would identify increases in collateral transactions which could indicate an increase in leverage, without a need for significant new data fields to be added.
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Q6. Do you agree with the information items listed in box 1 (see annex) for enhancing transparency in securities lending and repo markets? Which of the information items are already publicly available for all market participants and from which sources? Would collecting or providing any of the information items listed present any significant practical problems? If so, please clarify which items, the practical problems, and possible proxies that could be collected or provided to replace such items
We do not believe that the list of data items proposed by the FSB in Box 1 would present significant practical problems for DB to deliver, though this in part reflects the fact that a significant proportion of the items are already required as part of existing regulatory reports or surveys. To the extent that more granular or frequent data is required by the FSB or there is an explicit need for additional data items to be captured, then there will be associated system costs for market participants to deliver them. As such, it will be important to ensure that all items requested are necessary, as relevant for the detection of emerging systemic risk, and are not already being captured through other means. The benefits of increased granularity must be weighed against the costs of collection - not just for market participants, but also for supervisors who will have to absorb and interpret data flows. Where it is concluded that data fields over and above those currently captured by reporting requirements or surveys across jurisdictions are needed, then the FSB should ensure that appropriate phasing of implementation is in place to avoid any sudden spikes in systems costs and to allow firms to manage implementation projects appropriately.
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This would ultimately ensure a greater degree of accuracy in the data collected.
Q7. Do you agree TRs would likely be the most effective way to collect comprehensive market data for securities lending and/or repos? What is the appropriate geographical and product scope of TRs in collecting such market data?
We would agree that a Trade Repository(ies) (TR) may ultimately be the most effective way to collect comprehensive market data on sec lending and repo activity and overall would be supportive of this approach, as long as there is scope for market participants to shape the number and nature of the TRs created (i.e. there should be flexibility for firms to determine the most effective way of delivering and verifying the accuracy of the required trade data). The logistical requirements of establishing a TR must be carefully thought through. While not all regulators currently receive detailed transaction-level data it is available in many cases. As mentioned in response to previous questions, the FSB is therefore right to recommend that further study and interim steps are needed to determine feasibility and cost before proceeding with a TR. For example, the gains from improvements in data collection discussed above should be fully explored alongside assessing the costs and feasibility of establishing TRs. We agree with the FSBs assessment that global TRs for securities lending are preferable and believe that repo TRs should also be considered on a regional or an international basis.
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In order to be viable, TRs need to have a critical mass and in some currencies repo markets may not be sufficiently large to sustain this. As such, factors such as the size of the market, scope for co-location with complementary markets and the opportunity to exploit existing platforms for other products should be considered when determining the appropriate level for a repo TR. Market participants will be best placed to answer many of these questions about optimal scope and product reach for individual TRs and as such it is important that firms themselves are closely involved in the development of TRs. It is also important that commercial sensitivities, confidentiality and information security are properly respected in the establishment of a TR. While there are strong arguments for a wide range of data to be available to supervisors, it does not automatically follow that it would be beneficial to make all of this information publicly available. Consideration should also be given to the use of service providers who provide outsourcing services (such as fund management and agency securities lending) to market participants and could perform reporting on behalf of the underlying entity.
Q8. What are the issues authorities should be mindful of when undertaking feasibility studies for the establishment of TRs for repo and/or securities lending markets?
From market participants experience of the move to central TRs for OTC derivatives, several lessons must be learned. First, TRs should be global where possible and organised more regionally/nationally depending on the size and nature of the product market.
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As outlined above, this will vary by market and will also depend on the scope for co-location with other markets or existing platforms. The location of TRs will also affect implementation around data collection - as trading happens globally and spans different time-zones - and delivery dates. The legal framework under which the TR operates should also be considered, as some jurisdictions have very stringent rules around outsourcing usage, data security and privacy of information. This should not impede regulatory access. To ensure global comparability of data, fields and formats of data collected should be consistent with the FSB Legal Entity Identifier initiative. Second, the purpose of collecting that data and who would have access to it must be clearly defined up front. A clear purpose will help determine what scope, in terms of products covered and information provided, would be most relevant and appropriate to report. While regulators should be able to have access to that information providing they follow confidentiality rules around information exchange the FSB rightly recognises that public information would have to be an aggregated (and anonymised) subset of that submitted and available to regulators. It should also be clarified what action could be taken by a regulator and under what terms, based on the information collected. In addition to respecting confidentiality, stringent information security at every stage of the handling process is needed and should be reflected in choice of provider, warehousing, technology used and process for maintaining and receiving information. This will carry significant costs but is essential given the highly commercially sensitive nature of the information.
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Third, the terms under which the TR can collect, use or share that data should be made public and should be based on the premise of objective, non-discriminatory access and pricing. Service providers, including from within the TRs parent company, should only have access to the information maintained by the TR when the relevant counterparties have provided their consent. That said, the legal framework applying to the TR should be considered with regards to confidentiality and data security - as some jurisdictions have very stringent rules in place that may prevent legitimate regulatory access and outsourcing arrangements. Fourth, consideration needs to be given to which products and what data it is necessary and relevant to report to the TR, the volume of information to be provided (e.g. many repo transactions have maturities of less than one day and as such, could significantly add to the volume of data without significantly enhancing its relevance for systemic risk purposes) and the timing in which it must be supplied. For instance, it would not be practical to require any data delivery prior to T+1. The need for timeliness must be balanced against the requirement for data accuracy. In addition, early thought should be given to how to ensure consistent formatting and prevent duplication of reporting. In our experience, it has proved complicated to integrate into existing internal systems the ability to replay or correct/amend information in the TR and for the TR to confirm the receipt and accuracy of the amendment. Finally, and most importantly, assessments of cost and feasibility need to ensure that existing platforms are fully explored and an appropriate
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timeframe for implementation is assessed based on the feasibility of adapting these or setting up new platforms. Interim improvements in data collection should be pursued before setting up new TRs, which should have a long lead-in time to allow all the issues of implementation outlined above to be thoroughly considered.
Q9 Do you agree that the enhanced disclosure items listed above would be useful for market participants and authorities? Would disclosing any of the items listed above present any significant practical problems? If so, please clarify which items, the practical problems, and possible proxies that could be disclosed instead.
Global harmonisation around the rules regarding public disclosure would be beneficial. Publicly reported information can be more relevant than just notional transaction data, for example, capital allocation reporting under Basel III. In addition, under Pillar 3, banks already report their credit risk exposure through repos and other securities financing transactions in a detailed breakdown by industry, country, and maturity. Other financial market participants should be encouraged to do the same. In addition, the recently concluded work of the FSB Enhanced Risk Disclosure Task Force goes some way to closing the data gaps identified in this report. For example, it recommended that participating banks provide greater detail on sources and use of collateral and on asset encumbrance, including collateral received that can be re-hypothecated.
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Participating banks will implement these enhanced disclosures in their 2012 financial year reports. Public disclosure may not be appropriate for some of the data items list; care would need to be taken to ensure that the definitions of items to be disclosed were clear to avoid any confusion or erroneous reporting. In particular, we would suggest that very careful thought would need to be applied to the definition of trading on own account. This might be done relatively simply by requiring disclosure of aggregate re-hypothecated assets against aggregate client indebtedness across a firm. If the first of these is lower that the latter, it will be clear that the re-hypothecation of collateral has only been carried out to fund client activity.
Q10. Do you agree that the reporting items listed above would be useful for investors? Would reporting any of the items listed above present any significant practical problems? If so, please clarify which items, the practical problems, and possible proxies that could be reported instead.
We agree that these items would be useful for investors and would not foresee significant practical problems reporting them, though with the same caveat above around consistent definition of items to be disclosed. In the EU, new disclosure requirements have recently been introduced for UCITS and UCITS ETFs that use efficient portfolio management techniques, which cover much of this ground including: the intention to use such techniques; the risks arising; the counterparties; type of collateral received; revenues received and operational costs.
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These will take effect early in 2013 and existing funds will have 12 months to become compliant.
C. Minimum haircuts
DB does not support the use of mandatory minimum haircuts as a tool to limit the build up of excessive leverage or reduce pro-cyclicality in the financial system. We do not believe that minimum haircuts will be effective in tackling the stability risks identified by FSB, and can see clear risks attached to their introduction. First, it is unclear the extent to which haircuts would ever be an effective tool in reducing the risk of a run on repo identified in the recent financial crisis. These occurred as a result of sudden changes in market sentiment driven by a complex range of factors and were limited to a specific asset class and the US market. The role which minimum haircuts would play in preventing a repeat of such a scenario is not obvious - certainly not when placed alongside other regulatory interventions designed to target capital, liquidity and leverage directly. Secondly, the introduction of minimum haircuts would limit market indicators of stress. A haircut widening signifies a loss of confidence in: i) A counterpartys ability to repay; and ii) The availability of liquidity within the market.
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Installing hard mandatory minimums would blunt or even remove this important early warning indicator, which is a crucial tool for financial institutions and regulators alike. Minimum haircuts would also increase the credit exposure of borrowers, which could aggravate system risks in stress situations. Finally, a significant unintended consequence of this measure would be that any transactions taking place below the haircut floor in both the repo and secondary markets would be lost. This would have a directly opposite effect to other regulatory initiatives, which attempt to promote and sustain the health of the secured financing market. Furthermore, increasing the cost of secured financing in relation to the alternative (i.e. unsecured lending transactions) could have perverse effects.
Q11. Are the factors described in section 3.1.2 appropriate to capture all important considerations that should be taken into account in setting risk-based haircuts? Are there any other important considerations that should be included? How are the above considerations aligned with current market practices?
Although we agree with the sentiment of introducing consistency to the calculation of haircuts within the sec lending and repo markets, the proposed methodology of using the long-run maximum expected decline in the market price of the collateral, calibrated at the 95% confidence level, could be significantly problematic. The haircut an institution employs is a product of two factors: price volatility and counterparty risk.
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Though the second part of section 3.1.2 suggests that other risks should be taking into account where relevant, it is very unclear as to precisely what risks this might include, or how they might be captured alongside the methodology in the first part of 3.1.2. As drafted, the proposed haircut methodology appears to ignore the second factor above - counterparty risk. However, as historic haircuts would clearly have taken into account counterparty risk alongside collateral price volatility, this could significantly distort future haircut levels. Applying extended haircuts to credit-worthy counterparties on an ongoing basis could result in costly implications for the availability of liquidity to credit-worthy market participants. For example, in Tri-party Repo (where all trades are cleared centrally and the risk of CCP default is extremely low) applying the long-run worst case scenario, which may have been based on non-credit-worthy counterparties, would be unsound. Furthermore, any institution-specific worst-case model which goes beyond the haircuts prescribed in the Basel III Liquidity Coverage Ratio (i.e. standardised haircuts based on predicted worst-case price volatility) could produce significant unintended consequences. In light of these concerns, we would advocate as an alternative to the proposed standards the creation of a well-developed set of guidelines on the calculation of haircuts for market participants.
Q12. What do you view as the main potential benefits, the likely impact on market activities, and possible unintended consequences of introducing a framework of numerical haircut floors on securities financing transactions where there is material pro-cyclicality risk?
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Do the types of securities identified in Options 1 and 2 present a material pro-cyclical risk?
Introducing a framework of numerical floors for the valuation of collateral in securities lending and repo transactions, in the current regulatory setting, may have perverse consequences for the functioning of financial markets.
Secured lending represents a low risk transaction:

