Basel iii Compliance Professionals Association (BiiiCPA)

Transcription

1 P a g e G Street NW Suite 800 Washington, DC USA Tel: Web: Dear Member, According to the supply and demand concept, in a competitive market, the price for a particular service will vary until it settles at a point where the quantity demanded will equal the quantity supplied, resulting in an economic equilibrium for price and quantity. Well, which is the economic equilibrium in Basel III jobs? You may look at the graphs: (

2 P a g e 2 In the City, things are even better:

3 P a g e 3 We see that the average salary for Basel iii jobs in UK was GBP 90,000 (we know many professionals and experts that made real money in the early implementation phase of Basel III). Now the average salary is GBP 77,500. Not too bad, as my friends from UK use to say. What about other compliance jobs? The average salary in quality assurance and compliance in UK is GBP 47,500. Interesting Job Descriptions, Location: Greater London Regulatory COREP Analyst (BASEL III) - 6 Month Contract My client, a market leading financial software organisation based in Central London, is currently recruiting for a test Preparation Consultant to join their highly successful and expanding team. My client is an extremely well reputed organisation with a strong customer base and track record and this is a fantastic opportunity to join the team at the early stages of an exciting software development project.

4 P a g e 4 Main responsibility: Identifying appropriate test scenarios and test data (ie given the information to be reported on a particular COREP template, identifying the set of financial products that will be relevant, and the various combinations of test data that will be required to ensure good test coverage) Selecting representative transactions from our existing test database (or defining new test transactions if necessary) Specifying suitable data values for the additional data attributes that the new/amended reporting requirements need (ie "enrich" the existing test transactions to ensure they contain all the data required to drive the functional testing of the new/amended COREP templates). The data model we maintain, which defines the data our clients are required to supply to drive our reporting product, has already been updated to include any new or changed data attributes that the new reporting requirements need - this step then is all about bringing our existing test data into line with the revised data model. Preparing expected results for the test transactions (ie which report cell or cells should a particular test transaction contribute to, and what value will we expect to see reported given the combination of data values in the test transaction) Essential Skills: In-depth knowledge of the Basel III/CRD4 reporting requirements, particularly in the area of credit risk - essential Familiarity with the latest COREP reporting templates - essential Previous experience in a testing role (specifically, test planning or test preparation) - desirable but not absolutely essential

5 P a g e 5 Dear member, Every time I read that banks must start ring-fencing their retail operations so that they will be able to fail without endangering depositors, I remember the cold war, especially the Berlin wall. Yes, I am an old man (born in 1959). Yes, I am feeling well. No, there is no doubt as to the person s state of mind (at the time of writing this newsletter). First, we read about the need for a fence in banking. The Independent Commission on Banking in UK has the opinion that: considering forms of retail ring-fencing under which retail banking operations would be carried out by a separate subsidiary within a wider group. The Berlin wall started with a fence too. Then, we read that this fence in banking must be electrified The Chairman of the UK Parliamentary Commission on Banking Standards, Andrew Tyrie MP, has said: The Government asked us to look at one of its main proposals for increasing financial stability ring-fencing as part of our work. The Commission welcomes the creation of a ring-fence. It can, in principle, contribute to the Government s objectives of making the banking system more secure. It is essential that banks are restructured in a way that allows them to fail, whether inside or outside the ring-fence. Ring-fencing can also help address the damage done to culture and standards in banking. But the proposals, as they stand, fall well short of what is required. Over time, the ring-fence will be tested and challenged by the banks.

6 P a g e 6 Politicians, too, could succumb to lobbying from banks and others, adding to pressure to put holes in the ring-fence. For the ring-fence to succeed, banks need to be discouraged from gaming the rules. All history tells us they will do this unless incentivised not to. That s why we recommend electrification. The legislation needs to set out a reserve power for separation; the regulator needs to know he can use it. They believed the same for the Berlin wall. A simple fence was not good enough. They also recommended electrification. What is next with the electrified ring fence in banking? If they find that the electrified ring fence falls well short of what is required what is next? We can learn from the Berlin wall. There was a constant process of expansion and reinforcement on the East Berlin side, to create what gradually became a multi-layered security system. 1 Concrete slab wall, with or without piping 2 Wire mesh fence 3 Control strip 4 Floodlights 5 Anti-vehicle trench 6 Outermost boundary of manned area 7 Border patrol road 8 Wire guiding dog patrols 9 Signal device 10 Observation tower 11 Electrified signal fence Self-firing devices and mines could also help. I fear that the banking consultants of the future must have some war experience in order to be hired. What about:

7 P a g e : Management Consultant : Soldier of Fortune At the peer review of the UK, we read: Ring-fencing: Ring-fencing will improve the resolvability of banks and create a more sustainable banking industry. It will insulate core banking services whose temporary disruption would have a significant direct impact on the domestic economy in particular the taking of deposits and the provision of overdraft facilities and payments services. Ring-fencing will also support continuity of provision of these vital core services, even where financial institutions are in trouble, reducing the perceived implicit guarantee that the Government will be compelled to step in to support failing banks that are perceived to be too big to fail. Electrification : The UK Government has agreed with the PCBS that a reserve power to require banks to divest certain operations may be a powerful additional tool to guarantee the independence of ring-fenced banks within their corporate group. This so-called electrification of the ring-fence will enable the regulator to split individual banks if this is necessary to achieve the purposes of ring-fencing. Regulators, be careful. Banks need more Common Equity Tier 1 capital. They need investors. Don t put an electrified ring fence between investors and banks.

8 P a g e 8 G20 Roadmap Towards Strengthened Oversight and Regulation of Shadow Banking

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10 P a g e 10 Basel Committee on Banking Supervision Report to G20 Leaders on monitoring implementation of Basel III regulatory reforms This is the fourth report from the Basel Committee on Banking Supervision to update G20 Leaders on progress in implementing the Basel III regulatory reforms. The last update was issued in April The report provides an overview of the Committee s Regulatory Consistency Assessment Programme (RCAP), which includes (i) Monitoring the progress of Basel Committee members in adopting the globally agreed Basel III standards; and (ii) Assessing the consistency of national or regional banking regulations with the global Basel III standards and analysing the outcomes that are produced by those regulations. The report also includes an overview of the progress made in finalising outstanding components of the Basel III regulatory reforms. Of the 27 jurisdictions that comprise the Basel Committee, 25 have now issued the final set of Basel III based capital regulations. Indonesia and Turkey have draft rules in place and efforts are under way to finalise them. Most recently, the European Union and the United States issued final regulations in June and July 2013, respectively. In addition, a number of members have begun to move towards introducing regulations for the liquidity and leverage ratios, as well as the requirements that apply to firms designated as global systemically important banks (G-SIBs) and domestic systemically important banks (D-SIBs).

11 P a g e 11 The Basel Committee s periodic monitoring of Basel III s quantitative impact indicates that internationally active banks continue to build capital, and appear well placed to meet the full set of fully phased-in minimum Basel III capital requirements ahead of the 2019 deadline. In the six months to December 2012, the average Common Equity Tier 1 (CET1) capital ratio of large internationally active banks rose from 8.5% to approximately 9% of risk-weighted assets. In addition, the aggregated capital shortfall of those banks that still have capital ratios below the fully phased-in 2019 CET1 requirements continues to decrease: the shortfall is now well below half the aggregate annual profits of the industry (which in 2012 totalled over 400 billion). Despite this progress and in the light of the current challenging global economic environment, banks and national authorities must remain particularly vigilant to actual and potential deterioration in banks asset quality in order to ensure further improvement in capital adequacy. Adjustments may also be required as the process of implementation of finalised capital regulations deepens further. The Committee s assessment programme of Basel III implementation remains on track. The Committee recently concluded an assessment of the consistency of Switzerland s capital regulations with the Basel III standards, and is currently assessing China, Brazil and Australia. It is encouraging to note that those jurisdictions that have undergone an assessment of their final rules have so far promptly rectified identified issues and are continuing with regulatory reforms. The RCAP process has thus far helped improve member jurisdictions consistency with the Basel III standards. As a result, regulations to adopt and implement Basel III standards are stronger than would otherwise have been the case absent the Committee s efforts at monitoring and assessing implementation.

12 P a g e 12 However, the Committee has also published studies of banks calculations of risk-weighted assets in both the banking and trading books. The results revealed material variations in the measurement of risk-weighted assets across banks, even for identical hypothetical test portfolios. The Committee is actively considering possible policy reforms to improve the comparability of outcomes. In doing so, it needs to ensure an optimal balance between the risk sensitivity of the framework and its complexity. The Committee, in accordance with agreed timelines, continues to work to finalise a few remaining policy-related elements of the Basel III framework. Timely adoption of Basel III standards, ensuring good quality implementation of national regulations that are consistent with the globally- agreed Basel III standards, and improving the reliability of risk-weighted asset calculations remain key priorities of the Committee over the medium term. Progress report on Basel III implementation Full, timely and consistent implementation of Basel III remains fundamental to building a resilient financial system, fostering public confidence in regulatory ratios and providing a level playing field for internationally active banks. To aid in the adoption of Basel III regulatory standards and their implementation, the Basel Committee has put in place the Regulatory Consistency Assessment Programme (RCAP) to monitor, review and report on Basel III implementation. The programme broadly consists of two parts: (i) Monitoring, which includes the monitoring of standards adoption by member jurisdictions and of banks progress in raising capital and liquidity buffers to meet the new minimum standards; and

13 P a g e 13 (ii) Assessments and review studies, which include the assessments of local regulations and their consistency with the Basel standards, and reviews of banks calculations of capital ratios, risk- weighted assets and other regulatory outcomes. This report provides an update on the work done by the Basel Committee since the previous update issued in April In particular, the report outlines the progress made on: (i) The adoption of rules by member and non-member jurisdictions; (ii) The assessments of regulatory consistency and outcomes; and (iii) The policy reform of outstanding elements of the Basel framework. (i) Adoption of Basel III standards Member jurisdictions have made considerable progress since the last report was published in April More details regarding the implementation status of each member jurisdiction can be found in the tables in Annex 1, which includes summary information about the next steps and the implementation plans being considered. A four-scale classification is used for the status of adoption of Basel regulatory rules: (1) Draft regulation not published: no draft law, regulation or other official document has been made public to detail the planned content of the domestic regulatory rules. This status includes cases where a jurisdiction has communicated high-level information about its implementation plans but not detailed rules;

14 P a g e 14 (2) Draft regulation published: a draft law, regulation or other official document is already publicly available, for example for public consultation or legislative deliberations. The content of the document has to be specific enough to be implemented when adopted. (3) Final rule published: the domestic legal or regulatory framework has been finalised and approved but is still not applicable to banks; and (4) Final rule in force: the domestic legal and regulatory framework is already applied to banks. Capital Basel II Of the 27 Basel Committee member jurisdictions, 24 have implemented Basel II fully. The United States, which is one of the three jurisdictions yet to fully implement Basel II, has issued final regulations on Basel II; however, its largest banks are still on parallel run for implementing the advanced approaches. The remaining two jurisdictions (Argentina and Russia) have also initiated the process to complete the implementation of Basel II. Basel 2.5 The number of member jurisdictions who have fully implemented Basel 2.5 is 22. Of the other five members, the United States has issued the remaining part of the rules, which will come into force in Argentina, Indonesia, Mexico and Russia have either partially adopted Basel 2.5 or have initiated steps to do so.

15 P a g e 15 Basel III Of the 27 member jurisdictions, 11 have now issued final Basel III capital rules that are legally in force. The number of members that have issued final rules but not yet brought them into force has increased to 14 (this includes Argentina, Brazil, Korea, Russia, the United States and the nine EU member states that are members of the Basel Committee). The two remaining member jurisdictions (Indonesia and Turkey) have issued draft rules. Leverage The Basel Committee is currently in the process of finalising the details of the Basel III leverage ratio standard. The agreed start date for banks to begin disclosing their leverage ratios is 1 January 2015 (see also Section (iii) below). Some member jurisdictions have already initiated steps in preparation for the introduction of this new requirement. This should assist in prompt implementation once a final international standard is agreed. Liquidity Regarding the adoption of regulations relating to the Liquidity Coverage Ratio, 11 member jurisdictions have issued final rules (South Africa, Switzerland and EU member states), while four member jurisdictions have started the implementation process by issuing draft rules (Australia, Hong Kong SAR, India and Turkey). The agreed start date for the phase-in of liquidity requirements is 1 January 2015.

16 P a g e 16 Systemically important banks With regard to the global systemically important banks (G-SIBs) and domestic systemically important banks (D-SIBs) requirements, only two member jurisdictions (Switzerland and Canada) have so far issued final regulatory rules and begun to enforce them. Ten member jurisdictions have issued the final set of regulations, which are not yet in force (South Africa and EU member states). The remaining member jurisdictions have not yet issued draft rules. The agreed start date to phase in the requirements is 1 January However, to enable timely implementation of the requirements, the Committee has agreed that national jurisdictions will adopt official regulations/legislation consistent with the Basel III standards that establish the reporting and disclosure requirements by 1 January Non-Basel Committee/non-EU jurisdictions Several non-basel Committee member jurisdictions are reporting the adoption and implementation of Basel II, 2.5 and III standards. In July 2013, the Financial Stability Institute (FSI) issued its annual progress report on Basel adoption in jurisdictions that are neither members of the Basel Committee nor members of the EU. The report updates the FSI s previous progress report and provides results as of end-may The FSI survey questionnaire was sent to over 100 non-basel Committee/non-EU jurisdictions, and 74 jurisdictions responded. Compared to 2012, there has been significant progress in the efforts to adopt Basel capital standards (see Annex 2 for detailed information). Among the surveyed jurisdictions, 54 have either implemented Basel II or are in the process of implementation, 16 have implemented Basel

17 P a g e or are in the process of implementation, and 26 have implemented Basel III or are in the process of implementation. (ii) Assessing consistency and outcomes As part of the RCAP, the Committee has started to assess in detail the consistency of local regulations implementing the Basel III risk-based capital standards. The assessments cover the substance of the local regulations, but also their form, ie whether the rules are laid down in regulatory instruments that are binding from a regulatory and supervisory perspective. In 2012, the Basel Committee assessed the final capital regulations in Japan, and the draft capital regulations in the European Union and the United States.

18 P a g e 18 The Committee continued with assessments of Singapore and Switzerland, published in March and June 2013, respectively. The Committee is currently in the process of assessing China, Brazil and Australia. New assessments of the European Union, United States and Canada will commence in the second half of 2013, and be published in The Basel Committee urges jurisdictions to address material inconsistencies between domestic regulations and the globally agreed Basel standards identified by the final assessments under the RCAP. The Committee will monitor implementation progress in future assessments as well as analyse prudential outcomes. The assessments are demonstrably contributing to greater consistency in the national adoption of Basel III standards. For example, in the case of Japan, Singapore and Switzerland, the regulatory authorities promptly resolved a number of initial assessment findings by amending the domestic regulations that implement Basel III capital standards (see table below). These amendments have contributed to a more consistent domestic implementation of the Basel framework, and thus set a positive precedent for future RCAP assessments and for the implementation process as a whole.