Numerical floors or backstops on haircut values, set in contrast to prevailing market rates, would lead to the significant risk that institutions opt to undertake unsecured lending because secured lending and repo is made too costly. This is in stark contrast to the incentives trying to be created by the Basel III regulatory framework.
The haircut value incorporates counterparty risk:

The haircut applied to a secured lending transaction incorporates a number of factors, including counterparty risk. Mandatory minimum levels which are in excess of those used when lending to highly credit-worthy counterparties would eliminate the incentive to lend to credit-worthy customers, and thereby potentially increase systemic risk.
Severe market distortion:

There would be a significant risk that numerical floors become a de facto market standard if set at a backstop level.
Incentivising poor collateral risk management practices:
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Imposing numeric haircut floors which are higher than those used in normal market practice could create perverse incentives for firms to take a more relaxed approach to collateral management. For example, of two sovereign debt securities, if one security is issued by a more highly rated sovereign than the other, then it will receive a lower haircut in normal times. If both are subject to a 4% floor, collateral managers will be dis-incentivised from utilising the higher quality collateral, thus undermining risk sensitivity in the market.
High risk of regulatory duplication:

The risks that the proposed numerical floors or backstops intend to allay are already, if not soon to be, extensively mitigated within the regulated banking sector:
I. Basel III liquidity standard:

The LCR accounts for secured lending and repo transactions by ensuring outflows related to these transactions during a stressed period are adequately covered by a stock of liquid assets. Were these proposed floors to conflict with those prescribed in the LCR, there will be a net benefit for holding the collateral instead of using it in the repo markets. For example, if you hold an unencumbered level 1 asset you can count 100% of its value in the liquidity buffer. Alternatively, if you repo that security you will only receive the post-haircut value in cash. Hence, for LCR compliance, it would be advantageous to fund your position unsecured if a haircut is applied.
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II. Basle 2.5 and Basel III credit and market risk requirements:
Efficient management should already be ensured for credit institutions through the strengthened counterparty credit risk framework.
III. Basel II standard supervisory haircuts:

Incentives are already in place to prevent pro-cyclical haircuts, as capital penalties would apply to counterparty risk where haircuts are lower than the Basel II standard supervisory haircuts.
IV. Ongoing Fundamental Review of the Trading Book:

Market risk requirements will be further strengthened following the review currently being undertaken by the Basel Committee. In fact, banks run very low market risk due to stressed VaR constraints, with the vast bulk of bank inventory being hedged. This, combined with daily margining, means that a haircuts based on price volatility are less relevant than they may have been in the past.
Q13. Do you have a view as to which of the two approaches in section 3.1.3 (option 1 high level or option 2 backstop) is more effective in reducing pro-cyclicality and in limiting the build-up of excessive leverage, while preserving liquid and well-functioning markets?
We do not support the introduction of numerical floors or backstops to the haircut value places on an asset used in secured lending or repo transaction. However, if constrained, we would have a clear preference for the backstop option.
Q14. Are there additional factors that should be considered in setting numerical haircut floors as set out in section 3.1.3?
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The FSB must give due consideration to the introduction of the Basel III framework and other pre-existing regulatory proposals which set out to achieve the same outcome as this proposal (see above). In particular, the FSB should carefully analyse the impact of the introduction of the numerical haircut floors coupled with the changes to the regulated banking sector and other changes to the regulation of collateral for all market participants as a result of post-crisis regulation.
Q15. In your view, how would the numerical haircut framework interact with model-based haircut practices? Also, how would the framework complement the minimum standards for haircut methodologies proposed in section 3.1.2?
We would challenge the proposal that haircut methodologies need to go beyond the Basel 2.5 VaR requirements and Basel III LCR haircuts and question the value of using the long-run maximum expected decline in market price of collateral as the basis of minimum haircut calculations. Such an approach ignores the fact that banks will already be required to run very low market risk due to stressed VaR constraints, with the vast bulk of bank inventory being hedged. This, combined with daily margining, means that haircuts based on price volatility are less relevant than they may have been in the past. There is risk with this recommendation that haircuts would be set unnecessarily high on the basis of scenarios that existing regulatory reforms will ensure cannot be repeated. In our view, the most effective way to address the concerns raised in the paper around pro-cyclicality is through ensuring proper risk management and documentation are in place within institutions, whereas imposing numeric haircut floors which are higher than those used in normal market
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practice could incentivise less robust collateral risk management practices.
Q16. In your view, what is the appropriate scope of application of a framework of numerical haircut floors by: (i) transaction type; (ii) counterparty type; and (iii) collateral type? Which of the proposed options described above (or alternative options) do you think are more effective in reducing procyclicality risk associated with securities financing transactions, while preserving liquid and well-functioning markets?
We do not support the introduction of numerical floors or backstops to the haircut value places on an asset used in secured financing or repo transaction. Please also see answers above.
Q17. Are there specific transactions or instruments for which the application of the numerical haircut floor framework may cause practical difficulties? If so, please explain such transactions and suggest possible ways to overcome such difficulties.
As outlined above in response to question 12, we see the implications of minimum haircuts as broad rather than instrument-specific. A detailed impact assessment should be conducted to ensure that impacts on specific instruments are well understood before haircuts are considered. The FSB paper makes clear that further consultation is intended on the detail of a minimum haircut approach. We think this will be important. Prior to any final recommendation on minimum haircuts, impact analysis should be undertaken to assess the impact on cost of funding, banks
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balance sheets and market liquidity to ensure there are no unintended consequences. This should also take into account the impact of BCBS and IOSCO proposals on margin for non-cleared derivatives. The quantitative implications of a framework of minimum haircuts would need to be fully understood before it was introduced.
Q18. In your view, how should the framework be applied to transactions for which margins are set at the portfolio basis rather than an individual security basis?
The majority of securities lending trades are currently margined at a portfolio level basis. In line with our response above, we question the necessity of minimum haircuts.
D. Cash collateral reinvestment

Q19. Do you agree with the proposed minimum standards for the reinvestment of cash collateral by securities lenders, given the policy objective of limiting the liquidity and leverage risks? Are there any important considerations that the FSB should take into account?
It is important to be clear about the intended scope of this recommendation. As applied to non-bank securities lenders and their agents, then we would agree that these are sensible standards to propose and are aligned with rules that are already in place in some jurisdictions (i.e. in EU under UCITS regulations).
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However, were these requirements to be applied to regulated credit institutions, there would be significant overlap with existing regulatory initiatives in this space. For example, the recommendation for a minimum portion of cash collateral to be kept in short-term deposits or short-term highly liquid assets would conflict with the Liquidity Coverage Ratio set out in Basel III - whereby a specific portion of liquid assets is kept to safeguard against collateral valuation changes and haircut widening in a stress scenario. Imposing limitations on the Weighted Average Maturity (WAM)/Life of the portfolio in which cash collateral is reinvested could have a number of repercussions. For instance, it ignores actual repo market practice where the bulk of assets are funded overnight (particularly in the US Treasury and agencies repo market). There are also a number of technical complications when calculating WAM on a matched book business, including: - The provision of netting reverses against repos before applying the WAM limit. - Potential for manipulation by employing one very long-dated trade vs. the bulk in overnight. - The need to take into account the gross and net repo flows in absolute terms for each tenor e.g. WAM of one day based on an outstanding of 100mn vs. WAM of 30 days based on an outstanding of 100bn.
E. Re-hypothecation
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Re-hypothecation of collateral assets is essential to the flow of collateral through the financial system and underpins financing and liquidity of securities markets. By facilitating collateral velocity, there is a link between re-hypothecation and leverage at a systemic level, but any risks arising from this are best addressed by interventions targeting effective liquidity and counterparty risk management (as are already in place for banks), as opposed to direct restrictions -or even blocks - on re-hypothecation. These could have very significant and dramatic consequences for market liquidity, especially if introduced on top of existing regulatory reforms which will place greater demand and restrictions on collateral, such as margining for non-cleared derivatives. Such approaches would also fly in the face of the wide range of regulatory reforms which are designed to incentivise much greater use of secured financing in financial markets. Furthermore, the risks associated with collateral re-hypothecation in secured lending and repo transactions only materialise where any orderly wind down of the re-hypothecation chain cannot be achieved. Rather than arbitrarily limit the re-hypothecation of collateral, which would extensively curtail the availability of secured finance within the market by extracting the availability of assets for use, an approach which focuses explicitly on collateral recovery and transaction wind-down should instead be considered. Such approaches should also ensure consistency with the Basel III regulatory framework and ongoing work on Recovery and Resolution. We welcome the fact that the FSB has recognised the risks associated with heavy-handed interventions and agree that the primary focus must be on ensuring effective disclosure to market participants who are
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already much more wary of counterparty and liquidity risk in the wake of the financial crisis.
Q20. Do you agree with the principles set out in Recommendation 9?

We agree that financial intermediaries should be obliged to provide sufficient information to clients about the re-hypothecation of their assets to ensure that those clients have a reasonable understanding of their potential exposures in event of a failure. However, it is important to note that in most cases (certainly in respect of prime brokerage activity) a clients potential exposure to an intermediary will be clearly established at a contractual level. When considering an appropriate scope of application of these principles, consideration should also be given to existing limits which regulated institutions are already subject to. For instance, in the US, SEC rule 15c3-3 explicitly limits re-hypothecation of collateral to 140% of the clients net indebtedness. In other jurisdictions where there is no hard limit, commercial negotiation will determine precise re-hypothecation limits for each client, but it would be rare to see re-hypothecation limits above 140%. Whatever way the limit is determined, the important point is that there is an upfront negotiation which will set the maximum exposure to a broker. Regular reporting of precise exposure / level of collateral re-hypothecation at any given point in time provides further clarity as to exposure. In the UK, for example, disclosure to clients of both the indebtedness calculation and the assets re-hypothecated to fund said indebtedness is already provided on a daily basis, in conjunction with FSA Client Asset (CASS) rules.
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Where no beneficial interest is retained in collateral, as in repo transactions where collateral is transferred from one party to another by full title transfer, the disclosure of collateral re-hypothecation is not relevant. Whilst the principle of requiring that client assets should not be re-hypothecated for the purpose of financing the own-account activities of the intermediary may be attractive, the practical application of such a rule would be very difficult to achieve. As mentioned above, identifying aggregate re-hypothecated assets against aggregate client indebtedness across a firm might be one approach to achieving this aim. Limiting re-hypothecation to entities which are subject to regulation of liquidity risk is likely to have significant unintended consequences for availability of collateral and market liquidity more broadly. Where there are not currently restrictions (i.e. Europe) such a move could significantly thin the market and reduce the amount of available collateral. A careful assessment of implications and potential costs alongside other regulatory proposals that will affect the amount of available collateral would be needed before proceeding. The issue of client asset protection is complicated and would need to be scrutinised in a variety of different contexts - e.g. prudential regulation, insolvency law, reporting etc. An expert group looking at all of these different issues with a view to ensuring greater consistency would be a valuable enterprise.
F. Minimum standards for collateral valuation

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Q21. Do you agree with the proposed minimum standards for valuation and management of collaterals by securities lending and repo market participants? Are there any additional recommendations the FSB should consider?
We would strongly agree with the proposed minimum standards for valuation and management of collateral by market participants. In our view, these standards represent prudent risk management that should be general market practice. Whilst it is important that market participants have a clear view of how they would manage the failure of their counterparties, the level of detail and reporting associated with contingency planning should be proportionate (i.e. not overly onerous or costly).
G. Structural aspects of securities financing markets

Q22. Do you agree with the policy recommendations on structural aspects of securities financing markets as described above?
If there is trade reporting and consistent assessment of risks and valuation of collateral, then it is not clear to what extent there would be a benefit from requiring central clearing of repo and securities lending transactions. This would be a costly exercise which would further tie up collateral. Benefits would be limited and, as has been widely discussed in the context of OTC derivative reforms, the concentration of risk within central counterparty (CCP) infrastructure creates potential new systemic challenges for supervisors. As such, we support the FSBs scepticism about further work in this area at this time.
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Only once other recommendations have been finalised and effectively implemented and only if there are clear continuing risks identified within the system that cannot otherwise be addressed should a CCP solution be considered. Even then, a rigorous assessment of impacts would need to be the starting point for any discussion. Whilst we recognise the challenges that would be attendant in trying to deliver changes to bankruptcy law treatment, or the development of Repo Resolution Authorities (RRAs), we do not think they should be dismissed as options entirely at this stage. Consistent bankruptcy law treatment would address persistent concerns from some quarters around perceived risks of re-hypothecation. Insofar as this focused on ensuring improved transparency around outcomes in the event of bankruptcy, to avoid the dramatic market consequences of interventions designed to limit re-hypothecation directly, then this would be a better approach to take.
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J.P. Morgan Asset Management - Response to the FSB Consultative Documents
Strengthening Oversight and Regulation of Shadow Banking

[The FSB published in November 2012 its Consultative Documents on Strengthening Oversight and Regulation of Shadow Banking, which provided an initial integrated set of policy recommendations to strengthen oversight and regulation of shadow banking]
RE: Financial Stability Board Consultation on Strengthening Oversight and Regulation of Shadow Banking Work Stream 2: Money Market Funds
Dear Sir/Madam
Executive Summary
J.P. Morgan Asset Management (JPMAM) supports regulatory reforms that address structural vulnerabilities and decrease systemic risk in money market funds (MMFs). The reforms enacted by the US in 2010 and subsequently reflected in the Institutional Money Market Funds Association (IMMFA) Code, in conjunction with the guidelines set down by the European Securities and Markets Authority (ESMA), were very effective in reducing risk taking, improving liquidity and disclosure, and have been important in ensuring the stability of the short-term fixed income markets; however, concerns remain about the susceptibility of MMFs to run risk, as well as the implicit support investors believe is provided by fund sponsors. The Financial Stability Board (FSB) has requested feedback on a series of recommendations proposed by the International Organization of Securities Commissions (IOSCO) to address these risks, and JPMAM
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appreciates the opportunity to provide its perspective on these proposals, presenting a constructive assessment. There also exists a series of other policy measures that regulators should consider, including standby liquidity fees and enhanced transparency to investors, which could further reduce risk and aid investors in understanding the true nature and risk of their investments. To demonstrate our commitment to enhanced transparency, three US-domiciled MMFs advised by JPMAM began to disclose their market-based net asset value (NAV) on January 14, 2013; JPMAM expects that other MMFs in our global range will follow this process in the near future. More frequent availability of market-based valuations will allow investors to better understand the nature of MMF risks and make more informed decisions regarding their investments in MMFs.
Discussion of JPMAM in the MMF Industry