19 P a g e 19 Studies on regulatory outcomes As part of RCAP, the Basel Committee has initiated studies to examine the consistency of risk-weighted assets (RWAs) measurement by banks that use internal model approaches. Following its first report on the measurement of market risk RWAs, issued in January 2013, the Committee published a second report in July 2013 on the regulatory consistency of RWAs for credit risk in the banking book. The banking book study draws on supervisory data from more than 100 major banks, as well as additional data on sovereign, bank and corporate exposures collected from 32 major international banks as part of a portfolio benchmarking exercise. The banking book study reveals that there is considerable variation across banks in average RWAs for credit risk across banks. While most of the variation can be explained by broad differences in the composition of banks' assets, reflecting differences in business models and risk preferences, there is also material variation driven by diversity in bank and supervisory practices with regard to measuring credit risk. Through a portfolio benchmarking exercise, the study found a high degree of consistency in banks' assessment of the relative riskiness of obligors. That is, there is a high correlation in how banks rank a portfolio of individual borrowers. Differences exist, however, in the levels of estimated risk that banks assign, as expressed in probability of default (PD) and loss-given-default (LGD). These differences drive the variation in risk weights attributable to individual bank practices, and could result in the reported capital ratios for some outlier banks varying by as much as 2 percentage points from a 10% risk-based capital ratio benchmark (or 20% in relative terms) in either

20 P a g e 20 direction, although the capital ratios for most banks are likely to fall within a narrower range. Notable outliers are evident in each asset class, with the corporate asset class showing the tightest clustering of banks, and the sovereign asset class showing the greatest variation. The low- default nature of the benchmark portfolios and the consequent challenges in obtaining appropriate data for risk estimation may be one factor contributing to differences across banks, especially for banks' estimates of LGDs in the sovereign and bank asset classes. In addition to the Committee s investigation of variability in RWA calculations, the Committee published a discussion paper in July to initiate discussion on the balance between risk sensitivity, simplicity and comparability within the Basel capital standards. In pursuing the potential policy options below, the Committee will seek to ensure that any changes in the framework strike an appropriate balance between the complementary goals of risk sensitivity, simplicity and comparability, as set out in the Committee s discussion paper. Possible policy options While some amount of variation is expected in any regime based on internal models, where it is considered excessive, the studies suggest a potential direction for future policy work that can narrow down variations. Possible short-term policy options include (i) improvement of public disclosure and regulatory data collection to aid in the understanding of risk-weighted assets; (ii) additional guidance and clarifications of the Basel framework; and (iii) further harmonisation of supervisory practices with regard to model approvals. Over the medium term, the Committee will examine the potential to further harmonise national implementation requirements and to place constraints on model parameter estimates.

21 P a g e 21 In addition, the ongoing policy work would benefit from additional analyses based on improved data, and it may be valuable to examine how cross-bank differences in RWAs vary over time as banks transition from Basel I to Basel II and then to Basel III. The Committee is therefore considering how best to periodically monitor and examine RWA dispersion across banks, and narrowing of inconsistent risk weighting. The overall aim is to reduce undesirable practice-based variations in RWAs, and improve the comparability of regulatory capital calculations by banks which is central to the implementation of the Basel III framework. (i) Enhanced disclosures by banks Enhanced Pillar 3 disclosures by banks could foster greater market discipline and prevent misperceptions as to the level and causes of RWA variations. Important areas of enhanced disclosure include: more granular information on asset class mix, internal risk grade distribution and associated risk parameter estimates, the share of defaulted exposures, information about the major sources of changes in RWAs over reporting periods, information about choices of credit risk approaches, capital floor adjustments, and other aspects of regulatory capital calculations that might vary across banks.

22 P a g e 22 In addition, use of standardised definitions and templates could support greater consistency and comparability of disclosures. The proposals parallel certain recommendations of the Financial Stability Board s Enhanced Disclosure Task Force, which are set out in its 2012 report. (ii) Additional guidance on aspects of the Basel framework Some drivers of RWA variation result from differences in interpretation and/or practices within areas that are left unspecified or less than fully specified within the capital framework. Examples include adjustment of risk parameters for conservatism or cyclical effects, and use of external data, particularly for low- default portfolios. In some areas, it may be appropriate for the Committee to provide additional guidance to reduce or eliminate undesirable variation attributable to such differences. (iii) Harmonisation of national implementation requirements Some of the drivers of variation in RWAs stem from aspects of the Basel framework itself, or from differences in its implementation in various jurisdictions. Examples where additional clarity could be provided and contribute substantially to reducing undesirable variation in RWAs include: capital floor adjustments, partial use of the standardised approach, definition of default, treatment of defaulted exposures, exemptions from the one-year maturity floor, and

23 P a g e 23 requirements related to estimation of IRB parameters. Many of these drivers could be addressed through clarification of the framework, through efforts to harmonise national implementation requirements, or through review of the continued relevance of various aspects of national discretion. In this context, the RCAP country assessments consider country-specific consistency vis-à-vis the Basel framework, and help identify potential areas of different interpretation that need clarification or refinement in the regulatory framework. In addition, national supervisors will undertake supervisory follow-up with specific banks. (iv) Constraints on model parameter estimates A final option could be to limit the flexibility of the advanced approaches. For example, supervisory benchmarks for risk parameters could be created from the data collected through the Committee s assessment and similar future work. Creation of such benchmarks could fill a valuable niche, for example, for low-default IRB portfolios, creating reference points for supervisors and banks. Benchmarks might include representative PD estimates for particular rating grades or for other indicators of credit quality, representative LGD estimates for various types of exposures or representative credit conversion factor estimates based on observed bank practices. Any benchmarks created would need to be communicated with care to avoid making them appear to be either regulatory requirements or safe harbour estimates, and to ensure that any potential reduction of variation does not come at the expense of a general decline in the level of RWAs.

24 P a g e 24 Other alternatives could include more explicit constraints, such as the creation of floors for certain parameters (such as LGD), or even fixed values of such parameters. (iii) Policy reform under way The core elements of the Basel III capital framework were finalised in Since then, the Basel Committee has largely completed the remaining components, including the capital frameworks for G- SIBs and D-SIBs and the final standard for the LCR. In June and July 2013, the Committee published a series of documents, including an updated assessment methodology and higher loss absorbency requirement for G-SIBs. It also made substantial progress in a range of areas of the Basel framework. Specifically, the Committee issued the following consultative documents: Revised Basel III leverage ratio framework and disclosure requirements Capital treatment of bank exposures to central counterparties The non-internal model method for capitalising counterparty credit risk exposures Capital requirements for banks' equity investments in funds Liquidity Coverage Ratio disclosure standards. The Committee will finalise these documents after considering comments from stakeholders and interested parties. Further work is also under way in relation to trading book capital requirements, securitisation and the Net Stable Funding Ratio.

25 P a g e 25 It is intended that these policy reforms will be largely completed during the course of Annex 1: Monitoring adoption status of Basel III The Basel III framework builds upon and enhances the regulatory framework set out under Basel II and Basel 2.5. The tables herein therefore review members regulatory adoption of Basel II, Basel 2.5 and Basel III. Basel II, which improved the measurement of credit risk and included capture of operational risk, was released in 2004 and was due to be implemented from year-end The Framework consists of three pillars: Pillar 1 contains the minimum capital requirements; Pillar 2 sets out the supervisory review process; and Pillar 3 corresponds to market discipline. Basel 2.5, agreed in July 2009, enhanced the measurements of risks related to securitisation and trading book exposures. Basel 2.5 was due to be implemented no later than 31 December In December 2010, the Committee released Basel III, which set higher levels for capital requirements and introduced a new global liquidity framework. Committee members agreed to implement Basel III from 1 January 2013, subject to transitional and phase-in arrangements. In November 2011, G20 Leaders at the Cannes Summit called on jurisdictions to meet their commitment to implement fully and consistently Basel II and Basel 2.5 by end-2011, and Basel III starting in 2013 and completing by 1 January In June 2012, G20 Leaders at the Los Cabos Summit reaffirmed their call for jurisdictions to meet their commitments.

26 P a g e 26 This message was reiterated in Moscow in February 2013 by the G20 Finance Ministers and Central Bank Governors. Methodology The data contained in this annex are based on responses from Basel Committee member jurisdictions. The following classification is used for the status of adoption of Basel regulatory rules: 1. Draft regulation not published: no draft law, regulation or other official document has been made public to detail the planned content of the domestic regulatory rules. This status includes cases where a jurisdiction has communicated high-level information about its implementation plans but not detailed rules. 2. Draft regulation published: a draft law, regulation or other official document is already publicly available, for example for public consultation or legislative deliberations. The content of the document has to be specific enough to be implemented when adopted. 3. Final rule published: the domestic legal or regulatory framework has been finalised and approved but is still not applicable to banks. 4. Final rule in force: the domestic legal and regulatory framework is already applied to banks. In order to support and supplement the status reported, summary information about the next steps and the implementation plans being considered by members are also provided for each jurisdiction. In addition to the status classification, a colour code is used to indicate the implementation status of each jurisdiction.

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32 P a g e 32 Annex 2: Adoption of Basel standards by non-basel Committee/non-EU jurisdictions: 2013 FSI survey The FSI survey covers the same scope as the BCBS survey jurisdictions regulatory adoption of Basel II, Basel 2.5 and Basel III. Methodology For the status of adoption of Basel regulatory rules, the FSI uses the same classification adopted by the Basel Committee: (1) Draft regulation not published; (2) Draft regulation published; (3) Final rule published; (4) Final rule in force. If a jurisdiction gets classification of 2, 3 or 4 for at least one subsection of Basel II, Basel 2.5 or Basel III, the jurisdiction will be deemed to be in the process of implementing the rules. Tables Basel II: Implemented / in the process of implementation (54 as of end-may 2013)

33 P a g e 33 Basel 2.5: Implemented / in the process of implementation (16 as of end-may 2013) Basel III: Implemented / in the process of implementation (26 as of end-may 2013)

34 P a g e 34 Annex 3: Assessment of regulatory consistency of capital regulations in Switzerland In June 2013, the Basel Committee issued the report on compliance of Switzerland's domestic capital rules vis-à-vis international Basel capital standards through its Regulatory Consistency Assessment Programme (RCAP). It is the fifth assessment report following earlier reports on the European Union, Japan, Singapore and the United States. The Assessment Team held technical discussions with senior officials and staff of the Swiss Financial Market Supervisory Authority (FINMA), and met with senior representatives from banks and regulatory audit firms based in Switzerland. Switzerland has implemented its Basel capital framework with the intention that it conform closely to the Basel standard. The assessment found the implementation of the International Approach closely aligned with Basel III standards and therefore assessed it as "compliant". In total, out of 14 assessed components were found to be "compliant", while three of the components were graded "largely compliant" (definition of capital, credit risk-irb and Pillar 3). Although some differences with the Basel framework were found in these three areas, none of the findings were evaluated to be material at this point. An alternative capital adequacy regime in Switzerland, the "Swiss Standardised Approach", which has its origins prior to Basel I, is used primarily by smaller Swiss banks and is being phased out by end This approach was not assessed as compliant, but given it is not the approach used by most internationally active banks and is being discontinued, the assessment team judged that it should not impact on the overall rating for Switzerland.

35 P a g e 35 In response to the assessment, FINMA initiated the rectification of the most important identified deviations from the Basel framework, without which the assessment would have been less favourable. This constitutes a strong commitment on the part of Switzerland to the global regulatory reforms, and is reflected in FINMA's response to the report.

36 P a g e 36 Communication on shadow banking: frequently asked questions 1. What is shadow banking? Shadow banking can be defined as a system of credit intermediation that involves entities and activities outside the regular banking system. Shadow banks are not regulated like banks, though their operations are like those of banks, as they: Take in funds similar to deposits Lend over long periods and take in deposits that are available immediately (known as maturity and/or liquidity transformation) Take on the risk of the borrower not being able to repay Use borrowed money, directly or indirectly, to buy other assets. They may include ad hoc entities such as securitisation vehicles or conduits, money market funds, investment funds that provide credit or are leveraged, such as certain hedge funds or private equity funds and financial entities that provide credit or credit guarantees, which are not regulated like banks or certain insurance or reinsurance undertakings that issue or guarantee credit products. Shadow banking also includes activities, in particular securitisation, securities lending and repurchase transactions, which constitute an important source of finance for financial entities. 2. Why is there a need to address shadow banking? The shadow banking sector needs to be better monitored because of its size, its close links to the regulated financial sector and the systemic risks that it may pose. There is also a particular need to prevent the shadow banking system being used for regulatory arbitrage.

37 P a g e 37 In addition to the risks associated with circumventing the rules and the fact that these shadow banking entities/activities can lead to high levels of debt being built up in the financial sector, authorities should monitor this sector for two main reasons: 1. The first factor is size. Even if not entirely accurate, the estimates of the size of the shadow banking system, both in absolute terms and as a share of the global financial sector, show that some of its components could be systemically significant. The latest studies by the FSB indicate that the aggregate shadow banking assets, reflected in the statistical category other financial intermediaries, are about half the size of the regulated banking system. Despite the fact that shadow banking assets have decreased slightly since 2008, the global figure in 2011 was 51 trillion. In terms of geographical distribution, the biggest share is concentrated in the United States (around 17.5 trillion) and in Europe (Eurozone with 16.8 trillion and the United Kingdom with around 6.8 trillion) 2. The second factor which increases risk is the high level of interconnectedness between the shadow banking system and the regulated sector, particularly the banking system. Any weakness that is mismanaged or the destabilisation of an important entity in the shadow banking system could trigger a wave of contagion that would affect the sectors subject to the highest prudential standards. 3. How does the Commission address risks inherent to shadow banking? While the notion of shadow banking has only recently been formally defined in the G20 discussions, the risks related to it are not new. The Commission has already implemented, or is in the process of implementing, a number of measures to provide a better framework for these risks, such as harmonised rules applying to hedge fund activity and reinforcing the relationship between banks and unregulated actors.

38 P a g e Who will benefit from the measures outlined in the communication? The main beneficiary of improved regulation is society as a whole. Ultimately, preventing systemic risk being created by the financial sector will increase stability and avoid situations where states, governments and citizens are responsible for repairing damage to the financial system. 5. What is the timeframe for the measures indicated in the communication? The first measure to be taken is the proposal for a regulation on money market funds presented today along with this communication (see MEMO/13/764). Other measures will follow as soon as possible. All dates mentioned in the text of the communication are indicative. 6. Why now? Should the Commission not wait until the reform of the regulated financial sector is fully implemented? The financial crisis, especially in 2007 and 2008, highlighted the need to improve regulation and monitoring outside the regulated banking sector, because the volume of transactions carried out outside the core banking sector had increased tremendously and risks created could be systemic. The Commission has been working on measures in this field since 2010 and it is important to act now. The measures that will be put in place respond to the risks identified in the past, but are also pro-active in order to make sure that new activities or techniques do not create systemic risk. The measures announced are also fully compatible with other measures taken.