JPMAM appreciates the opportunity to comment on the FSBs Consultative Document: Strengthening Oversight and Regulation of Shadow Banking. This response addresses the proposals from Work Stream 2: Money Market Funds. JPMAM is one of the largest MMF managers in the world, with fund assets under management of $412 billion. In Europe, JPMAM manages nine ESMA-compliant short-term money market funds and one ESMA-compliant money market fund, totalling $151 billion in assets under management, including the JPMorgan Liquidity Funds US Dollar Liquidity Fund, the largest stable NAV MMF in Europe, with assets of $74.3 billion. In the United States, it provides investment management services for 13 MMFs registered under the Investment Company Act of 1940 with assets totalling $250 billion.
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Role and Benefits of MMFs

By serving as an intermediary between borrowers seeking short-term funding and investors searching for a low risk cash management solution, MMFs perform a vital role in the process of capital creation and the short-term fixed income capital markets. These funds, which serve a broad range of investors all with similar objectives, have the following characteristics which have made them useful investment vehicles: 1. Daily liquidity. MMFs provide a convenient vehicle to invest incremental, often unpredictable, daily cash flows. Customers also benefit from the cash flow diversification achieved by the scale created through commingling their activities with other shareholders. 2. Administrative convenience. As currently structured, MMFs provide administrative efficiency. Tax and financial bookkeeping is simplified by the consolidation of investments into a single vehicle. The number of cash management transactions is greatly reduced and the need to track gains and losses separately from ordinary income is effectively eliminated as a result of the current ability to use amortized cost (stable NAV) accounting. 3. Credit risk management. By regulation and standard practice, MMFs transact in a broadly diversified, low risk mix of investments. Advisory firms maintain professional staffs and due diligence processes to monitor, approve, trade and construct portfolios consistent with regulatory and professional standards. Replicating the professional standards is costly even for the largest corporate investors.
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4. Competitive returns. MMFs are able to achieve competitive after-fee returns, making them a cost effective means of managing liquidity. The scale created by commingling of customer assets allows MMFs to more effectively structure investment tenors. 5. Sound governance. In the EU, MMFs will generally be regulated pursuant to EC Directive 2009/65, and therefore conform to the ESMA guidelines on MMFs. Further, UCITS9 funds are governed by a Board of Directors and the assets held by an independent, regulated credit institution. In the US, MMFs are regulated under the Investment Company Act of 1940 and are governed by independent Boards of Trustees charged to oversee the funds activities.
Crisis of 2007-2009, and Financial Reform

While investors and policymakers appreciate the usefulness of MMFs, there is ongoing concern about whether there are systemic risks arising from this market. As observed by IOSCO, although MMFs did not cause the crisis of 2007-2009, this period did highlight their vulnerability to significant redemptions and the implications thereof to the broader markets. The bankruptcy of Lehman Brothers Holdings Inc. and the collapse of the Reserve Primary Fund were quickly followed by a run on risk assets, including substantial redemptions from MMFs, and the freezing of short-term credit markets. Assets in US credit MMFs dropped by $466 billion in September 2008 alone, while $122 billion flowed out of IMMFA short-term money market funds in Europe over the same period (see Exhibit 1).
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Since the crisis, there has been significant debate within the MMF industry and among regulators on the central role that MMFs play in the global markets, and the risks that they pose.
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In the intervening period since the start of the crisis, market participants and regulatory bodies have worked together to implement a significant set of reforms to the regulatory framework in which MMFs operate. In Europe, a common definition of money market fund was established by ESMA. The guidelines published by ESMA comprised a series of impactful restrictions, including restrictions of weighted average maturity (WAM), weighted average life (WAL) and credit quality (see Exhibit 2).
In the US, the Securities and Exchange Commission (SEC) made substantial enhancements in 2010 to Rule 2a-7 of the Investment Company Act of 1940, which governs the management of US stable NAV MMFs. The changes have resulted in significantly higher levels of liquidity, more conservative portfolios with higher average credit quality, and a more conservative maturity structure, including restrictions on WAM and WAL. Board powers to limit redemptions in connection with a liquidation, and enhanced transparency and reporting were also added (see Exhibit 3).
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The reforms introduced in the EU and the US have already improved liquidity, reduced risk taking, improved disclosure, and have been important to ensuring the stability of the short term fixed income markets. As evident in Exhibit 4, the amendments to Rule 2a-7 resulted in a sharp decline in market-based NAV volatility in the US. In particular, the market volatility associated with the European sovereign debt crisis did not materially affect market-based NAVs. The 2011 crisis precipitated a run on risk assets in multiple asset classes across multiple European countries. Despite this, Exhibit 4 shows a smoothing of NAVs and a stemming of flows. This demonstrates that the 2010 reforms were substantial improvements that acted to greatly reinforce the industrys ability to weather a significant crisis.
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Regulators have expressed concern about continued systemic risks resulting from run risks, as well as the potential implicit backing of the funds at a fixed euro/dollar by sponsors. In particular, regulators have identified the potential for MMFs to have a destabilizing effect on financial markets if there were a run with significant numbers of investors redeeming shares within a short period of time. A central concern that has been articulated is that MMFs that operate a constant NAV (CNAV MMFs) are particularly susceptible to runs because: a) Investors are unaware of the market risks associated with these funds and b) The stable NAV creates a first mover advantage for early redeemers in the context of a market crisis.
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We share concerns about potential systemic issues and the proper disclosure to shareholders, as well as MMFs susceptibility to runs, which present challenges regarding equitable treatment among shareholders. While the 2010 reforms in Europe and the US were essential, JPMAM believes further enhancements can preserve the many beneficial attributes of MMFs while addressing these concerns. Below we will provide our thoughts on the FSB/IOSCO recommendations and some additional commentary on other related industry matters. As Exhibit 5 shows, only credit funds suffered runs on their assets and posed a systemic risk to the wider markets during the crisis. Government and treasury funds were a safe haven for investors leaving credit funds during the 2008 crisis, and government and treasury debt enjoyed excellent liquidity across the term spectrum. These factors separate government funds from credit funds, and we are unaware of evidence that government and treasury funds experienced runs or posed any systemic risk. As a result, the scope of any proposed reforms should be limited to credit MMFs at this time.
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Core Components of the FSB Proposal

The FSB endorsed the fifteen policy recommendations for MMFs published by IOSCO in October 2012. JPMAM is similarly in agreement with many of these recommendations, with specific comments as expressed in this document. Recommendation 1: Money market funds should be explicitly defined in CIS regulation Recommendation 2: Specific limitations should apply to the types of assets in which MMFs may invest and the risks they may take Recommendation 7: Money market funds should hold a minimum amount of liquid assets to strengthen their ability to face redemptions and prevent fire sales
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Explicitly defining MMFs in EU regulation, and setting restrictions on permitted investments, WAM, WAL, etc, is a logical development for fund regulation in Europe. Such regulation is already in place in respect of US-domiciled MMFs, under Rule 2a-7. In Europe, positive steps have already been taken in this regard with the development of the ESMA guidelines, which set out restrictions on eligible investments, credit quality, residual maturity, WAM, WAL, etc, and have established a robust framework for the control of the principal risks to which MMFs are exposed (interest rate risk, credit risk and liquidity risk). In particular, consideration should be given to the effect that new European restrictions governing liquidity may have in reducing the level of risk in MMFs. The requirement for MMFs to hold an appropriate proportion of their assets in cash or securities that are sufficiently liquid to meet reasonably foreseeable shareholder redemptions is an important safeguard for the industry and for the wider financial markets. Liquidity restrictions effectively mitigate risk. The level of liquid assets in a MMF takes on its greatest importance during a crisis, when the actions of some quick-acting investors may adversely impact remaining shareholders. During such a situation, an appropriate level of liquidity in a MMF can limit the impact of a run on remaining shareholders. In the US, the 2010 introduction by the SEC of tighter liquidity standards was highly effective in reducing risk in MMFs (as evidenced in Exhibit 4). Similar liquidity requirements are already reflected in the IMMFA Code of Practice.
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Consideration should be given to introducing similar requirements expressly into European regulation. Taking the US/IMMFA standards a step further, a 50% monthly liquidity requirement could complement the daily and weekly requirements and provide additional safeguards to MMFs. The FSB should also consider further clarification of requirements governing diversification. The increased diversification of underlying portfolio assets in combination with the other measures described above would be a reasonable way to reduce risk in European MMFs. Enhancements to the credit related portfolio constraints could act to further minimize the potential of a defaulted security having a material impact on the overall value of these portfolios. Building on this by applying exposure limits based on long-term issuer ratings and tenors could be an effective measure for reducing the impact credit events have on the perception of risk in a MMF portfolio. The prudent management of credit risk is clearly paramount for a MMF, given that a credit event (or the perception that one is imminent) can facilitate a run. Implementing additional requirements that assist MMFs from taking on excessive credit exposures to a single entity and creating additional transparency around these exposures would further protect investors and reduce the likelihood of a run triggered by a credit event in a MMF portfolio. Any regulation of EU MMFs should be introduced as part of the existing UCITS regulation, rather than developing a separate regulatory regime specifically for MMFs.
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The UCITS brand represents a globally-recognised standard that investors trust, and many have accordingly hard-coded the requirement for eligible MMFs to be UCITS-compliant into their internal investment policies. Recommendation 4: Money market funds should comply with the general principle of fair value when valuing the securities held in their portfolios. Amortized cost method should only be used in limited circumstances. Recommendation 10: MMFs that offer a stable NAV should be subject to measures designed to reduce the specific risks associated with their stable NAV feature and to internalise the costs arising from these risks. Regulators should require, where workable, a conversion to floating/variable NAV. Alternatively, safeguards should be introduced to reinforce stable NAV MMFs resilience and ability to face significant redemptions. The FSB drew particular attention to IOSCOs Recommendation 10 that CNAV MMFs should be converted into floating NAV (FNAV) where workable. In the US, CNAV MMFs currently hold $2.70 trillion in US investors cash assets, and in Europe, CNAV MMFs comprise 493 billion. There are a few important features of these funds, including same day settlement and the 1.00 NAV, which leads to simplicity in the accounting and tax treatment utilized by investors. A requirement for CNAV MMFs to float NAVs would fundamentally reshape the product and its ability to deliver these core benefits to investors. Floating the NAV has the benefits of providing transparency of market values to investors and reducing the possibilities for transaction activity that result in non- equitable treatment across all shareholders; however, it will likely give rise to a number of consequences for investors and market
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participants that should be examined rigorously and addressed in order to arrive at a constructive solution. To implement a floating NAV solution that preserves the utility of CNAV MMFs for cash managers, a move to FNAV will need to carefully consider and address the following considerations:
Accounting Treatment for Investors