39 P a g e 39 The European Parliament also adopted an own initiative report on shadow banking in November Why is additional regulation necessary in view of the ongoing extensive reform of the financial sector? The Commission has undertaken the biggest ever reform of financial services regulation with the aim of restoring sustainable health and stability to the sector. The approach consists of tackling all financial risks and ensuring that the benefits achieved by strengthening certain actors and markets are not diminished by financial risks migrating to less regulated sectors. Room for regulatory arbitrage should be avoided in all cases. Therefore, it is necessary to strengthen regulation, also outside the regulated banking sector. 8. How does the communication fit in with work at international level? Financial markets are global, hence systemic risks created by shadow banking entities and activities need to be tackled in an internationally coordinated manner. The Commission is therefore following very closely the work of the Financial Stability Board (FSB), which is in charge of identifying risks and coming forward with recommendations addressing those risks. All major jurisdictions are members of the FSB and are working with the FSB on putting a harmonised international framework in place. Since 2011, the Commission has been an active participant in the FSB s work focusing on shadow banking. The Commission proposals are fully in line with the recommendations issued so far at international level.

40 P a g e 40 Final FSB policy recommendations are to be endorsed by the G20 leaders in Saint Petersburg on 5-6 September What are the main elements of today s communication? This communication provides a comprehensive overview of the Commission s measures addressing existing and potential systemic risk in the area of shadow banking. It explains in detail the measures already undertaken that address some elements of those risks, such as measures aimed at financial entities and measures undertaken to strengthen market integrity. While they do not deal with all the risks, the reforms implemented through the revised requirements on banks in Europe make it possible to lay down clearer rules for shadow banking (indirect regulation). These measures relate to the regulatory requirements imposed on transactions concluded between banks and their financial counterparties and the rules on the consolidation of risk. Other measures already underway include additional regulatory requirements for insurance companies, a harmonised framework for alternative investment fund managers (AIFMD), a framework for risk transfer instruments (known as EMIR European Market Infrastructure Regulation), strengthened securitisation arrangements and an enhanced framework for credit rating agencies (CRAs). Furthermore, the communication provides an overview of additional measures providing a framework for the risks associated with shadow banking. These include increasing the transparency of the shadow banking sector, improving the framework for certain investment funds, reducing the risks associated with securities financing transactions, strengthening the prudential banking framework in order to limit contagion and arbitrage risks and supervising the shadow banking sector more effectively. In order to increase transparency the communication suggests:

41 P a g e 41 supplementing initiatives regarding the collection and exchange of data; developing central repositories for derivatives within the framework of EMIR and the revision of the Markets in Financial Instruments Directive (MiFID) (see IP/11/1219); implementing the Legal Entity Identifier (LEI), an initiative established by the FSB; increasing the transparency of securities financing transactions. In addition to the proposal on money market funds, the communication indicates that an enhanced framework for certain investment funds could be implemented by strengthening the UCITS framework. Other elements of the communication include the reduction of risks associated with securities financing transactions, a project the Commission has already been working on for some time. A proposal will follow in the coming months. The communication suggests completing the prudential rules applied to banks in their operations with unregulated financial entities in order to reduce contagion risks and potentially extending the scope of application of prudential rules in order to reduce arbitrage risks. Finally, improved supervision at national and European level should help to monitor this dynamic and diverse sector and help prevent the accumulation of (systemic) risks. 10. What preparatory work has been done before coming up with this communication? This communication was preceded by extensive consultation with the relevant industry players and stakeholders back in A special working group was set up under the auspices of the Financial Services Committee.

42 P a g e 42 A Green Paper was published in 2012, which launched a public consultation. The Commission organised a public conference in Brussels on 27 April The Commission published a summary of the submissions received in the context of the public consultation in December 2012.

43 P a g e 43 Progress and Next Steps Towards Ending Too-Big-To-Fail (TBTF) Report of the Financial Stability Board to the G-20 Summary and Key Recommendations At the Pittsburgh Summit in 2009, G-20 Leaders called on the FSB to propose measures to address the systemic and moral hazard risks associated with systemically important financial institutions (SIFIs). SIFIs are institutions of such size, market importance and interconnectedness that their distress or failure would cause significant dislocation in the financial system and adverse economic consequences. The too-big-to-fail (TBTF) problem arises when the threatened failure of a SIFI leaves public authorities with no option but to bail it out using public funds to avoid financial instability and economic damage. The knowledge that this can happen encourages SIFIs to take excessive risks and represents a large implicit public subsidy of private enterprise. 1. What has been done At the Seoul Summit in 2010 the G-20 leaders endorsed the FSB framework for Reducing the moral hazard posed by SIFIs (SIFI Framework). This framework addresses the TBTF issue by reducing the probability and impact of SIFIs failing. It comprises requirements for assessing the systemic importance of institutions, for additional loss absorbency, for increased supervisory intensity, for more effective resolution mechanisms, and for stronger financial market infrastructure. Substantial progress has been made in implementing this framework.

44 P a g e 44 Assessment and designation: Methodologies for assessing the global systemic importance of banks (G-SIBs) and insurers (G-SIIs) have been issued and 28 G-SIBs and nine G-SIIs have been designated. Higher loss-absorption capacity, more intensive supervision and resolution planning requirements will apply to all these institutions. Additional loss absorbency: A new strengthened capital regime requiring additional going-concern loss absorption capacity for the G-SIBs has been finalised and in many cases the G-SIBs are building the extra capital ahead of schedule. Since the end of 2009, the G-SIBs have increased their common equity capital by about US$ 500 bn, amounting to close to 3 per cent of their risk weighted assets. Supervisory intensity: Recommendations for enhanced supervision and heightened supervisory expectations for risk management, risk aggregation and risk reporting have been developed and are now being implemented. Effective resolution: In 2011 the G-20 endorsed the Key Attributes of Effective Resolution Regimes for Financial Institutions ( Key Attributes ) as a new international standard. Since then, guidance has been issued on resolution strategies for G-SIBs. The approaches to deal with the resolution of financial market infrastructure (FMI) and insurers, as well as the protection of client assets in resolution, will be finalised by the end of this year. Strengthened core infrastructure: Good progress has also been made in strengthening core financial market infrastructure, such as central counterparties (CCPs), to address risks of contagion through the financial system. There are signs that firms and markets are beginning to adjust to authorities determination to end TBTF.

45 P a g e 45 Where effective resolution regimes are now in place, rating agencies give less credit for taxpayer support and there are signs of financial markets revising down their assessment of the implicit TBTF subsidy. Market prices of credit default swaps for banks have become more highly correlated with equity prices, suggesting a greater expectation amongst participants that holders of debt will, if necessary, bear losses. However, the job is not finished. If we are to resolve the issues related to SIFIs and in particular the problem of TBTF, further action is required from G-20 countries, the FSB and other international bodies. 2. What G-20 Authorities still need to do We urge G-20 Leaders to renew their commitment to address TBTF, in particular by further progress in the following six areas. 1. Commit to legislative reforms. G-20 Leaders are requested to make a renewed commitment to the legislative reforms that are necessary to implement the Key Attributes by 2015 for all parts of the financial sector that could cause systemic problems. Recent reforms in several jurisdictions, including Australia, Germany, France, Japan, Netherlands, Spain, Switzerland, the United Kingdom and the United States demonstrate that substantive progress is being made in the implementation of the Key Attributes across FSB jurisdictions. In the EU, the Bank Recovery and Resolution Directive is expected to be adopted later this year. Its implementation within a year of adoption will be an important step towards implementation of the Key Attributes in EU Member countries. However, many FSB jurisdictions need to take further legislative measures to implement the Key Attributes fully, in substance and scope.

46 P a g e 46 Important areas where jurisdictions need to act relate to the adoption of bail-in powers and other resolution tools, powers for cross-border cooperation and the recognition of foreign resolution actions. Implementation of the Key Attributes in the non-bank financial sectors has lagged behind the progress made in relation to banks. In light of the move towards mandatory central clearing of OTC derivatives, all jurisdictions with systemically important CCPs must have in place powers to resolve them. FSB jurisdictions are expected to adopt by end-2015 resolution regimes for systemically important financial market infrastructure, including CCPs, consistent with the FSB Guidance on FMI Resolution set out in an Annex to the Key Attributes that will be finalised by end Remove obstacles to cross-border resolution. For globally operating firms, we will adopt meaningful cross-border co-operation agreements for supervisors and resolution authorities. G-20 Leaders should empower their domestic authorities to cooperate fully and commit to legislative action as necessary to: Make resolution effective in a cross-border context. Resolution strategies for global systemically important financial institutions (G-SIFIs) are coalescing around single-point-of-entry resolution for globally integrated firms and multiple-point-of-entry resolution for firms with multiple national or regional subsidiaries. In order to make these strategies operational, jurisdictions need to put in place the powers and arrangements for cross-border cooperation and for the recognition of foreign resolution measures. Remove obstacles to the sharing of information for resolution purposes. Authorities with responsibility for resolution must be able to share firm-specific information, both within jurisdictions and cross-border.

47 P a g e 47 Given the confidentiality of much supervisory and resolution-related information, this may require legislation. The FSB will finalise an Annex on information sharing for resolution purposes by end FSB Members should use this Annex to assess and set out the necessary legislative or regulatory changes by end Improve the resolvability of firms structures and operations. Impediments to resolvability also arise from complexities in firms legal, financial and operational structures. Home authorities should enter into a dialogue with firms about changes needed to their structures and operations to ensure that their preferred (single- or multiple-point- of-entry) resolution strategy is a realistic strategy for the firm. The resolvability of each G-SIFI will be assessed at the level of senior policy makers within the Resolvability Assessment Process that the FSB will launch in early Consider domestic structural measures that are complementary to an effective SIFI Framework. As the SIFI Framework recognised, structural measures could reduce the risks or externalities that a G-SIFI poses. Structural reform measures, including the separation of activities, intra-group exposure limits, local capital and liquidity requirements, seek to put restraints on excessive risk-taking by SIFIs and thus help promote financial stability. They can also contribute to improving the resolvability of SIFIs at a jurisdictional level, thus reducing the moral hazard of TBTF. There is, however, a risk that diverging structural measures imposed by different jurisdictions may have an impact on integration across national or regional markets.

48 P a g e 48 FSB members should therefore monitor and discuss the potential cross-border spill-over effects that may result from different approaches. They should also take account of progress on cross-border cooperation, and seek to avoid unnecessary constraints on the integration of the global financial system or the creation of incentives for regulatory arbitrage. The G-20 Finance Ministers and Central Bank Governors have requested that the FSB, in collaboration with the IMF and OECD, assess the cross-border consistency and global financial stability implications of these measures, taking into account country-specific circumstances. The FSB will do this by end Implement policy measures for domestic systemically important banks (D-SIBs). The TBTF problem exists not only for global firms. The SIFI framework therefore also extends to domestic SIFIs. The framework for D-SIBs developed by the BCBS allows for appropriate discretion at jurisdictional level to accommodate structural characteristics of domestic financial systems. Implementation in each jurisdiction should be subject to an international peer review program to ensure appropriate adherence to the principles of the framework. The BCBS is therefore developing a programme for such a peer review, which will start no later than mid Remove obstacles to supervisory effectiveness. A G-SIFI can have close to 8,000 people in risk management, compliance and internal audit. Supervisory teams, on the other hand could be anywhere from people for a specific G-SIFI.

49 P a g e 49 While they are not there to replicate this coverage, supervisors must be equipped with clear mandates, robust resources (in regard to skills and experience) and independence to act. G-20 governments should reaffirm their November 2010 commitment to ensure supervisors have the capacity to resource themselves and the independence to effectively meet their mandate. 3. What the FSB and others still need to do with the support of the G-20 countries The FSB and other international bodies also need to take further actions to ensure the TBTF problem is addressed. G-20 countries can support these actions in five areas. 1. The FSB will design information sharing mechanisms in coordination with relevant standard-setting bodies. G-20 authorities should ensure the implementation of effective information systems by G-SIFIs. Effective resolution planning requires firms to be able to produce accurate information quickly. It also requires efficient processes for sharing that information, both within crisis management groups (CMGs) and with authorities in host jurisdictions not represented on CMGs where the local operations of a G-SIFI are systemic. Furthermore, co-ordinated risk assessment requires supervisory authorities to share more information on the key risks facing G-SIFIs. By the end of 2014, the FSB will develop recommendations for consistent and comparable firm-specific information for resolution planning purposes. By the end of 2014, the FSB will develop proposals on how to strengthen information sharing within CMGs and, in consultation with standard-setting bodies, within core supervisory colleges.

50 P a g e 50 In 2014, the FSB will develop recommendations for cooperation and sharing information with authorities in G-SIFI host jurisdictions that are not represented on the CMG, but where a G-SIFI s local operations are systemic. 2. The FSB, in consultation with standard-setting bodies, will prepare proposals on the adequacy of G-SIFI loss absorbing capacity in resolution. To avoid the need for a bail- out with public funds a SIFI needs to have sufficient resources to absorb losses in resolution ( gone concern loss absorbing capacity GLAC). An adequate amount of GLAC should facilitate the implementation of a resolution strategy with a recapitalisation at a level that promotes market confidence and, at a minimum, meets going-concern regulatory capital requirements. The FSB will prepare proposals for consideration by end on the nature, amount, location within the group structure, and possible disclosure of GLAC. 3. The IAIS will finalise proposals for the regulation of global systemically important insurers (G-SIIs). G-20 authorities can ensure implementation of these requirements. G-SIIs will be subject to a set of policy measures comprising effective resolution planning, enhanced group-wide supervision and higher loss absorbency (HLA), consistent with the requirements of the SIFI Framework. The IAIS will develop by end-2015 implementation details for higher loss absorbency requirements, which will build on straightforward, backstop capital requirements to apply to all group activities, including non-insurance subsidiaries, to be finalised by the time of the G20 Summit in 2014.

51 P a g e 51 The FSB will report on the status of resolution planning for all G-SIIs identified in July 2013 by mid G-SII home authorities will be asked to provide an interim report on the establishment of CMGs and status of their resolution planning by mid By end 2014, the FSB will develop proposals for contractual or statutory approaches to prevent large-scale early termination of financial contracts in resolution. Large- scale close-out of financial contracts based on early termination and cross-default rights when firms enter resolution can hinder the effective implementation of resolution strategies. G-20 authorities can encourage ISDA and other industry bodies to review contract provisions to prevent large-scale early termination of financial contracts. 5. Finally, the FSB will monitor to ensure that greater regulation does not lead to a shift of activities outside the regulatory perimeter. G-20 authorities can empower and encourage their regulators to expand their monitoring beyond the current perimeter of regulation. Conclusion The policy initiative to end TBTF is ambitious, but necessary. We have made good progress to date in putting the overall international policy framework in place. Detailed technical work now needs to give real teeth to the application of policies to individual SIFIs, and financial institutions themselves must undertake any restructuring necessary to make themselves resolvable. While much has been accomplished, more needs to be done in particular putting in place the internationally agreed policies at the jurisdictional level through legislation and regulation, where necessary, and through practical application to individual institutions.