Due to the nature of CNAV MMFs, they have generally been classified as cash equivalents. The Financial Accounting Standards Board (FASB)s Generally Accepted Accounting Principles (US GAAP) codification defines cash equivalents as short-term, highly liquid investments that have both of the following characteristics: a) Readily convertible to known amounts of cash, and b) So near their maturity that they present insignificant risk of changes in value because of changes in interest rates. US GAAP currently provides a specific exemption for MMFs to allow them to be treated as cash and cash equivalents, provided that the NAV is stable and not impaired. This definition reinforced the efficacy of CNAV MMFs as a cash investment solution for investors and serves as a critically important attribute of the product as it enables those investors to include their CNAV MMF assets in net leverage ratios which may have material implications for the availability and cost of financing as well as compliance with any debt covenants. The introduction of a floating NAV regime may create uncertainty for businesses, both large and small, and their accountants with respect to the appropriate balance sheet classification for FNAV MMFs going forward.
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The treatment of FNAV MMFs as cash equivalents is warranted for several reasons. The portfolios of these funds are comprised of instruments which if held directly would typically be classified as cash equivalents (e.g. T-bills, short-term agency obligations, commercial paper, repurchase agreements). Overall weighted average maturity and life of the underlying money market portfolio is sufficiently short (ie a maximum of 60 days and 120 days respectively) to limit to a de minimis amount the fluctuation in the underlying value of the portfolio. The classification of FNAV MMFs as a cash equivalent is essential to the investors that invest in MMFs. If FNAV MMF regulations are adopted, regulators should work with the FASB/IASB20 to ensure that a specific exemption is provided in US GAAP/IFRS21 to allow investors, pursuant to UCITS, to continue to receive cash equivalent treatment.
Tax Treatment of Gains and Losses

Careful consideration should be given to the diversity of tax regimes across European member states. In particular, there will be operational impacts on fund administrators who have to produce, together with the FNAV, a range of bespoke tax numbers for a variety of countries in Europe (for example, Germany, the United Kingdom, Austria and Switzerland). It may be that system enhancements are required to continue to support such tax reporting after this change.
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It is likely, for those countries that do not apply tax transparency principles, that gains in a FNAV MMF will be considered as capital rather than income. This may have different tax impacts for investors depending upon if there is a different tax rate for income and capital gains for that particular investor. The UK operates a simplified tax reporting system for CNAV MMFs which apply for UK reporting fund status the FNAV MMF would not qualify for this simplification.
Operational Issues will Require Significant Transition Time

A move to a floating NAV will require workflow and operational changes to multiple processes in order to accurately price and settle fund share activity on a daily basis. - Existing pricing and valuation infrastructure is not set up for supporting a FNAV and same day settlement. In order to maintain same day settlement, the infrastructure supporting MMFs, including pricing mechanisms, will require significant enhancements and partnership with industry vendors. - Many transfer agents cannot currently support a floating NAV with same day settlement (t+0) and would need to enhance recordkeeping systems to accommodate this new fund type. The cash versus fund share activity and other daily audit controls will condense to the end of the day, introducing additional time constraints and heightened risks. - Financial intermediaries distribute MMFs via various channels including a significant amount through sweeps and portals. Each will need enhancements.
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The stable NAV is the mechanism that facilitates the efficient movement of assets into and out of the products on a daily basis. Certain channels may no longer be supported in the floating NAV scenario. Many financial intermediaries are not set-up for a daily floating NAV for MMFs and have said that a significant amount of programming would be necessary to support a change. Consideration should be given to providing a significant implementation /transition time so that the operational issues above can be effectively worked through and solved. A long transition time could help to mitigate run risk and disruption of funds as investors elect to monitor the impact of the new FNAV requirements and avoid a higher concentration of investors to a smaller less diversified universe of MMFs.
Industry Viability and Outflow

Investors have expressed strong concerns about the complexity from an accounting, tax and operational perspective associated with FNAV MMFs under the current regulatory framework. Recent market surveys of existing US corporate treasurers found that between 77% and 79% of respondents would reduce or eliminate the use of MMFs if their per share NAVs were forced to float. In addition, accessibility would likely be materially diminished for those that remain active: automated investment sweeps are a dominant access point for MMF investing activity, with our own corporate treasury surveys finding 52% of US investors utilizing this kind of service to facilitate investments of their excess cash. An implication of the various FNAV-related operational issues is that the number of intermediaries capable of making sweeps to MMFs available
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to their underlying investors should be expected to shrink materially, particularly in the near-term as the industry adjusts and market participants gauge outflow and reallocation activities by investors. The market feedback to date implies that this sort of structural change may result in a substantial reduction in assets, investors and intermediaries participating in the credit MMF segment; however, some of the market feedback may be due in part to the level of uncertainty and collateral effects that are triggered by a change of this scale. Although it is difficult to quantify, some proportion of these investors may be encouraged to remain active participants in the credit funds if the industry and regulators establish a comprehensive set of proposals and policies. Recommendation 6: Money market funds should establish sound policies and procedures to know their clients. Requirements that enable managers to have a better understanding of the type of investors in the funds will allow managers to better manage for risks that may arise from high shareholder concentration and to better monitor subscription and redemption cycles. These would be positive steps for the industrys ability to manage potential MMF risks. IOSCO is correct to acknowledge the current practical impediments in monitoring investors in omnibus accounts. Steps to encourage distributors/agents to provide better information to MMF managers on the underlying investor bases in omnibus accounts, in terms of concentrations, investor types and trading patterns, would be protective for existing MMF investors and therefore positive for the industry.
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Recommendation 9: Money market funds should have tools in place to deal with exceptional market conditions and substantial redemptions pressures In Europe, UCITS funds provide a number of safeguards in this respect. The UCITS Directive provides for the temporary suspension of redemptions in exceptional circumstances and where suspension is justified having regard to the interests of the shareholders. This ability to suspend is a powerful tool for situations where the market conditions may cause a "run" on the fund. Suspension would allow the fund to stabilise and reduce first mover advantage. In accordance with Luxembourg law, fund prospectuses must specify the conditions under which the Board of Directors of the funds has the power to suspend the issue, redemption and switch of shares in the funds. European regulation and practice also allows the operation of what is sometimes referred to as a "gate" or scaling provision. For example, if redemptions of more than 10% of the total number of shares in issue of any fund are received on a particular day, such redemptions may be postponed to the next day. These redemption requests are then given priority over other requests on subsequent days. Although not frequently utilised, this form of gating provides relief for the fund in circumstances where a substantial number of redemption requests are received. This, combined with the ability to suspend, provides the funds with significant protection to deal with exceptional market conditions and substantial redemption pressure.
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Standby Liquidity Fee/Gates