52 P a g e 52 The renewed support of the G-20 will be vital to achieving these imperatives in order to address fully one of the most important elements of the global reform agenda. Overview At the Pittsburgh Summit in 2009, G-20 Leaders called on the FSB to propose possible measures to address TBTF problems associated with systemically important financial institutions (SIFIs). The following year at the Seoul Summit the G-20 Leaders endorsed the FSB framework for Reducing the moral hazard of systemically important financial institutions (SIFIs) (SIFI Framework). The SIFI Framework sets out recommendations for improving the authorities ability to resolve such institutions in an orderly manner, without exposing tax-payers to loss, while maintaining continuity of their vital economic functions. This may require changes to resolution regimes and tools at national levels, and legislative changes to enable resolution authorities to co-ordinate in cross-border resolutions. It recommends that SIFIs and initially in particular financial institutions that are clearly systemic in a global context (global systemically important financial institutions - G-SIFIs) have higher loss absorbency capacity and that these institutions be subject to more intensive co-ordinated supervision and resolution planning to reduce the probability and impact of their failure. In November 2011, the FSB further specified the details of the policy framework. The G-20 asked the FSB to report on progress made toward ending TBTF at the 2013 St. Petersburg Summit. This report briefly describes the SIFI Framework, and, for each of its main elements, presents a summary of progress to date and what remains

53 P a g e 53 to be done, by both G-20 authorities and international bodies, to fully and effectively implement the SIFI Framework. G-20 Leaders are urged to renew their commitment to addressing TBTF, and the FSB and other international bodies also need to take further action, with the support of G-20 countries, to end the TBTF problem. 1. The FSB SIFI Framework The objective of the SIFI Framework is to address the systemic risks and the associated moral hazard problem for institutions that are seen by markets as TBTF. It does so by reducing the probability of SIFIs failing through requirements for additional loss absorbency and increased supervisory intensity, and by reducing the impact of failure through effective resolution regimes and strengthened core financial market infrastructures, which reduce the potential for contagion arising from interconnectedness. To implement the SIFI Framework the FSB developed a multipronged and integrated set of policy measures to address systemically important financial institutions, that was endorsed by the G-20 in November 2011, consisting of: Effective resolution regimes and policies comprising: a new international standard as the point of reference for the reform of resolution regimes, that sets out the responsibilities, instruments and powers that resolution regimes in all jurisdictions should have to enable authorities to resolve failing financial firms in an orderly manner and without exposing the taxpayer to the risk of loss ( FSB Key Attributes of Effective Resolution Regimes for Financial Institutions ) requirements for resolvability assessments, recovery and resolution planning the development of institution-specific cross-border cooperation agreements

54 P a g e 54 a peer-based resolvability assessment process to periodically review G-SIFI resolvability at the international level. Requirements for additional loss absorption capacity to reflect the greater risks that G-SIFIs pose to the global financial system. More intense and effective supervision, including through stronger supervisory mandates, resources and powers, and rigorous coordinated assessments through international supervisory colleges of the risks facing G-SIFIs that are achieved through coordination; higher supervisory expectations for firms risk governance and internal control frameworks, risk management functions, and risk data aggregation capabilities. Strengthened core market infrastructures to reduce the potential for contagion arising from the interconnectedness of significant market participants and the limited transparency of counterparty relationships. 2. Assessment and designation of G-SIFIs The implementation of the SIFI Framework requires as a first step the assessment of the systemic importance of financial institutions at a global level. The SIFI Framework defines G-SIFIs as institutions of such size, market importance, and global interconnectedness that their distress or failure would cause significant dislocation in the global financial system and adverse economic consequences across a range of countries. The SIFI Framework recognises that SIFIs vary in their structures and activities, and that systemic importance and impact upon failure can vary significantly across sectors. It requires that the FSB and national authorities, in consultation with the standard-setting bodies, and drawing on relevant indicators, determine which institutions will be designated as G-SIFIs. The methodologies to identify G-SIFIs need to reflect the nature and degree of risks they pose to the global financial system.

55 P a g e 55 Global systemically important banks (G-SIBs) The Basel Committee (BCBS) finalised and published its assessment methodology to identify G-SIBs in November The methodology is based on twelve indicators for five drivers of systemic importance: size, global activity, interconnectedness, complexity and substitutability. Based on this methodology, the FSB and national authorities identified an initial group of G-SIBs in November This group is updated annually based on new data, and published by the FSB each November. The current list, published in November 2012, includes 28 global banks that are grouped into four buckets of increasing systemic importance, which correspond to increasing levels of required additional loss absorbency, ranging from 1 to 2.5 per cent of risk-weighted assets, with an additional empty bucket of 3.5 per cent to discourage further increases in systemicness. The additional loss absorbency requirement is to be met with common equity, the highest quality form of capital. The requirements for G-SIBs will be phased in initially for those banks identified as G-SIBs in November 2014 commencing in 2016 with a view to full implementation in Since the end of 2009, the G-SIBs have increased their common equity capital by about US$ 500 bn, amounting to close to 3 per cent of their risk weighted assets. About two thirds of this increase reflects retained earnings and the rest primary equity offerings and asset revaluations.

56 P a g e 56 Global systemically important insurers (G-SIIs) The IAIS developed an assessment methodology to identify global systemically important insurers (G-SIIs) that has some similarities to the overall approach developed by the Basel Committee for G-SIBs and differences in indicators used to reflect the fact that insurers vary significantly from banks in their structures and activities and, consequently, in the nature and degree of risks they pose to the global financial system. It is based on industry-specific indicators to reflect the drivers of systemic importance in the insurance sector. The drivers of systemic importance are: size, global activity, interconnectedness, non-traditional/non- insurance activities (NTNI), and substitutability. Higher weight is given to NTNI activities and interconnectedness, the two categories which are most important for capturing the potential negative externalities of insurance companies on the rest of the system and hence the importance of insurers for financial stability. Based on this methodology, the FSB, in consultation with the IAIS and national authorities, designated in July 2013 nine life and composite insurers as G-SIIs. These institutions will be subject to a set of policy measures consistent with the SIFI Framework which comprises recovery and resolution planning, enhanced group-wide supervision and higher loss absorbency requirements. A decision on the G-SII status of major reinsurers will be made in July 2014.

57 P a g e 57 Global systemically important non-bank non-insurance financial institutions (NBNI G-SIFIs) The FSB, in consultation with IOSCO, is currently working on assessment methodologies for identifying NBNI G-SIFIs. The proposed methodologies are expected to be issued for public consultation by end The methodologies should capture the systemic impact posed by the failure of financial entities in each type or sector, while maintaining consistency across the spectrum of non-bank financial entities. Regarding FMIs, the Principles for Financial Market Infrastructures (PFMIs) issued by CPSS and IOSCO in April 2012 (see Section 9), include already a presumption that all central securities depositories, securities settlement systems, central counterparties (CCPs) and trade repositories are systemically important, at least in the jurisdiction where they are located. 3. Effective resolution regimes At the Cannes Summit in 2011, the G-20 endorsed the Key Attributes of Effective Resolution Regimes for Financial Institutions ( Key Attributes ) as a new international standard for resolution. The aim of the Key Attributes is to help address the TBTF problem by making it possible to resolve any financial institution in an orderly manner without severe systemic disruption or exposing the taxpayer to the risk of loss, by protecting critical functions and by using mechanisms for losses to be absorbed (in order of seniority) by shareholders and unsecured and uninsured creditors. A first FSB peer review of national resolution regimes using the Key Attributes as a benchmark was completed this year. Substantial headway is being made in the implementation of the Key Attributes across FSB jurisdictions, as demonstrated in the United States by the adoption of the Dodd-Frank Wall Street Reform and Consumer

58 P a g e 58 Protection Act and amendments to resolution regimes in other FSB jurisdictions, including in Australia, France, Germany, Japan, Netherlands, Spain, Switzerland and the UK. In the EU, the Bank Recovery and Resolution Directive is expected to be adopted later this year. Its implementation within a year of adoption will be an important step towards implementation of the Key Attributes in EU Member countries. Many FSB jurisdictions need to take further legislative measures to implement the Key Attributes fully, in substance and scope. Important areas where jurisdictions need to act relate to the resolution powers and tools, including bail-in. Moreover, in order to make resolution strategies and operational plans functional across jurisdictions all home and key host jurisdictions of G-SIFIs should have in place powers and arrangements for cross-border cooperation and for the recognition of foreign resolution measures. Implementation of the Key Attributes in the non-bank financial sectors has lagged behind the progress made in relation to banks. In light of the move towards mandatory central clearing of OTC derivatives, all jurisdictions with systemically important CCPs must have in place powers to resolve them. The FSB, in conjunction with standard-setting bodies, is developing guidance on how the Key Attributes should be interpreted and implemented with respect to the resolution of FMIs, the resolution of insurers and the protection of client assets in resolution. The guidance should be incorporated into the Key Attributes as Annexes and will be finalised by end For G-20 governments that require further legislative changes to achieve compliance with the Key Attributes these reforms should be a priority. FSB jurisdictions have agreed to undergo intensive monitoring and engage in detailed reporting of their implementation of the Key Attributes, including through an iterative series of focused peer reviews.

59 P a g e 59 What G-20 Authorities need to do 1. G-20 countries that have not already done so should make a renewed commitment to legislative reforms and implement the Key Attributes by end-2015, in substance and scope, and for all parts of the financial sector that could cause systemic problems. FSB Members should, by end-2014, report on plans to implement the Key Attributes in the non-bank financial sector. 2. By end-2015, FSB jurisdictions are expected to adopt resolution regimes, CMGs or equivalent arrangements, and resolution planning arrangements, for FMIs that are systemically important in more than one jurisdiction as determined by the oversight or supervisory authorities and resolution authorities in those jurisdictions, and for systemically important insurers, consistent with the FSB Annexes to the Key Attributes that will be finalised by end What the FSB and other international bodies will do 3. So that the Key Attributes can be assessed by the IMF and the World Bank under the Standards and Codes Initiative, the FSB, in coordination with the IMF, the World Bank and the standard-setting bodies, will finalise the assessment methodology for the Key Attributes by early 2015, taking into account the results from the public consultation and the pilot assessments. 4. The FSB will develop a standardised reporting template to monitor progress in implementing the Key Attributes. Starting in 2014, the FSB will undertake follow-up peer reviews focused on resolution powers, cross-border cooperation and information sharing and recovery and resolution planning requirements. 4. Addressing remaining impediments to resolvability As home and host jurisdictions of G-SIFIs are working to put the necessary legislative regimes in place, authorities have made considerable progress in developing resolution strategies and identifying

60 P a g e 60 conditions relating to firms legal, operational and financial structures and their effect on resolvability. To support the resolution planning work within CMGs, established now for all the G-SIBs, the FSB in July 2013 released Guidance on recovery and resolution planning, and the development of effective resolution strategies. The resolution strategies that are being developed for global institutions are based broadly on two stylised approaches: single point of entry resolution, in which resolution powers are applied to the top of a group by a single resolution authority and multiple point of entry resolution in which resolution tools are applied to different parts of the group by two or more resolution authorities acting in a coordinated way. Whichever resolution strategy is pursued for cross-border institutions, its effectiveness will be maximized if there is cross-border cooperation as called for by the Key Attributes. G-20 governments should consider what additional steps they may need to take to empower and encourage their domestic authorities to co-operate fully and to remove obstacles to cross- border resolution, and to address uncertainties as regards the effectiveness of resolution measures in a cross-border context, including by passing legislation to that effect if needed. Work on cooperation agreements that set out a framework to support the cross-border implementation of these resolution strategies and plans is progressing, albeit more slowly than originally planned. These agreements should be institution-specific and not general terms agreements. Progress on this front will also be helped by the full implementation of the legal framework conditions for cross-border cooperation set out in the Key Attributes and of the additional guidance on Information Sharing for Resolution Purposes set out in a new Annex to the Key Attributes.

61 P a g e 61 As resolution planning work for G-SIFIs has progressed, authorities have identified a number of issues that remain to be addressed for authorities and market participants to have confidence that resolution strategies and plans can be implemented in practice. These relate to the legal, operational and financial structures of G-SIFIs, including in particular: the availability of GLAC in sufficient amounts and at appropriate locations; the ranking of claims in the creditor hierarchy and implications for resolution, the cross-border enforceability of resolution actions, including on bail-in ; the ability to avoid detrimental large-scale termination of financial contracts based on early termination and cross-default rights when a firm enters resolution; the operational continuity of critical services and market access of firms in resolution, including access of the firm in resolution to services of FMIs; and firms information systems and data availability to support resolution. What G-20 Authorities need to do 1. Remove obstacles to cross-border resolution. The effective implementation of resolution strategies can be stymied if the cross-border effectiveness of bail-in and other resolution powers is uncertain. All home and key host jurisdictions of G-SIFIs in FSB and G-20 countries that have not already done so should implement the requirements of the Key Attributes on cross-border cooperation in resolution and remove the remaining obstacles to cross-border resolution, including the legal uncertainties in regard to the cross-border effectiveness of bail-in and temporary stays, and of other resolution measures, by passing legislation, if necessary. 2. Remove obstacles to the sharing of information for resolution purposes. Authorities with responsibility for resolution must be able to share firm-specific information, both within jurisdictions and cross-border. Given the confidentiality of much supervisory and resolution-related information, this may require legislation.

62 P a g e 62 The FSB will finalise an Annex on information sharing for resolution purposes by end FSB Members should use this Annex to assess and then set out the necessary legislative and regulatory changes by end Address impediments to resolvability in legal and operational structures. Impediments to resolvability may not only arise from the lack of adequate resolution regimes and cross-border cooperation arrangements, but also from complexities in the legal, financial and operational structures of the institutions themselves. Home authorities should enter into a dialogue with firms about changes needed to their structures and operations to ensure that their preferred (single- or multiple-point-of- entry) resolution strategy is a realistic strategy for the firm. The resolvability of each G-SIFI will be assessed at the level of senior policy makers within the Resolvability Assessment Process that the FSB will launch in early What the FSB and other international bodies will do 4. The FSB will design information sharing mechanisms, and G-20 authorities can ensure the implementation of these by G-SIFIs. Effective resolution planning requires firms to be able to produce accurate information quickly. It also requires efficient processes for sharing relevant information, both within crisis management groups (CMGs) and with authorities in host jurisdictions not represented on CMGs where operations of a G-SIFI are locally systemic. Furthermore, co-ordinated risk assessment requires supervisory authorities to share more information on the key risks facing G-SIFIs. By the end of 2014, the FSB will develop recommendation for consistent and comparable firm-specific information for resolution planning purposes.

63 P a g e 63 By the end of 2014, the FSB will develop proposals on how to strengthen information sharing within CMGs and, in consultation with standard-setting bodies, within core supervisory colleges. In 2014, the FSB will develop recommendations for cooperation and sharing information with host authorities in jurisdictions where a G-SIFI has a systemic presence but that are not participating in the CMG of that G-SIFI. 5. The FSB, in consultation with standard setting bodies, will prepare proposals on the adequacy of G-SIFI loss absorbing capacity in resolution. To avoid the need for a bail-out with public funds a SIFI needs to have sufficient resources to absorb losses in resolution ( gone concern loss absorbing capacity GLAC). An adequate amount of GLAC should facilitate the implementation of a resolution strategy with a recapitalisation at a level that promotes market confidence and, at a minimum, meets going-concern regulatory capital requirements. The FSB will prepare proposals for consideration by end-2014 on the nature, amount, location within the group structure, and possible disclosure of GLAC. 6. The FSB will develop policy proposals by end-2014 on how legal certainty in cross-border resolution can be further enhanced, such as by inclusion in debt instruments of clauses that recognise the effect of resolution actions taken in another jurisdiction. 7. The FSB will develop recommendations to further enhance G-SIFI resolvability, with work on the following areas: The FSB will develop in 2014 an analysis of the funding and liquidity needs that arise in resolution, sources of resolution funding and

64 P a g e 64 mechanisms for providing such funding, drawing on past resolution experience. By early 2015 the FSB will develop proposals on measures that support operational continuity in resolution. To facilitate and support operational continuity of core critical services (such as payment systems, correspondent banking, clearing, custody) that are either performed within a financial group or outsourced to third-party, firms need to adopt service level agreements, transitional support arrangements or take other appropriate measures to secure continuity of services that support the provision of critical functions. Continued access for firms in resolution to FMIs will also be important for operational continuity. FMI rules should accommodate that, subject to adequate safeguards to protect the safe and orderly operations of the FMI itself and consistent with the FMI Annex to the Key Attributes that will be finalised by end Senior policymakers from home and key host jurisdictions will assess the resolvability of each G-SIFI within the Resolvability Assessment Process (RAP) which the FSB will launch early The FSB will report on the intermediate results of the RAP process in early CMGs are expected to undertake a first review of the feasibility and credibility of putting the G-SIBs resolution plans into operation in the second half of By mid-2014, based on the work of CMGs and in preparation for the RAP, all G-SIBs should have transmitted to their home supervisors a high-level plan of any changes to their legal, financial and operational structures that are necessary to ensure that the preferred resolution strategy is workable. To support the RAP and ensure a consistent evaluation of the key resolvability conditions across G-SIFIs, the FSB will prepare an

65 P a g e 65 assessment template covering critical resolvability conditions, including the availability of sufficient loss absorbing capacity, the cross-border effectiveness of resolution actions, the operational continuity of core critical services (such as payment systems, correspondent banking, clearing, custody), and other conditions that affect the implementation of resolution strategies, such as accelerated regulatory approvals or requirements under securities laws. 9. By end-2014, the FSB will develop proposals for contractual or statutory approaches to prevent large-scale early termination of financial contracts. Large- scale close-out of financial contracts based on early termination and cross-default rights when firms enter resolution can hinder the effective implementation of resolution strategies. G-20 authorities can encourage ISDA and other industry bodies to review contract provisions to prevent large-scale early termination of financial contracts. 5. Implementing policy measures for D-SIBs The TBTF problem exists not only at the global level but also at the national level. The 2010 SIFI Framework extends to institutions that are systemically important at the domestic level. The BCBS published in October last year a principles-based minimum framework for domestic systemically important banks (D-SIBs) that is compatible with the G-SIFI framework. It allows for appropriate national discretion to accommodate structural characteristics of domestic financial systems. The principles include guidelines for authorities to assess the systemic importance of banks in a domestic context and include the option for countries to go beyond the minimum D-SIB framework and impose additional requirements based on the specific features of the jurisdiction and its domestic banking sector.

66 P a g e 66 What G-20 Authorities need to do 1. G-20 countries should ensure that the D-SIB framework is appropriately and promptly implemented in their jurisdiction. What the FSB and other international bodies will do 2. To ensure appropriate adherence to the principles of the D-SIB framework, its implementation by authorities within a jurisdiction should be subject to an international peer review programme. The BCBS is developing a programme for such a peer review, which will start no later than mid Implementing policy measures for G-SIIs G-S IIs will be subject to a set of policy measures consistent with the SIFI Framework which comprises recovery and resolution planning, enhanced group-wide supervision and HLA requirements. HLA requirements for G-SIIs will be built upon straightforward backstop capital requirements for all activities of the insurance group (including those of non-insurance subsidiaries). HLA requirements, which will need to be met by the highest quality capital, will apply from January 2019 to those G-SIIs identified in November 2017 on the basis of the IAIS methodology. A sound capital and supervisory framework for the insurance sector is essential for supporting financial stability. A global quantitative capital standard will be established as part of a comprehensive, group-wide supervisory and regulatory framework for internationally active insurance groups (IAIGs).

67 P a g e 67 What G-20 Authorities need to do 1. G-20 countries should ensure that the implementation of enhanced group-wide supervision commences immediately, and includes the group-wide supervisor having direct powers over holding companies and overseeing the development and implementation of a Systemic Risk Management Plan by July For the G-SIIs identified in July 2013, CMGs should be established by July Recovery and resolution plans for G-SIIs, including liquidity risk management plans, should be developed by the end of G-SII home authorities will be asked to provide an interim report on the establishment of CMGs and status of the resolution planning work within CMGs by mid What the FSB and other international bodies will do 3. The IAIS will produce and the FSB will review proposals for the regulation of IAIGs and G-SIIs. G-20 authorities can ensure implementation of these requirements The IAIS will finalise straightforward backstop capital requirements for all group activities, including non-insurance subsidiaries, by the G-20 Summit in The IAIS will by end-2015 develop a detailed proposal for implementing the HLA requirement for G-SIIs. By end 2013, The IAIS will develop and the FSB will review a work plan to develop a comprehensive, group-wide supervisory and regulatory framework for Internationally Active Insurance Groups (IAIGs), including a quantitative capital standard. 4. By mid-2015, the FSB will report on the status of resolution planning within CMGs for all G-SIIs listed in July 2013 using the relevant provisions of the Key Attributes and Annexes as reference.

68 P a g e Global systemically important NBNI G-SIFIs The FSB is reviewing how to extend the SIFI Framework to global systemically important non-bank non-insurance (NBNI) financial institutions. This category of firms includes securities broker-dealers, finance companies, asset managers and investment funds, including hedge funds. What the FSB and other international bodies will do 1. The FSB, in consultation with IOSCO, will issue for public consultation proposed methodologies for identifying NBNI G-SIFIs by end The FSB, in cooperation with IOSCO and other standard-setting bodies where relevant, will begin work to develop within the SIFI policy framework the incremental policy measures needed to address the systemic risks posed by NBNI SIFIs, once the identification methodologies have been finalised and published. 8. More intense and effective supervision The level of supervision must be commensurate with the potential destabilisation risk that firms pose to the financial system. The FSB issued its first recommendations for enhanced supervision of financial institutions, in particular SIFIs, in October The first report underscored the key preconditions for effective supervision, including the needs for (i) strong and unambiguous mandates; (ii) independence to act; (iii) sufficient quality and quantity of resources; and

69 P a g e 69 (iv) supervisors having a full suite of powers to execute on their mandate. Subsequent recommendations in 2011 and 2012 strengthened the supervisory expectations for firms risk governance and internal controls, risk management functions, risk aggregation and risk reporting capabilities. A number of these recommendations have been implemented and, collectively, have raised the bar for both supervisors and SIFIs. In light of these recommendations, the BCBS, IAIS and IOSCO have strengthened their core principles for effective supervision which collectively address many of the early recommendations for enhanced supervision. FSB jurisdictions need to strengthen their adherence to these prerequisites for effective supervision: findings from the IMF-World Bank Financial Sector Assessment Program (FSAP) reveal that significant weaknesses continue to exist. In particular, G-20 authorities must ensure that resource needs at supervisory authorities are adequately addressed and best practices for ensuring supervisory independence and accountability are fully implemented in order to deliver high quality supervision. The FSB and standard-setting bodies also have issued new principles and standards related to risk management that address many of the weaknesses highlighted by the financial crisis, including sound practices f appetite framework. To remedy the gaps in information technology and management information systems highlighted during the crises, the FSB recommended the development of principles for effective risk data aggregation and risk reporting. G-SIBs are required to meet the BCBS Principles for Effective Risk Data Aggregation and Risk Reporting by 2016.

70 P a g e 70 Central to the work on enhancing supervisory and macro-prudential authorities information is the FSB Data Gaps initiative, which provides authorities with a stronger framework for assessing potential systemic risks and clearer view of financial networks. G-SIBs will submit a common data template for counterparty credit exposures and other common exposures to a new data hub at the BIS. Authorities will have clearer sight of the interconnectedness of the largest financial institutions. Despite good progress in strengthening supervisory regimes and processes, cross-border supervisory cooperation and coordination needs to be intensified for the agreed supervisory approaches and methods to be effective. A key element of the SIFI Framework is for home jurisdictions of G-SIFIs to enable a sharing of information for the purpose of rigorous co-ordinated assessments on the risks facing the G-SIFI through international supervisory colleges, and although progress has been made by home jurisdictions and by the relevant standard-setting bodies, more work is needed to ensure that progress towards rigorous co- ordinated assessments of the risks facing the G-SIFIs through international supervisory colleges continues to be made. What G-20 Authorities need to do 1. G-20 governments should take the necessary actions to implement their November 2010 commitment to ensure supervisors have the capacity to resource themselves and the independence to effectively meet their mandate. What the FSB and other international bodies will do 2. By end-2013, the IMF in consultation with the FSB will examine the root causes for FSAP findings, in particular with reference to supervisory independence and resources, in order to ensure that material deficiencies are effectively followed up and rectified.

71 P a g e 71 The FSB reiterates its request made in November 2011 for the IMF and World Bank to increase resources for FSAPs to provide assessors the capacity to formor effective risk governance and principles for an effective risk appetite framework. To remedy the gaps in information technology and management information systems highlighted during the crises, the FSB recommended the development of principles for effective risk data aggregation and risk reporting. G-SIBs are required to meet the BCBS Principles for Effective Risk Data Aggregation and Risk Reporting by Central to the work on enhancing supervisory and macro-prudential authorities information is the FSB Data Gaps initiative, which provides authorities with a stronger framework for assessing potential systemic risks and clearer view of financial networks. G-SIBs will submit a common data template for counterparty credit exposures and other common exposures to a new data hub at the BIS. Authorities will have clearer sight of the interconnectedness of the largest financial institutions. Despite good progress in strengthening supervisory regimes and processes, cross-border supervisory cooperation and coordination needs to be intensified for the agreed supervisory approaches and methods to be effective. A key element of the SIFI Framework is for home jurisdictions of G-SIFIs to enable a sharing of information for the purpose of rigorous co-ordinated assessments on the risks facing the G-SIFI through international supervisory colleges, and although progress has been made by home jurisdictions and by the relevant standard-setting bodies, more work is needed to ensure that progress towards rigorous co- ordinated assessments of the risks facing the G-SIFIs through international supervisory colleges continues to be made.

72 P a g e 72 What G-20 Authorities need to do 1. G-20 governments should take the necessary actions to implement their November 2010 commitment to ensure supervisors have the capacity to resource themselves and the independence to effectively meet their mandate. What the FSB and other international bodies will do 2. By end-2013, the IMF in consultation with the FSB will examine the root causes for FSAP findings, in particular with reference to supervisory independence and resources, in order to ensure that material deficiencies are effectively followed up and rectified. The FSB reiterates its request made in November 2011 for the IMF and World Bank to increase resources for FSAPs to provide assessors the capacity to form more robust opinions on the effectiveness of supervision. The FSB, in collaboration with the IMF, will report its findings in early Building on resolution-related work, the FSB will promote more effective cross- border supervisory information sharing across all SIFI-related workstreams, including in ongoing supervision, in the work of core supervisory colleges and the Data Gaps initiative. To this end, authorities will report by mid-2014 on legal or practical issues that they have identified as obstacles to: i. the sharing of supervisory information within supervisory colleges and CMGs; ii. implementation of the Data Gaps initiative; and iii. the sharing of material parts of resolution strategies and plans within CMGs. 4. Supervisors of G-SIFIs working through core supervisory colleges should remove any remaining obstacles to achieving effective and coordinated assessments of the risks facing the G-SIFIs.

73 P a g e 73 By end-2014 the FSB, in consultation with standard-setting bodies, will develop proposals on how to strengthen the operation and effectiveness of core supervisory colleges, including information sharing, to enable coordinated assessments of the risks facing the G-SIFIs. 5. By end-2014, the FSB will launch a peer review of supervisory frameworks and approaches to identify improvements and remaining challenges in supervisory practices for SIFIs, including the ability for supervisors to exercise judgement and more effectively challenge firms risk management practices and decision making processes. The FSB will, in coordination with the standard-setting bodies, develop policy recommendations, as appropriate, in areas where obstacles to effective supervision of G-SIFIs still exist. 9. Strengthening core financial market infrastructures FMIs will have an increasingly important role in global and national financial markets going forward. In particular, the policy reforms to require all standardised OTC derivatives to be centrally cleared reinforce the importance of strong safeguards and consistent oversight of the CCPs for derivatives. Central clearing is also becoming increasingly common in the settlement of money market transactions such as repos. Robust FMIs will make an essential contribution to reducing interconnectedness between systemic firms and making these markets more resilient in the face of the default of a major market participant. At the same time, authorities must take steps to ensure that core financial infrastructures do not themselves become a source of systemic risk. The CPSS-IOSCO Principles for Financial Market Infrastructures (PFMIs), issued in April 2012, contain new and more demanding international standards for payment, clearing and settlement systems, including central counterparties.

74 P a g e 74 It is important that authorities use them to establish a level playing field for robust and resilient FMIs. More extensive use of CCPs in OTC derivatives markets will see the functioning of these markets less exposed to any single firm s balance sheet. All market participants in the markets it clears are subject to rigorous participation and ongoing margining requirements, and concentration limits can be imposed. It is also urgent to set out and implement standards for recovery for systemically important CCPs and, if necessary, to put in place legislation providing the powers to resolve such CCPs. The development of comprehensive recovery plans by and resolution regimes for FMIs will help ensure that the greater reliance of the global financial system on market infrastructure does not result in a new category of entity that is TBTF. CPSS/IOSCO published a consultative report on FMI recovery in August 2013, at the same time as the FSB published its consultation on the resolution of FMIs. Recognising that not all transactions may be eligible for central clearing, the BCBS, IOSCO, CPSS and CGFS are close to finalising minimum standards for margin requirements that will apply to transactions that remain non-centrally cleared. These will ensure that most exposures between large financial market participants are collateralised on a mark-to-market basis, with the potential loss given default covered by margin. What G-20 Authorities need to do 1. FSB jurisdictions are committed to fully implement the principles and responsibilities contained in the PFMIs. CPSS and IOSCO are monitoring and will periodically report on the status of implementation of the PFMIs.