There have been numerous proposals discussed globally regarding standby liquidity fees (SLFs), and gates that suspend redemptions. These proposals have considerable merit and should be given serious consideration; however, it is important to recognize the benefits and limitations of SLFs and this form of gating. Broadly speaking, proposals have focused on a trigger point that activates a liquidity fee and gate. For example, the trigger point could be tied to some combination of a funds liquidity level and the market-based NAV, eg when weekly liquidity falls below 7.5% or the market-based NAV reaches 0.9975. Once a fund hits a trigger point, a gate is imposed suspending redemptions. The funds Board of Directors may then choose to re-open the fund, provided shareholders pay a non-refundable liquidity fee, suggested to be 1% of redemption proceeds to redeem their shares. In particular, the standby character of these proposals appropriately balances the goal of allowing MMFs to operate normally when not under stress, yet promote stability, flexibility and reasonable fairness when stressed. If a run on a fund has begun, such a gate can help to mitigate that run. Funds that re-open with a SLF will require investors to pay an appropriate charge for the liquidity they require. Investors who do not need liquidity will not be disadvantaged by remaining in the fund.
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However, such gates and SLFs with objective triggers will prompt investors of those funds to require full and frequent disclosure of those objective triggers. Any fund that is in jeopardy of breaching a trigger will likely see significant redemptions ahead of the actual trigger event. Therefore, it is important to recognize the limitation of SLFs: they do not prevent an initial run, but they do provide a useful tool to slow the run after it has begun.
Capital
In our experience, liquidity concerns are fuelled by credit events. In the past sponsor capital used at the discretion of sponsors has generally been effective in preventing idiosyncratic risk in a single fund leading to a broader systemic issue across the industry and short term funding markets. There are a number of ways that capital could be funded, ie by sponsors, shareholders or third parties, and a number of ways it could be structured, ie first loss reserve used only upon liquidation or a buffer that absorbs day-to-day fluctuations in market-based values. While there are some distinct benefits to capital, there are also challenges that should be addressed.
Benefits
- Accessing a dedicated amount of sponsor support only upon the liquidation of a fund and providing a fixed amount of capital makes investors more cognizant of the limits of capital protection.
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- A dedicated amount of sponsor support could lead to "right sizing" the industry. Those sponsors managing larger credit funds would be required to have the appropriate access to capital. - A dedicated amount of sponsor support can be made available more quickly and aligns the interests of the sponsor with the investors interests of proper risk taking and credit oversight. Shareholder capital aligns the cost of liquidity and the 1.00 NAV of the fund to the shareholder.
Challenges
- To the extent that sponsors are required to provide a dedicated amount of sponsor support, additional guidance would be necessary to clarify that consolidation of the MMF is not required onto the financial statements of the sponsor under the applicable accounting rules. - Given a low rate environment (such as that currently experienced in markets globally), the amount of time required to build up a sufficiently-sized buffer by withholding shareholder income would leave investors exposed for an extended period of time until the buffer grows to sufficient size. - Capital that is not dynamic in funding can lag as assets in a MMF grow, leaving the actual support available underfunded. - Capital requirements can create barriers to entry. With regard to shareholder funded buffers, once existing funds have fully funded their required buffers, new funds would be challenged to attract investors. Investors who delay their share purchases would receive all the benefits of the reserve but incur none of its costs.
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With regard to a dedicated amount of sponsor support, sponsors without access to capital would find it difficult to enter or remain in the market. Size of the capital support is key. JPMAM has conducted extensive work on this topic, which we are happy to share with regulators. Given the high quality nature of the assets held in MMF portfolios, the optimal capital level must strike an appropriate balance, addressing MMF risks such as minimizing credit default risk, without becoming uneconomical for sponsors or investors. Our research suggests the optimal size is within a range of between 50bps and 100bps. Additionally, where capital support is utilized as a first loss position upon liquidation, the level of capital available can be tied to a MMFs highest asset levels. This can result in a structure whereby, as redemptions accelerate and cause the unrealized loss per share to increase further, the amount of capital support available per share increases accordingly, providing further capital support to the remaining shareholders that do not redeem their shares. Ultimately, the capitals source sponsor or shareholder is less important than applying consistent risk measures across the industry and ensuring the capital is callable and useable under a proper regulatory framework. The key is that capital be funded upfront and that it remains dynamic in order to be consistently appropriately sized for any asset growth.
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Recommendation 13: MMF documentation should include a specific disclosure drawing investors attention to the absence of a capital guarantee and the possibility of principal loss. Recommendation 14: MMFs disclosure to investors should include all necessary information regarding the funds practices in relation to valuation and the applicable procedures in times of stress. As the industry and regulators continue to work towards a constructive solution, JPMAM believes the theme of transparency should play a central role. Transparency and disclosure are strong themes already embedded in European regulation via the UCITS Directive. UCITS law provides for extensive disclosure in the prospectus, the Key Investor Information Document ("KIID") and the half-yearly and annual reports. These contain an overriding requirement that the prospectus contains the information necessary for investors to be able to make an informed judgement of the investment proposed to them and in particular of the risks of such investment. A clear and easily understandable explanation of the fund's risk profile must also be included. The prospectus must also contain certain other detailed information regarding the fund's operation, for example details of the types and characteristics of the units, the types of investments made by the UCITS and its use of financial derivatives. The valuation rules must be set out in the prospectus and this includes any method used in times of stress.
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The combination of the requirements for the prospectus, KIID, and half-yearly/annual reports provides a robust disclosure regime for the protection of investors in UCITS funds, into which further enhancements such as specific risk disclosures could be built. Recognizing the central role of transparency, on January 14, 2013, three US-domiciled credit MMFs advised by JPMAM began disclosing their market-based NAVs each business day. All redemptions and subscriptions for the funds will continue to be processed using the stable NAV determined under the amortized cost method of accounting consistent with the provisions under Rule 2a-7. (The funds per share market-based NAVs have historically been calculated at least weekly, and since December 2010, have been disclosed monthly to the SEC and released to the public on a 60 day lag.) The steps that JPMAM is taking will not impact the operation of the funds and will allow investors to continue to rely on the funds for short-term liquidity and investment diversification, while providing an additional layer of disclosure. This will allow investors to better understand the nature of MMF risks and make more informed decisions regarding their investments in MMFs. JPMAM expects that other MMFs in our global range will follow this process in the near future.
Conclusion
JPMAM appreciates the opportunity to comment on the FSBs recommendations. We acknowledge regulators efforts to research, consult and define a set of solutions to ensure the stability of the MMF industry and the broader
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financial system, while preserving the viability of this industry for investors and the short-term capital markets. It is evident that there is no single solution to address the systemic concerns around MMFs; however, a combination of several thoughtful initiatives, selectively applied and rigorously implemented, could have a significant impact in addressing their structural vulnerabilities and the risks they present. We would be pleased to provide any further information or respond to any questions that the FSB may have.
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Speech by the Chancellor of the Exchequer, Rt Hon George Osborne MP, on the Reform of Banking
Thank you for welcoming me to JP Morgan here in Bournemouth. When you think about where to give a speech on culture and ethics and the future of British banking, the offices of one of the worlds largest American investment banks may seem like an odd choice of venue. But its a deliberate one. For the four thousand people who work here are, each one of you, a reminder that when banking works, it works for the families and communities of the whole of Britain. You, each one of you, are a reminder that when we attract international firms to our country firms that could go anywhere in the world to do their business those firms bring jobs, and investment and prosperity. That for every one of the people employed here at the largest business in Dorset, there are many more employed in the businesses that support this office, in the shops that take your custom, and in the local economy that has grown stronger on your back. Im going to see two of those businesses after I speak here a catering company and a landscaping business called Stewarts. Four of the employees at that landscaping business work full time on JP Morgan site, jobs that wouldnt exist without your presence.
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From JP Morgan, one of the worlds biggest companies, to Stewarts landscaping, Bournemouth teaches us that Britain should continue to aspire to be a home to the worlds financial services. And what is true for Bournemouth is also true of Bristol, and Edinburgh, Leeds, Cardiff, Birmingham and Manchester. In all these cities, financial services are some of our largest and most innovative employers. And its true about London too and the City of London. Generations have created in the City something extraordinary a global centre of finance.
The global centre of finance.