75 P a g e 75 What the FSB and other international bodies will do 2. CPSS and IOSCO will finalise their guidance on the recovery of FMIs, and the FSB will finalise an Annex to the Key Attributes on the resolution of FMIs by end Review of bank structural measures The process of strengthening financial regulation in response to the crisis is still underway in a number of jurisdictions. FSB Members are continuing to review the need for further national policy initiatives in light of (i) the continued growth of many TBTF firms in relation to the size of the financial system (ii) concerns about dependence on short-term wholesale funding and increased secured borrowing at banks and non-banks (iii) the adoption or planned adoption of structural measures in some jurisdictions (e.g. separation of activities into different legal entities, intra-group exposure limits, increased local capital and liquidity requirements etc.). Several models for structural reforms have emerged: one places an outright prohibition on certain combinations of financial activity (e.g. the Volcker Rule contained in section 619 of the Dodd-Frank Act). Alternative approaches, associated with the UK s Independent Commission on Banking (the ICB or Vickers Commission ), the High-Level Expert Group on Reforming the Structure of the EU Banking Sector chaired by Bank of Finland Governor Erkki Liikanen and recent legislation in Germany and legislative initiative in France, emphasise instead a requirement for different types of financial activity to be conducted by separately capitalised subsidiaries. Approaches for structural regulation differ in scope and content reflecting the different institutional characteristics of the jurisdictions for which they have been developed.

76 P a g e 76 What G-20 Authorities need to do 1. Consider domestic structural measures that are complementary to an effective SIFI Framework. As the October 2010 FSB SIFI Framework recognised, structural measures could reduce the risks or externalities that a G-SIFI poses. Structural reform measures (including separation of activities, intra-group exposure limits, local capital and liquidity requirements, etc.) seek to put restraints on excessive risk-taking by SIFIs and thus help promote financial stability. They can also contribute to improving the resolvability of SIFIs at a jurisdictional level, thus reducing the moral hazard of TBTF. There is, however, a risk that diverging structural measures imposed by different jurisdictions may have an impact on integration across national or regional markets. FSB members should therefore monitor and discuss the potential crossborder spill-over effects that may result from different approaches. They should also take account of progress on cross-border cooperation, and seek to avoid unnecessary constraints on the integration of the global financial system or the creation of incentives for regulatory arbitrage. What the FSB and other international bodies will do 2. The G-20 Finance Ministers and Central Bank Governors have requested that the FSB, in collaboration with the IMF and OECD, assess the cross-border consistency and global financial stability implications of these measures, taking into account country- specific circumstances. The FSB will do this by end-2014.

77 P a g e Conclusion overall progress to date and next steps The implicit government guarantee that arises when public authorities are perceived to have limited options in dealing with a threatened failure of a financial institution, leading them to bail it out and pass on the costs of failure to taxpayers, provides a public subsidy to TBTF firms in the form of lower funding costs and adversely affects market discipline, competition, systemic risk and public finances. There are signs that firms, markets and rating agencies are adjusting to authorities determination to address TBTF. As such, rating agencies have lowered their assumptions on the likelihood of government support in light of the considerable progress that has been made in devising a credible and feasible resolution plan for certain firms. In the case of other firms, markets have not yet changed their assumptions of reliance on extraordinary public support, in part due to lack of disclosure around the progress in making the firms more resolvable and in developing credible resolution plans, coupled with uncertainties relating to the legislative reforms of resolution regimes. It will understandably take time to fully establish the credibility of the new framework in addressing TBTF. The policy initiative to end TBTF is ambitious, but necessary. We have made good progress to date in putting the overall international policy framework in place. Detailed technical work is now giving real teeth to the policies. While much has been accomplished, more needs to be done to finish the job through legislation and regulation to put in place at jurisdictional level the internationally agreed policies, and through practical application to individual institutions. To make enduring progress, we must establish coherent regulatory frameworks with approaches to regulation and resolution across all home

78 P a g e 78 and relevant host jurisdictions that are aligned and mutually supportive, through resolution regimes that comply with the Key Attributes. This report sets out next steps to make resolution strategies for G-SIFIs operational and to make the legal, financial and operational structures of G-SIFIs resolvable, and thus takes a major stride toward giving authorities the credible capacity to resolve G-SIFIs without economic disruption or costs to taxpayers. The FSB will work with standard-setting bodies to agree the necessary refinements to regulatory policies. The FSB will rigorously monitor implementation to ensure that members fulfil their commitments in this area and will disclose to G-20 Leaders its findings, including the consistency of national measures with agreed international policies. Authorities will need to make the necessary changes to legislation and regulation. Supervisors, together with resolution authorities, will need to ensure that individual groups restructure to the extent needed.

79 P a g e 79 Consultation Paper on Local Implementation of Basel III Liquidity Rules Liquidity Coverage Ratio On 6 January 2013, the Group of Central Bank Governors and Heads of Supervision ( GHOS ) endorsed the Basel III Liquidity Rule - Liquidity Coverage Ratio ( LCR ) as the global minimum standard for liquidity risk. The LCR framework aims to improve the short-term resilience of a bank's liquidity risk profile. It does this by ensuring that a bank has an adequate stock of unencumbered high quality liquid assets ( HQLA ) that can be converted into cash at little or no loss of value to meet its liquidity needs for a 30 calendar day liquidity stress scenario. Under the timeline for implementation, the LCR requirement starts at 60% on 1 January 2015 and increases 10% annually to reach 100% by 1 January As a member of the Basel Committee of Banking Supervision ( BCBS ), Singapore will adopt Basel s recommended implementation timeline. MAS is proposing to replace the existing MLA framework with the LCR framework for all banks and finance companies. The new framework will also be extended to merchant banks. MAS will be conducting a Quantitative Impact Study ( MAS QIS ) for all banks, merchant banks and finance companies ( financial institutions ) in Singapore based on 28 June 2013 positions, to analyze the potential impact resulting from the local implementation of LCR. The details of the proposed local implementation of the LCR framework in Singapore are provided in this consultation paper.

80 P a g e 80 We invite comments on the proposals made in this paper. Electronic submission is encouraged. Please submit written comments by 16 September 2013 Please note that any comments received may be made public unless confidentiality is specifically requested. The draft rules for implementation of LCR in Singapore ( draft LCR rules for local implementation ) will be released at a later date after we have studied the data collected from the MAS QIS and the comments received from this public consultation. 1 Introduction 1.1 In January 2013, the Basel Committee issued the Basel III: The Liquidity Coverage Ratio and liquidity risk monitoring tools document that sets out the finalized LCR rules. The LCR is an essential component of the Basel III reforms, which are global regulatory standards on bank capital adequacy and liquidity endorsed by the G20 Leaders. 1.2 As a member of the BCBS, Singapore will adopt the Basel III LCR rules and proposes to make refinements in certain areas for local implementation. The existing MLA framework will also be replaced with the adoption of the LCR rules. Section 2 of this consultation paper covers the regulatory framework and scope of application for the local implementation of LCR requirements in Singapore. The refinements and additional requirements for local implementation are discussed in Section 3.

81 P a g e 81 2 Regulatory Framework and Scope of Application 2.1 Compliance and Reporting of LCR Requirement The existing Minimum Liquid Assets ( MLA ) requirement, as stated under MAS Notice 613, stipulates that every bank shall hold, at all times, a minimum percentage of its SGD-denominated qualifying liabilities in liquid assets. Similar requirements apply to finance companies under MAS Notice 806. The objective of the MLA is similar to the LCR, which is to ensure that banks hold sufficient liquid assets to meet their estimated cash outflows over a short-term horizon. In addition, allowing MLA assets to be drawn down during a liquidity crisis on notification to the MAS is also aligned with the intent of the LCR framework While there are similarities between the MLA and LCR frameworks, the scope of coverage for the LCR framework is broader as it covers assets and liabilities beyond those denominated in the domestic currency. The LCR framework also includes all cashflows of the financial institution in determining its liquidity risk instead of only deposit liabilities in the existing MLA framework. Overall, the new LCR framework is more comprehensive than the MLA framework and MAS is proposing that it replaces the MLA framework as the main liquidity requirement for financial institutions in Singapore Similar to the current MLA requirement, financial institutions that are subject to the LCR rules will be required to comply with them on a daily basis but only need to submit a monthly report under MAS Notice 613. The financial institutions may utilize their HQLA in a liquidity stress situation after notifying MAS in writing.

82 P a g e 82 MAS Notice 613 will be amended accordingly to take into account the necessary changes. The detailed reporting requirements will be released at a later date when the draft LCR rules for local implementation are finalized. 2.2 Scope of Application of LCR Requirement The Basel III LCR standard establishes a minimum level of liquidity for internationally active banks, to be met at a Group level. Consistent with the Basel Capital Adequacy standard, the LCR standard recognises the need for national authorities to require higher minimum and additional levels of liquidity to be held, if they deem that the LCR requirement does not adequately provide for the liquidity risks that their banks face Locally incorporated banks, foreign bank branches and finance companies in Singapore are currently required to comply with the MLA requirement, as stipulated under MAS Notice 613 and MAS Notice 806 respectively. These banks and finance companies will be required to comply with the LCR requirement with the shift from the MLA to the LCR framework. In addition, MAS is proposing that merchant banks, which are currently excluded from the MLA requirement, be subject to the LCR requirement, in order to strengthen their liquidity risk management. 3 Key Modifications 3.1 Aggregated Country Level versus Entity Level The LCR rules are silent on its scope of application beyond the internationally active banks on a group basis. An area which the national authorities have to decide when they extend the LCR requirement beyond the internationally active banking groups is whether related entities in a country are subject to individual LCR

83 P a g e 83 requirement on an entity level or collective LCR requirement on an aggregated country level. In the latter, all related entities in Singapore will compute and comply with a single collective LCR requirement. For example, Foreign Bank A and its related Merchant Bank B will be treated as a country banking group and instead of maintaining an individual LCR for each entity, a collective LCR will be computed and maintained on a country banking group level under this treatment We propose to impose an individual LCR requirement on an entity level for financial institutions in Singapore given that most of the individual entities have different liquidity profiles, separate liquidity management policies and liquid assets management frameworks. However, MAS is prepared to consider imposing a collective LCR requirement on an aggregated country level where the related entities in Singapore can justify and demonstrate that their liquidity needs are managed on a country level basis; governed by clear and common liquidity management frameworks, policies and processes; and that there are effective inter-related entity liquidity support in place. MAS will assess the merits of each application for collective LCR requirement and approve it on a case by case basis. 3.2 Varying LCR Requirement for Foreign Bank Branches under Certain Conditions The recent financial crisis has demonstrated the need for foreign bank branches to maintain sufficient level of liquidity locally to meet their immediate short-term liquidity obligations. MAS noted the industry feedback that maintaining liquid assets by foreign bank branches at each location to meet the LCR requirement is inefficient for liquidity risk management at the group.

84 P a g e 84 On balance, MAS is prepared to vary the LCR requirement for foreign bank branches under certain conditions. For example, where the Head Office has fully met the 100% LCR requirement at the Group level and MAS is satisfied with the strength of the liquidity risk management of the Group and the Singapore branch as well as assured of the Head Office providing liquidity support to the Singapore branch during periods of stress. A reduction in the LCR requirement for each foreign bank branch, if any, will be granted on a case-by-case basis based on supervisory assessment. 3.3 LCR by Currency Singapore Dollars ( SGD ) LCR Requirement As SGD is the local currency of financial institutions based in Singapore and it is systemically important to our financial system, sufficient SGD-denominated liquid assets must be available as a buffer for their SGD-denominated net outflows. Imposing a SGD LCR requirement will ensure that there is adequate SGD-denominated HQLA within the total HQLA pool. This is also in line with the current requirement under the MLA framework. In view of the fact that the LCR requirement is meant to replace the MLA requirement and most financial institutions are already in compliance with the SGD LCR requirement, we propose to impose a SGD LCR requirement of 100% Foreign Currency LCR Requirement While the LCR requirements are calculated on a consolidated basis and reported in a common currency, the Basel liquidity standard also expects banks and their supervisors to closely monitor LCR by significant currency.

85 P a g e 85 Singapore is a regional treasury centre for many banks and their liabilities here are diversified in terms of currencies. U.S. Dollar ( USD ) is the dominant foreign currency for most financial institutions in Singapore and one-third of these financial institutions also have 3 or more other significant currencies. As such, there is a need to impose LCR by significant currencies, on top of the consolidated currency LCR requirement, to ensure that financial institutions have sufficient liquid assets in the foreign currencies and are not overly-reliant on the FX swap markets to meet their foreign currency liquidity needs during a liquidity stress situation, as highlighted by the reduced FX swap market liquidity during the last financial crisis MAS proposes to impose a USD LCR requirement on all financial institutions in Singapore given that it is the next most significant currency in the banking industry besides SGD. The proposed LCR requirement for USD in Singapore will be set at 80%, allowing financial institutions to rely on external sources such as the FX swap market to some extent. MAS will monitor the market liquidity of the other non-usd foreign currencies as well as the adequacy of each financial institution s liquidity management of these currencies through its supervisory process. Bank-specific requirements will be imposed on a case-by-case basis if prudential concerns warrant them. 3.4 Definition of High Quality Liquid Assets ( HQLA ) HQLA are assets that can be easily and immediately converted into cash at little or no loss of value through sale or repo transaction even in times of stress. HQLA are categorised into three broad categories, Level 1, Level 2A and Level 2B assets.

86 P a g e 86 In the December 2010 version of the LCR rules text, HQLA comprised mainly cash, central bank reserves, and certain marketable securities backed by sovereigns and central banks, among others. The finalized LCR framework has three additions to the definition of HQLA, subject to certain criteria: a) Residential mortgage-backed securities ( RMBS ) rated AA or higher; b) Non-financial corporate securities rated A+ to BBB-; and c) Non-financial equities that are a constituent of the major stock index in the home jurisdiction RMBS under (a) are subject to a 25% haircut while non-financial corporate securities and equities under (b) and (c) are subject to a 50% haircut MAS proposes to exclude RMBS as HQLA in the local LCR implementation as we have concerns about the liquidity of RMBS in a financial crisis, as seen during the recent global financial crisis. MAS is also proposing to exclude equities as HQLA in view of prudential considerations, in particular concentration and contagion risks as only a small number of counters can satisfy the HQLA criteria. MAS proposes to accept nonfinancial corporate securities as HQLA but limited to those that are rated A and above MAS has considered the need to adopt the Alternative Liquidity Approaches ( ALA ), which allow jurisdictions with insufficient supply of Level 1 HQLA in their domestic currency to meet the aggregate demand of financial institutions to adopt alternative treatments for HQLA. We have assessed that there are sufficient SGDdenominated HQLAs in Singapore and there is no need to adopt ALA at the current juncture. However, we may consider adopting ALA in future when the need arises.