Whether its insurance and accountancy, shipping and legal services, hedge funds, private equity, asset management or investment banking, when the world wants to transact it wants to transact through London. And we want to keep it that way in the years ahead. Thats why its been good to see Britain and London maintain its number one spot as the home of global financial services. Thats why its been exciting to see the first Renminbi bond issued anywhere in the world outside of Chinese sovereign territory issued in London in the last twelve months. For that is not just good for their future, its good for ours too. Its how we will win in the global race. Its what I am personally determined to achieve.
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And part of having a successful financial services industry is having successful British banks, who want to lend at home and compete around the world. Think of some of the most important moments in your life. When you bought your own home with a mortgage. When you took the plunge and started your own business. When you retired and drew on your pension. On each of those occasions, you relied on the financial system and put your trust in them That is why its so important to have that trust reciprocated and a banking system that works for you. And that is what Im working night and day to deliver for you. Like all this Governments reform to welfare, to the economy, to schools and to banking we want to back aspiration and be on the side of those who want to work hard and get on. Our principles are simple: if you do the right thing, government should support and help you, and remove the barriers in your way. If you do the wrong thing, you should take responsibility for your actions. And sadly, nowhere have these simple principles been broken more clearly and indefensibly than in our banking system over the last decade. Irresponsible behaviour was rewarded, failure was bailed out, and the innocent people who have nothing whatsoever to do with the banks suffered.
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For many, the financial crash was confirmation of what they felt about our society: that those who are only out for themselves get away with it; and those who work hard and play by the rules get punished. That is why, five years on from that crash, people are still so angry. And when people discover more about what went so wrong: the mis-selling of interest rate swaps to small firms who went bust as a result; the greed and corruption on the LIBOR trading floor. They get angrier still. I understand that anger. I feel it too. But anger can be a negative, destructive thing if it is not channelled into change. Change for the good. Any bunch of politicians can bash the banks, chase the headlines, court the populist streak. But what good would that do our country? The jobs, the investment, the banking system we all need would go with it. Lets take the anger we feel about the banks and turn it into change to build the banking system that works for us all.
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That is precisely what we are doing. And through the work weve done, the expert help weve enlisted, we can make 2013 the year of change in our banking system. 2013 is the year when we re-set our banking system. So the banks work for their customers and not the other way round. So that those who guard over the banks to keep our economy safe are the right people with the right weapons to do the job. And so that when mistakes are made, its the banks and not the taxpayer that picks up the bill. Let me explain how. Let me tell you about the four concrete things that are going to change this year. First, weve got a brand new watchdog with new powers to keep our banks safe so they dont bring down the economy. Second, weve got a new law to separate the branch on the high street from the dealing floor in the city to protect taxpayers when mistakes are made. Third, were going to start, with the industry, changing the whole culture and ethics of the business, so they work for you. Fourth, were going to give customers the most powerful weapon of all: choice. Real choice about who you bank with and choice to change who you bank with if you want a better deal. Let me take each in turn.
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First, protecting our economy by keeping our banks safe. The decision taken by the last government to divide responsibility for financial stability from banking supervision was one of the worst economy policy mistakes of the modern era. The Bank of England was stripped of its responsibility for keeping the banking system safe. The Financial Services Authority was only focussed on compliance, with a myriad of individual rules, and missed the wood for the trees. The Treasurys banking division was run down. No-one saw it as their job to monitor risks across the whole system. So no-one spotted the increase of debt. Staggeringly, total debt reached five times the size of the entire economy. The fire alarm was ringing when Northern Rock handed out 120 per cent mortgages. The fire alarm was ringing when the Royal Bank of Scotland made its reckless purchase of ABN AMRO, after the credit markets had already seized up. The fire alarm was ringing, but no-one was listening. And when the crisis hit, the fire was then so great that the whole economy was sacrificed to put it out. Ten per cent of the entire wealth of this country was lost. Hundreds of thousands of people lost their jobs and their livelihoods. Yes, those responsible should be held to account.
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But British people need to know that lessons have been learnt. And they have. This April, the FSA is being abolished. This April, the Bank of England will be in charge of keeping our financial system safe. With the authority that comes from its history, and the new powers we have given it for the future, the Bank of England will be the super cop of our financial system. The Bank is ready. The logistics are in place. And from day one, we will have a powerful new watchdog with real teeth. Not just to intervene and stop individual wrong doing. But the power to make a judgement call about the whole system - the power to spot increases in debt or warn of risky practices. The power to call time before the party gets out of control. But also the power to support the economy if credit conditions get too tight. The Bank of England wont be just empowered to protect us from the excesses of a banking boom, but also to help the bank support us in a bust. And were also creating from April a strong new conduct regulator, the FCA, to ensure London and the UK have the best, most open, and transparently policed markets in the world.
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That will win business for Britain, attract investment. And through the Funding for Lending scheme, were giving banks incentives to boost lending to families and businesses. Weve already seen the availability and cost of borrowing coming down, but we are monitoring it closely to ensure that rates and availability continue to improve. Good regulation. Watchdogs with real teeth. Open markets with clear rules, properly policed. These support innovation. For the industry that suffers most when something goes wrong in finance is finance itself. Second, this year were going to start separating the high street banking we all depend on from the City trading floor. When the RBS failed, my predecessor Alistair Darling felt he had no option but to bail the entire thing out. Not just the RBS on Britains high streets, but the trading positions in Asia, the mortgage books in sub-prime America, the property punts in Dubai. I want to make sure that the next time a Chancellor faces that decision they have a choice. To keep the bank branches going, the cash machines operating, while letting the investment arm fail.
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No more rewards for failure. No more too big to fail. No more taxpayers forking out for the mistakes of others. The same rules for the banking business as any other business in a free market. When the Government came into office, there was no agreement about how this massive task would be achieved. Thats why we spent two and a half years painstakingly building a consensus on the future structure of our banking industry, working with leading experts and Members of Parliament and I want to thank Vince Cable for his help in doing that with me. The work that Sir John Vickers and his Commission has done has won respect all around the world, and has already influenced the European debate. Today, we are published the legislation that will turn their ideas and this consensus for change into law. A law for the first time ever, to separate the retail and investment arms of banks, and erect a ring fence around the retail bank so its essential operations continue even if the whole bank fails. Im sending the legislation to the House of Commons today and I expect them to be passed by Parliament this time next year. It wont mean banks wont make mistakes. But it does mean that if they do, those parts of the banking system that are vital for families and businesses can continue without resort to the taxpayer.
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Today, we will go further than previously announced, enshrining in law these simple principles. I can announce that your high street bank will have different bosses from its investment bank. Your high street bank will manage its own risks, but not the risks of the investment bank. And the investment bank wont be able to use your savings to fund their inherently risky investments. My message to the banks is clear: if a bank flouts the rules, the regulator and the Treasury will have the power to break it up altogether full separation, not just a ring fence. Were not going to repeat the mistakes of the past. In America and elsewhere, banks found ways to undermine and get around the rules. Greed overcame good governance. We could see that again so we are going to arm ourselves in advance. In the jargon, we will electrify the ring fence. I want to thank Andrew Tyrie and the fellow members of the Banking Commission we established for help developing this important new idea. Lets get on and pass it all into law. Let me turn to the third force for change a change in the culture and ethics of the banking industry itself.
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I have to say nowhere is this more keenly appreciated than in the responsible parts of the financial community itself. You here work hard in a great business. You service customers all over the world. You dont want the name of your whole industry to be besmirched because of the crimes of a few. And nor do I. Thats why the LIBOR scandal is about far more than atoning for the mistakes of the past. Its about becoming a catalyst for change in the future. We know what happened. From 2005, traders, brokers and bank officials attempted manipulation of one of the most important reference rates in our economy a rate which affects the mortgage payments and loan rates of millions of families and hundreds of thousands of firms, large and small. Deliberately submitting false rates for no motive other than greed. Lowballing their Libor submissions to conceal how vulnerable their banks really were. Years of manipulation, in twenty banks on three continents.
Over a billion pounds of fines have already been applied worldwide.

And we still havent seen the full extent of it more revelations will come. Were expecting reports into what happened at RBS very shortly.
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I expect there will be even more public anger if thats possible. But anger is not enough we need to channel the anger into change. And I want to do the right thing for the hundreds of thousands of people in the banking sector like you in all parts of our country who do conduct themselves with professionalism and make sure the reputation and standards of the industry are restored. LIBOR manipulation happened in many countries. But no country has responded as quickly as decisively as we have now done. Where people have broken the law, the authorities will have all the resources they need to make sure they are punished. Ive changed the system I inherited so that fines paid by banks for wrongdoing got to good causes not back to the industry I have already announced that 35 million pounds of Barclays fines will go to British Armed Forces charities to help those who fight on all our behalves. The first million has been allocated to the Fisher House Project, which will help the families of wounded soldiers being treated at the Queen Elizabeth Hospital in Birmingham to stay close by. And were now stepping in to regulate previously unregulated markets and were making it a criminal offence to make misleading statements about LIBOR. Shockingly that was not the case before.
And as we approach bonus season let me say this.