87 P a g e Treatment of Minimum Cash Balance ( MCB ) The MCB requirement, as stipulated in MAS Notice 758 and MAS Notice 806, is intended to prevent payments gridlock in the MAS Electronic Payment System ( MEPS+ ) by ensuring that banks and finance companies hold sufficient liquidity to meet their payment obligations each day. While banks and finance companies are allowed to utilise the full amount of their cash balances within a day, they are required to maintain a minimum cash balance of 2% of their Qualifying Liabilities at the end of each day and a minimum daily average of 3% over each two-week maintenance period. The end-of-day minimum cash balance is intended to ensure that banks and finance companies start the next settlement day with sufficient balances to meet their payment obligations for the day Recognising that requiring banks and finance companies to continue holding a 2% end-of-day cash balance could exacerbate their liquidity shortfall in a stress situation, MAS is prepared to waive the end-of-day cash balance requirement for banks and finance companies in a liquidity stress situation, to allow them to meet their payment obligations for the day. Banks and finance companies intending to utilise their cash balances held to meet the MCB requirement should notify MAS of the intent prior to the utilisation, and be able to demonstrate that they have drawn down all other available liquid assets. On this basis, we propose to allow cash balances held to meet the MCB requirement to be included as HQLA for the computation of LCR. 3.6 Trade Finance Trade finance instruments consist of trade-related obligations directly underpinned by the movement of goods or the provision of services.

88 P a g e 88 Examples include documentary trade letters of credit and guarantees directly related to trade finance obligations, such as shipping guarantees. Some of these contingent funding obligations are explicitly contingent upon a credit or other events that are not always related to the liquidity events simulated in the stress scenario, but may nevertheless have the potential to cause significant liquidity drains in times of stress. Under the LCR framework, national authorities have discretion to apply a run-off rate of 5% or less on contingent funding obligations stemming from trade finance. We propose to apply an outflow factor of 3% to trade finance instruments. 3.7 Intragroup Flow The LCR rules do not make any explicit reference to intragroup transactions and they are treated as third party financial institution transactions. For example, funds to and from Head Office or other related financial entities will be given 100% inflow and 100% outflow factors, in line with that given to third party financial institution transactions We note that this treatment coupled with the 75% cap on inflows, can result in some of the entities, in particular group funding centres, having very low LCR which may not be a true indication of their liquidity position. As intragroup transactions carry less liquidity risk as compared to transactions with external parties, we propose to allow netting of intragroup flows within each day inside the 30 days period in recognition of the lower liquidity risk associated with intragroup flows within the same day. For instance, the gross intragroup inflow and gross intragroup outflow can be netted within each day to arrive at the net inflow and outflow for each day.

89 P a g e 89 The respective net daily inflow or outflow will then be added up to arrive at the 30 days intragroup inflow and outflow. By only allowing netting within each day instead of across the full 30 days period, the timing mismatches are reduced. MAS will however, have the power to disallow financial institutions from netting their intragroup flows if they have intragroup transactions that carry substantial liquidity risk. 3.8 Timeline of Implementation Under the finalized LCR rules, the LCR requirement will be introduced as planned on 1 January 2015, but the minimum requirement will be set at 60% and rise in equal annual steps to reach 100% on 1 January We propose to adopt the same timeline and level of requirement for the consolidated LCR requirement in Singapore to provide financial institutions with sufficient time for compliance. Financial institutions that are currently holding more than the required amount of HQLA are expected not to materially weaken their liquidity positions in the interim As MLA will be superseded by the LCR and most financial institutions are already able to meet the 100% SGD LCR based on preliminary analysis, we propose to impose a 100% SGD LCR on 1 January As for the USD LCR, we propose to start at 40% on 1 January 2015 and rise in equal annual steps to reach 80% on 1 January The proposed timeline will apply to all entities subject to the LCR requirement.

90 P a g e 90 The impact of payments system and prudential reforms on the Reserve Bank of Australia s provision of liquidity Address by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, to the Australian Financial Markets Association (AFMA) and Reserve Bank of Australia (RBA) Briefing, Sydney. This speech was co-authored with Matt Boge. Today, I wish to talk about several important changes that will be made to the framework under which the Reserve Bank operates in domestic financial markets. These changes will be introduced at different points during the next 18 months and will have significant implications for the size of the Reserve Bank s balance sheet and the way in which the Bank provides liquidity to financial institutions. The primary purpose of the Bank s operating framework is to implement the monetary policy decisions of the Reserve Bank Board. As you would be aware, the Board states its policy stance in terms of a target for the cash rate. To be precise, it s the rate on overnight unsecured loans between authorised deposit-taking institutions (ADIs). While the Board has been announcing targets for the cash rate since 1990, the Bank s operating framework has continued to evolve over this time, although the underlying principles haven t changed. To a large extent, these modifications have been prompted by the need to accommodate structural changes within markets, such as the end of the arrangements for Authorised Money Market Dealers in the mid-1990s and the reduced supply of government bonds during the following decade. In responding to these developments, the Bank has been guided by the need for its operating framework to enable the Bank to meet the Board s

91 P a g e 91 cash rate target and to facilitate the most effective transmission of those policy decisions to the prices of financial assets more broadly, and ultimately, to the real economy. With that in mind, during the global financial crisis, when different segments of financial markets became impaired to varying degrees, the Bank modified several aspects of its operating framework. Some of these changes were only temporary and were discontinued after markets stabilised, such as offering term deposits and US dollar repos to domestic financial institutions. Other changes have been permanent, such as broadening the range of securities that are eligible for the Bank s repurchase transactions. The Bank s operating framework has also needed to adapt to changes in the payments system, such as the shift to real-time gross settlement in the late 1990s and the settlement of the Australian dollar leg of foreign currency transactions via CLS Bank a few years after that. Going forward, further innovations to the payments system as well as the introduction of the Basel III liquidity reforms will require more changes to be made. Before describing these changes, it is worth recapping what the core features of the Bank s operating framework are. Essentially, the Bank seeks to control the supply of settlement funds that ADIs use to meet their payment obligations, so that the rate at which ADIs borrow and lend these funds to each other is equal to the Board s target for the cash rate. To create the incentive for exchange settlement (ES) account holders to participate in the overnight cash market, the Bank pays account holders 25 basis points below the cash rate target on their end-of-day balances. On the other side, a penalty rate of 25 basis points above the cash rate is charged if an ADI needs to borrow overnight from the Reserve Bank to ensure its ES balance is positive.

92 P a g e 92 Together, these rates comprise the 50 basis point interest rate corridor that the Bank uses to guide the cash rate to the Board s target. As payments to and from the Reserve Bank (or its clients) are constantly changing the supply of exchange settlement funds, each day the Bank will transact in the market to maintain the appropriate supply of funds. These transactions are almost always repos; that is, the Bank s counterparty agrees to repurchase the security it has sold to the Bank at some future date. This framework has been successful in achieving its objectives: the interbank cash market is quite active, with usually around $5 billion transacted each day; the cash rate consistently trades at the Board s target; and changes in the cash rate pass through rapidly to the overall rate structure within the domestic market. Given that background, I ll now turn to the forthcoming changes to the payments system and liquidity regulations and explain what they are likely to mean for the demand for ES balances. At the present time, the demand for ES balances is generally low as ADIs seek to minimise their balances, subject to the constraint that they must be positive. Although ES funds are a risk-free investment, the 25 basis point spread to the cash rate is usually wide enough to discourage ADIs from using them as a store of liquidity. During periods of financial turmoil, that can change. Between 2007 and 2009, the amount of ES funds rose as ADIs became increasingly risk averse and sought to hold larger precautionary balances at the central bank, which the Reserve Bank accommodated with increased supply (Graph 1). However, for the past three years or so, aggregate ES balances at the end of each day has usually only been around $1 billion, a very small component of the Reserve Bank s liabilities and of ADIs liquid assets.

93 P a g e 93 As payments arrangements evolve in the coming years, the demand for ES funds will rise significantly. As you might be aware, the Payments System Board last year established a number of strategic objectives for the payments system, including improving the process for settling electronic direct entry (DE) payments. The direct entry system is used very widely, such as for salary payments, the payment of Centrelink benefits, Pay Anyone internet transfers and for many dividend payments. While most individual direct credit and direct debit transfers are quite low in value, the total value of such payments averages more than $40 billion per day.

94 P a g e 94 At present, like most low-value payments, direct entry payments are not settled on the same day that the details of the transaction are exchanged between financial institutions. DE payments are settled in one batch at 9 am on the following business day. From November this year, DE payments will be able to be settled for same-day value, albeit still in batches. While this should be of great benefit to financial institutions and their customers, some of these settlements will be taking place outside of normal banking hours (Figure 1). Furthermore, at the time the interbank cash market closes at the end of the day, ADIs will not know the size of these payments (or receipts) that they will need to settle later that evening. Potentially, these payments could be quite large. To be assured of having sufficient funds with which to meet payments throughout the evening, ADIs directly involved in the DE exchanges will each need to retain higher balances in their ES account. From November, the Reserve Bank expects ES balances to increase from their current level of $1 billion to be between $20 and $30 billion on an ongoing basis. This is designed to ensure that payments made after the close of the day don t result in ADIs facing negative ES balances and hence being unable to make the payments. The size of these balances has been calculated by examining the largest payment obligations that have arisen from these later batches in recent times and providing a buffer above that.

95 P a g e 95 The size will be reviewed regularly as we see how the payments patterns evolve after November. The Bank will manage this expansion in its balance sheet through its existing liquidity facility for ES account holders. Unlike open market operations (which are conducted by auction), repos via the Bank s liquidity facility are made available to ES account holders on pre-specified terms. At the present time, ES account holders usually only access this facility for intraday funding; repos used for this purpose carry no interest charge. During the course of a normal day, the pool of ES balances (and therefore the size of the Bank s balance sheet) tends to expand by around $10 to $15 billion as ADIs use intraday repos to give them the capacity to make payments before the settlement of incoming funds. By the end of each day, these repos are unwound.

96 P a g e 96 On the very rare occasions that such repos are carried over to the next day, a penalty interest rate 25 basis points above the cash rate target applies. From November, the Bank will allow ES account holders to access a pre-determined amount of funds through its liquidity facility on an open basis; open repos are those contracted without an agreed maturity date. The interest rate on these open repos will be set at the cash rate target. At the same time, the Reserve Bank will change the way that interest on ES balances is calculated. To the extent that account holders retain matching funds against their open repo position, those ES balances will earn the cash rate rather than 25 basis points below. Hence while these changes will increase the size of the Bank s balance sheet, they won t change the net income the Bank earns. In net terms then, there need be no cost to holding an open repo position. However, as is the case currently, surplus ES funds, that is, funds held in excess of an open repo position, will earn a rate 25 basis points below the cash rate target. Similarly, any shortfall in funds below the account holder s open repo position will incur a 25 basis point penalty. An allowance will be made for variations in ES balances arising from direct entry payments that settle during the evening. This arrangement will not only provide the means for ADIs to hold sufficient liquidity to complete their payments throughout the evening, it also preserves the incentive for ADIs to participate in the interbank cash market while it is open, lending surplus balances or borrowing against a shortfall.

97 P a g e 97 We would expect the excess supply of ES balances to be much as it is now, around $1 billion above the sum of outstanding positions in open repos. Consequently, these operational changes will not alter the way in which the Bank implements monetary policy, as the operation of the cash market will be insulated from the structural increase in ES balances. This framework leaves us well placed to accommodate further innovations in the payments system in the coming years, such as the planned shift to 24/7 settlement for retail payments. One consequence of the new arrangements is that it will largely remove the need for an ES account holder to contract intraday repos with the Reserve Bank. For this reason, the Bank will allow all ADIs that operate ES accounts to contract open repos, not just those participating in the direct entry exchanges. Despite the operational changes the Bank is making, we nevertheless recognise that shifting a large quantity of payments activity to same-day settlement will complicate the task of liquidity managers. It is always difficult to forecast customers payments activity; this is not only true for ADIs, it is also true for the Reserve Bank. The size of the Reserve Bank s daily open market operations each morning are largely based on a forecast of that day s cash flows across the Australian Government s accounts with the Reserve Bank. Settling direct entry payments for same-day value will make it more difficult to forecast flows such as tax receipts. It may be that the Reserve Bank will need to conduct operations in the open market late in the day to address any unexpected payment flows and ensure the right amount of settlement funds are in the banking system to allow the cash market to function appropriately.

98 P a g e 98 In the past, the Bank has needed to resort to these second rounds of dealing only two or three times a year. Going forward, we anticipate that second rounds of dealing will be more frequent. Given this, we intend to formalise the arrangements for these operations, announcing at a set time each day whether further open market operations will be conducted and, if so, on what terms. Where there is a need for an operation, it will be important that there is active participation from ADIs. As with our regular open market operations, it will not be the Bank s aim to simply supply overnight funds to those individual institutions that are short, or absorb overnight funds from those that are long cash. That is what the interbank cash market is for. As I mentioned a minute ago, the Reserve Bank s operations are designed to put the appropriate amount of settlement funds in the system as a whole so that, in managing their individual ES accounts, ADIs will transact with each other at the cash rate target. I ll now turn to the Basel III liquidity reforms, which will be introduced in Australia from January As is well known, those ADIs to which APRA applies the Basel III liquidity standard will be required to hold enough high-quality liquid assets (HQLA) to withstand a 30-day period of stress. As is equally well known, with only Commonwealth Government Securities (CGS) and semi-government securities (semis) meeting the Basel criteria for HQLA in the domestic securities market, there will not be enough securities to enable ADIs to meet this liquidity standard. At the present time, ADIs own around $130 billion of these securities.

99 P a g e 99 A rough estimate would be that this is as much as $300 billion short of where they would need to be to meet the Basel standard, given their current balance sheet structures. Mostly, the ADIs holdings are in semis. These holdings of semis have increased almost tenfold since 2007, and now are around 40 per cent of the semi-government market. Our assessment is that ADIs aggregate holdings of HQLA are broadly appropriate to the current size of the market. This assessment was contained in a media release put out by APRA last week. Should the supply of these securities increase further, as is currently projected, we would expect that ADIs would raise their holdings in line with the increased supply. That said, it is not possible or desirable to be too precise about what is appropriate. The aim is to ensure that the markets for government securities continue to function well. We don t want to find out the hard way that ADIs are holding too large a share of the market. Compelling ADIs to hold the entire supply of government debt would be counterproductive for the liquidity of these markets. It would defeat the purpose of the liquidity standards which is for banks to hold liquid assets. Notwithstanding that fundamental issue, it would be difficult to actually engineer such an outcome. At some point, the scarcity of available securities would cause their yields to fall to a particularly low level.