This country now has the toughest and most transparent pay regime of any major financial centre in the world.
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City bonuses fell by almost two thirds last year, and are less than a quarter of their peak before the crash.
Everyone should exercise restraint and responsibility, but its important to remember that the vast majority of people in the banking sector like the people in this room do not receive million pound bonuses. We all know there are Libor investigations ongoing into RBS in both the UK and the US. Any UK fine will benefit the public. And when it comes to RBS, I am clear that the bill for any US fine related to this investigation should on this occasion be paid for by the bankers, and not the taxpayer. But the change to the culture and ethics of banking go beyond bonuses and fines. I believe we need proper professional standards in the banking sector just as we have for doctors and lawyers. I want to see the industry take pride in those standards, as our medical and legal professions do. And I want to see how we can strengthen the sanctions regime for senior bankers for example, should there be a presumption that the directors of failed banks do not work in the sector again? I have asked the Parliamentary Commission to look at how to improve the professional standards and culture of the banking sector. Their work is underway and will report in the spring. I would encourage the Commission to come forward with far reaching proposals.
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The fourth and final change we need to banking is more choice. Choice is the most powerful tool we have to improve markets and customer service, reward good companies and penalise poor ones. Yes, our new regulator can pick up the pieces from the interest swap mis-selling or PPI. Yes, I believe we must do much more to expose hidden charges and remove the conflicts of interest that plague too much so called independent financial advice. But I also want to see more banks on the high street, so customers have more choice. One of the prices were paying for the financial crisis is that our banking sector is now dominated by a few big banks. It verges on an oligopoly. 75% of all personal current accounts are in the hands of just four companies. I want new faces on the high street. I want upstart challengers offering new and better services that shake up the established players. Weve made a start: with the sale of Northern Rock to Virgin Money, and the proposed sale of Lloyds branches to Co-op. Were seeing new banks like Metro Bank on our high streets but I want to make it easier to start a small bank and grow the business.
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This year, in 2013, were taking a huge step towards making that happen by making it easier for customers to move banks if they can get a better deal elsewhere. From September this year, every customer of every bank in Britain will be able to switch their bank account from their existing bank to another one in seven days. All they will have to do is sign up to a new bank and the rest will follow. All the direct debits, the standing orders, everything will be switched for you with no hassle. This is a revolution in customer choice. But today, we will go further. Payments systems sit at the heart of the banking system. They are the hidden from view wirings that operate every time you get wages paid into your bank account, deposit a cheque or withdraw money from an ATM. Its how the money flows around the system. And its a bit like the electricity grid, every person and every business needs to be plugged into them to enter the banking market. At the moment, a new player in the industry has to go to one of the existing big banks to use the payment system. Asking your rival to provide you with the essential services you need at a reasonable price is not a recipe for success. And it other walks of life, like telecoms, we dont operate like that.
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There are no incentives on the big banks to deliver new and better services for users like saving the cheque or creating new services like mobile payments. Why, in the age of instant communication, do small businesses have to wait for several days before they get their money from a credit or debit card payment? It should be much quicker. Why do cheques take six days to clear? Customers and businesses should be able to move their money round the system much more quickly. Why is it that big banks can move their money around instantly, but when a small business wants to make a payment it takes days? The system isnt working for customers, so we will change it. I can announce today that the Government will bring forward detailed proposals to open up the payment systems. We will make sure that new players in the market can access these systems in a fair and transparent way. The last Government let the established players off the hook by failing to implement the conclusions of the review they themselves commissioned, and allowing the big existing banks to regulate themselves. This Government will make sure payment systems serve the needs of consumers, not the needs of the established banks. Bank working for their customers, not themselves. Taxpayers money protected.
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The guardians of financial stability with the tools they need to keep us safe. On all these fronts, we are making major changes. A financial industry that is strong, successful and inspires the pride of all those who work for it. Thats what Government should be about taking the big tough decisions because theyre right for the long-term good of our country. Our country has paid a higher price than any other major economy for what went so badly wrong in our banking system. The anger people feel is very real. Lets turn that anger from a force of destruction into a force for change. Change that will give us a banking system that will work for us all. In 2013, thanks to the changes we are making, that goal is in sight
P a g e | 244 Disclaimer The Association tries to enhance public access to information about risk and compliance management. Our goal is to keep this information timely and accurate. If errors are brought to our attention, we will try to correct them. This information: is of a general nature only and is not intended to address the specific circumstances of any particular individual or entity; should not be relied on in the particular context of enforcement or similar regulatory action; is not necessarily comprehensive, complete, or up to date;
is sometimes linked to external sites over which the Association has no control and for which the Association assumes no responsibility; is not professional or legal advice (if you need specific advice, you should always consult a suitably qualified professional); is in no way constitutive of an interpretative document;
does not prejudge the position that the relevant authorities might decide to take on the same matters if developments, including Court rulings, were to lead it to revise some of the views expressed here; does not prejudge the interpretation that the Courts might place on the matters at issue. Please note that it cannot be guaranteed that these information and documents exactly reproduce officially adopted texts. It is our goal to minimize disruption caused by technical errors. However some data or information may have been created or structured in files or formats that are not error-free and we cannot guarantee that our service will not be interrupted or otherwise affected by such problems. The Association accepts no responsibility with regard to such problems incurred as a result of using this site or any linked external sites.
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The Basel iii Compliance Professionals Association (BiiiCPA) is the largest association of Basel iii Professionals in the world. It is a business unit of the Basel ii Compliance Professionals Association (BCPA), which is also the largest association of Basel ii Professionals in the world.
Basel III Speakers Bureau

The Basel iii Compliance Professionals Association (BiiiCPA) has established the Basel III Speakers Bureau for firms and organizations that want to access the Basel iii expertise of Certified Basel iii Professionals (CBiiiPros). The BiiiCPA will be the liaison between our certified professionals and these organizations, at no cost. We strongly believe that this can be a great opportunity for both, our certified professionals and the organizers. To learn more: www.basel-iii-association.com/Basel_iii_Speakers_Bureau.html
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Certified Basel iii Professional (CBiiiPro) Distance Learning and Online Certification Program
The all-inclusive cost is $297 What is included in this price:
A. The official presentations we use in our instructor-led classes (1426 slides)

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

Processing, printing and posting to your office or home. To become a Certified Basel iii Professional (CBiiiPro) you must follow the steps described at: www.basel-iii-association.com/Basel_III_Distance_Learning_Online_C ertification.html
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Presentations only (not the full program)

1. CBiiPro www.basel-ii-association.com/Distance_Learning_Online_Certification_CBiiPro_Pr esentations.htm 2. CP2E www.basel-ii-association.com/Distance_Learning_Online_Certification_CP2E_Pres entations.htm 3. CP3E www.basel-ii-association.com/Distance_Learning_Online_Certification_CP3E_Pres entations.htm 4. CSTE www.basel-ii-association.com/Distance_Learning_Online_Certification_CSTE_Pres entations.htm 5. CBiiiPro www.basel-ii-association.com/Distance_Learning_Online_Certification_CBiiiPro_P resentations.htm 6. All 4 Programs CBiiPro, CP2E, CP3E, CSTE Presentations (all 4 programs) www.basel-ii-association.com/Distance_Learning_Online_Certification_CBiiPro_C P2E_CP3E_CSTE_Presentations.htm 7. All 5 programs CBiiPro, CP2E, CP3E, CSTE, CBiiiPro Presentations (all 5 programs) www.basel-ii-association.com/Distance_Learning_Online_Certification_CBiiPro_C P2E_CP3E_CSTE_CBiiiPro_Presentations.htm

Basel 3 News February 2013

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Basel iii Compliance Professionals Association (BiiiCPA)

I look forward to meeting some of you.

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Basel III monitoring Questionnaire and instructions

Scope of the exercise

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Section 2. Reserve requirements prior to the Federal Reserve

Section 2.1 Introduction of reserve requirements

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Section 2.2 The purpose of the reserve

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Section 2.3 Enforcing the reserve requirement

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Section 2.3 Use of interbank deposits in the reserve

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Section 2.4 Some empirical observations on reserve holdings

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Section 3. Reserve requirements and liquidity during panics

Section 3.1 Usability of the reserve during a panic

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Section 3.2 Evidence on Use of the Reserve During a Panic

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Section 3.4 Discussion

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Section 4. The Panic of 1907

Section 4.1 Brief history of the Panic of 1907

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Section 5. Reserve requirements after the founding of the Federal Reserve

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Section 6. Lessons and concluding remarks

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Bank for International Settlements

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

2. Link between sovereigns and banks

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

3. International interbank lending

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

4. The role of US money market funds

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com