100 P a g e 100 To some extent this is already the case with CGS, which generally trade in Australia at an expensive price compared to sovereign debt in other jurisdictions. If it was the case that the yields on both CGS and semis fell to a particularly low level, this would raise the demand for ES balances, given these balances are also HQLA. While the rate paid on surplus ES balances 25 basis points below the cash rate generally means that ADIs don t hold them as a store of liquidity, in the absence of sufficiently attractive alternatives, ADIs would inevitably use them to comply with the liquidity standard. Higher demand for ES balances need not be a problem in itself. However, it is important that it does not interfere with the Reserve Bank s ability to implement monetary policy. Within the Bank s framework, it would be quite problematic if the demand for ES balances varied to allow ADIs to comply with a liquidity standard, rather than with changes in their actual cash position. For this reason, in November 2010, the Reserve Bank Board approved the introduction of a committed liquidity facility (CLF) that is consistent with the arrangements for such facilities set out within the Basel standards. The facility was announced publicly the following month. The technical details of the CLF were worked out during 2011 in consultation with APRA and were announced publicly at the end of that year. There was then a public consultation process following APRA s announcement of the new liquidity arrangements that ran for three months. Put simply, for the payment of a fee, the CLF will commit the Reserve Bank to purchase eligible securities from ADIs under repurchase agreements.

101 P a g e 101 As the range of securities eligible to be sold to the Reserve Bank is considerably broader than just CGS and semis, it addresses the problem of there being insufficient securities for ADIs to hold that meet the Basel III standards. Subject to APRA s approval, an ADI will be able to use the Reserve Bank s commitment under the CLF to bridge the gap between its holdings of CGS and semis and the amount of HQLA required to meet the standard. When it comes into operation in January 2015, the CLF will work in exactly the same way as the Bank s existing liquidity facility. Indeed, the CLF is simply a means by which the Reserve Bank will make a contractual commitment to an ADI to provide funding under its liquidity facility. As is the case in commercial lending contracts more generally, the Bank s commitment under the CLF will be contingent on appropriate conditions being met, namely an assessment that the ADI continues to have positive net worth. As I have said, the CLF simply guarantees access to the Bank s existing liquidity facility, and ES account holders use this facility every day. At the present time, it is used almost exclusively for intraday funding; after November this year when DE payments are settled for same-day value, it will be used for open repos as well. From 2015, ADIs subject to the Basel III liquidity standards will only be able to use CGS and semis in the Bank s liquidity facility, unless they have paid the 15 basis points commitment fee for the CLF. In this way, any ES balances acquired from the Bank s liquidity facility will always represent the exchange of one liquid asset for another and cannot improve an ADI s compliance with the liquidity standard. The consequence of this is that small drawings on the CLF will be a routine event as part of normal operations to manage payment flows.

102 P a g e 102 Provided the funds are repaid same-day or, in the case of open repos, are retained in the ADI s ES account, there need be no cost to using the facility in this way. However, should the funds be used for any other purpose such that the balance on the account is below where it should be, the penalty will be 25 basis points above the cash rate target. Such a use of the CLF is likely to occur in more stressed circumstances. As I mentioned earlier, 25 basis points has long been the penalty rate attached to the Bank s liquidity facility and it is designed to discourage ADIs from relying upon the facility for funding purposes during normal times. In a stress scenario, of course, this penalty rate of 25 basis points may not appear so onerous. That is by design. In such circumstances, it is appropriate that the central bank provides liquidity support against suitable collateral. This principle of central banking dates back at least to Bagehot: lend against good collateral at a penalty rate but not a penal rate. The experience here in Australia over many years is that this penalty of 25 basis points has been sufficient to ensure that there has not been excessive use of the central bank s liquidity facility. The usage of this facility is published on the website with a small lag and recorded in the Bank s Annual Reports in the chapter on Operations in Financial Markets. Even in the stressed environment of 2008 and 2009, the facility was only drawn on a couple of times for small amounts, and for no longer than one day, to deal with unexpected payment flows.

103 P a g e 103 To put the rationale for the CLF another way, the purpose of holding liquid assets is to sell them during periods of stress. In the Australian context, this will mean using funds raised via the CLF. This need not be the last resort ; that is, after all other avenues have been exhausted. The point of liquidity regulations is to avoid fire sales of non-liquid assets and other actions that might have adverse effects on broader financial stability. Again, that a central bank should be prepared to play this role is nothing new. In this sense, the fee of 15 basis points that the Reserve Bank will apply to any commitments made under the CLF can be seen as a means of explicitly charging the large ADIs an appropriate price for a liquidity option they have always implicitly held. In thinking about the appropriateness of such a fee, it is important to remember that under the CLF, the Reserve Bank will only provide funding against the market value of an eligible security at the time the facility is accessed, not the market value at the time any commitment is established. Furthermore, the Bank will haircut the security s market value by as much as 25 per cent, depending on the type of security involved. So, taking account of the haircut, the effective cost of obtaining this liquidity can be considerably higher than the 25 basis point penalty combined with the annual 15 basis point commitment fee. Consequently, the CLF is only (and not completely) insuring an ADI against the liquidity risk on its securities. The credit and market risks attached to any securities remain with the ADI.

104 P a g e 104 As is the case with all repos contracted by the Reserve Bank, should the market value of a security decline, the Bank will require additional securities to be delivered to restore the original value of the repo. Similarly, should the credit quality of a security held by the Bank fall below a certain threshold, the ADI will be required to replace the security with one that meets the eligibility criteria. Deriving the precise value of such a liquidity option is not straightforward. Certainly, as acknowledged in the Basel standards, it is not appropriate to simply look at the yield differential between government bonds and other securities eligible for the CLF. That spread will largely reflect compensation for credit and other non-liquidity risks, as well as that part of the liquidity risk which the Bank is not insuring the Bank s haircut. The Bank is only interested in charging for the liquidity component. The credit spread should be retained by the party bearing the ongoing credit risk, the ADI in this case. For example, if we look at the spread between a threemonth bank bill and the expected cash rate, it is around 18 basis points currently. Before 2007, it was in the single digits. Much of this spread is credit risk which implies the liquidity component is small. While this spread rose considerably during the crisis and some of this reflected an increase in the liquidity premium, much of the increase was a result of heightened credit concerns, evidenced by the rise in CDS premia at the same time. Theoretically, some indication of the cost of hedging liquidity risk can be extracted from term repo rates on eligible securities.

105 P a g e 105 By way of illustration, since adopting its current haircut schedule for repos, the Reserve Bank has, through its open market operations, contracted one-month repos at an average premium of about 4 basis points above cash, while for a six-month repo the average premium is about 8 basis points over the expected cash rate. The CLF is effectively an option with a strike price set 25 basis points above the cash rate. Of course, during periods of stress, the cost of liquidity can rise significantly and it is the potential for this to occur that would give the option some value. Separate to any market-derived estimates, an equally important consideration in pricing the CLF was to maintain consistency with the rest of the Reserve Bank s operating framework and not compromise the Bank s ability to implement monetary policy. As I suggested earlier, it is likely that at least initially, the Bank will be making commitments under the CLF of around $300 billion; we will have a more precise indication of that figure after APRA completes the trial liquidity budgeting exercise that is currently underway. Instead of introducing a CLF and committing to fund assets, the Bank could have opted to purchase the assets ex ante, expanding the supply of ES balances, and the Bank s balance sheet, by $300 billion. That is, the liquidity provision could be provided for the whole system ex ante, rather than provided to an individual institution when required. Effectively, the CLF requires ADIs to pre-position the securities but retain them on their own balance sheet. The alternative approach would see the Reserve Bank s balance sheet increase by more than three times over. Such an outcome would not only jeopardise the functioning of the cash market and hence the implementation of domestic monetary policy, but also impair the functioning of domestic securities markets.

106 P a g e 106 Moreover, it would not be feasible for the Bank to conduct such large-scale asset purchases through its regular open-market operations. This would mean a large-scale purchase of domestic securities by the RBA, but there simply is not a large enough pool of such assets that the Reserve Bank is willing to hold on an outright basis. Hence, it would have meant a series of bilateral arrangements with ADIs along the lines of the open repo arrangements I discussed earlier, with self-securitised assets serving as the collateral. To implement monetary policy in such an environment, the price of accessing such an arrangement would have needed to be set so as not to create an incentive for ADIs to generate the required ES balances through other means. This is no different to the CLF. The purpose of establishing the CLF was to ensure that ES balances could continue to play their existing role in the Bank s operations. This means that ADIs seeking to raise their liquid asset holdings should, at the margin, prefer to use additional CGS, semis and/or an increased subscription to the CLF for this purpose instead of ES balances. Our assessment is that a CLF fee of 15 basis points should allow this to be the case. The pre-positioning of these securities, combined with the enhanced information requirements for asset-backed securities the Bank announced last year, will allow the Bank to make a much more detailed credit assessment of the securities. Consequently, the Bank will be able to more precisely assess the value of these securities at any point in time and will be able to reduce its use of ratings agencies. To conclude, over the next 18 months, there will be some significant developments in the Reserve Bank s balance sheet, resulting from some

107 P a g e 107 upcoming changes in the payments system and the commencement of the Committed Liquidity Facility. Both of these changes are being accommodated within the general framework for the implementation of monetary policy that has operated successfully in Australia for some considerable time. The payments system changes will see some increase in the size of the Reserve Bank s balance sheet, but no material change in either the risk or income derived from that balance sheet. The design of the CLF is very much in keeping with the Reserve Bank s (and other central bank s) provision of liquidity to the financial system. It should not result in any material change in the size of the Bank s balance sheet and has been structured to avoid a significant increase in the balance sheet that would have risked the effective functioning of domestic markets.

108 P a g e 108 Point of Sale disclosure in the insurance, banking and securities sectors - consultative report August 2013 Impotrant parts Point of Sale disclosure in the insurance, banking and securities sectors identifies and assesses differences and gaps in regulatory approaches to point of sale (POS) disclosure for investment and savings products across the insurance, banking and securities sectors. The report considers whether regulatory approaches to POS disclosure need to be further aligned across sectors, and it makes a number of recommendations, mainly to policymakers and supervisors, to assist them in considering, developing or modifying their POS disclosure regulations: 1. Jurisdictions should consider implementing a concise written or electronic POS disclosure document for the product sample identified in this report, taking into account the jurisdiction's regulatory regime. 2. The POS disclosure document should be provided to consumers free of charge, before the time of purchase. 3. A jurisdiction considering POS disclosure should consider requiring that a POS disclosure document disclose key characteristics including costs, risks and financial benefits or other features of a given product and any underlying or referenced assets, investments or indices, irrespective of the financial sector from which the products are derived. 4. The POS disclosure document should be clear, fair, not misleading and written in a plain language designed to be understandable by the consumer.

109 P a g e The POS disclosures should include the same type of information to facilitate comparison of competing products. 6. The POS disclosure document should be concise, set out key information about a product and may include, as appropriate, links or refer to other information. It should make clear that it does not provide exhaustive information. 7. Allocation of responsibility for preparing, making available and/or delivering the POS disclosure document should be clearly established, and the POS disclosure document should identify which entity is responsible for its content. 8. A jurisdiction considering POS disclosure should consider how to use its capabilities and powers to implement these POS recommendations, taking into account the jurisdiction's regulatory regime. Comments on this consultative report should be submitted by Friday 18 October 2013 by to baselcommittee@bis.org. Alternatively, comments may be sent by post to: Secretariat of the Joint Forum (BCBS Secretariat), Bank for International Settlements, CH-4002 Basel, Switzerland. All comments may be published on the websites of the Bank for International Settlements, IAIS and IOSCO unless a commenter specifically requests confidential treatment. Point of Sale disclosure in the insurance, banking and securities sectors Executive summary Background The mandate for this work related to point of sale disclosure in the insurance, banking and securities sectors was prompted by the Joint Forum s January 2010 Review of the Differentiated Nature and Scope of Financial Regulation.

110 P a g e 110 That report highlighted the fact that supervisory and regulatory standards for similar activities in different sectors, while at times appropriate, could pose risks to financial stability and create regulatory arbitrage opportunities. In particular, the report recommended that the Basel Committee on Banking Supervision ( BCBS ), the International Organization of Securities Commissions ( IOSCO ), and the International Association of Insurance Supervisors ( IAIS ) work together to develop cross-sectoral standards where appropriate so that similar rules and standards are applied to similar activities. The issue of different cross-sectoral approaches to regulation was later raised by IOSCO in its February 2011 report Principles on Point of Sale Disclosure ( IOSCO Report ). That report set out high level principles for disclosure of key information with specific relevance to collective investment schemes ( CIS ). It further touched on the impact of different cross-sectoral approaches to Point of Sale ( POS ) disclosure and encouraged further work by appropriate bodies on POS disclosure regarding products similar to CIS. In this context, the parent committees of the Joint Forum (the BCBS, IAIS, and IOSCO) mandated the Joint Forum to identify and assess differences and gaps in regulatory approaches to POS disclosure in relation to investment or savings products in the insurance, banking and securities sectors. The mandate requested that the group identify whether regulatory approaches to POS disclosure need to be further aligned across sectors, keeping in mind that differences in regulatory approaches can arise from legitimate differences in sectoral regulatory objectives as well as from differences in product features. Methodology The Joint Forum selected a sample of products in each of the insurance, banking and securities sectors that in the opinion of the Joint Forum and

111 P a g e 111 broadly confirmed by roundtable participants, compete with CIS for consumer savings or investments: structured notes, structured deposits, unit-linked life insurance, variable annuities and indexed annuities. This sample is not exhaustive and other products may also compete with CIS. The Joint Forum then identified differences in POS disclosure regimes across jurisdictions and among the sample products, considered the impact of those differences, and formulated recommendations for further action by IAIS, IOSCO and BCBS ( Parent Committees ). The elements of information which comprise POS disclosure (eg key product features, costs, risks), format requirements (eg document length, font size), and the sharing of responsibilities among producers6 and distributors including primary responsibility for the information s accuracy were analysed. Comprehensive disclosure documents required by law were considered: prospectus or general terms and conditions, as well as more abbreviated disclosure documents, such as a prospectus summary, encadré or a key investment information document. The regulatory obligations often associated with POS disclosure, such as filing and pre-approval obligations, plain language requirements, and liability imposed for material misstatements and omissions were also considered. Finally, jurisdictional disclosure requirements were analysed and compared via a mapping exercise, two roundtables (one in Europe and one in North America) attended by both industry and consumer representatives were held, and additional information was garnered through the contributions of Joint Forum members. Significant differences identified The Joint Forum identified key sectoral and inter-jurisdictional differences in POS disclosure requirements:

112 P a g e 112 The format of POS disclosure documents does not always facilitate comparison across products. The content of POS disclosure documents varies across products. Securities regulations in many jurisdictions are more likely to mandate or establish disclosure requirements for products in the sample. In some cases, this may require the submission to the regulator of disclosure material prior to sale to a consumer, while prior authorisation in the insurance and banking sectors is forbidden in some jurisdictions. In several jurisdictions, structured deposits have been identified as having less prescriptive POS disclosure requirements than those imposed on structured products that are subject to securities regulation. The Joint Forum did not identify a jurisdiction or sector with absolutely no POS disclosure requirements. However, regulatory approaches vary to a great extent being either more or less explicit with respect to disclosure requirements. In some instances, disclosure requirements are imposed only in general consumer protection laws. Certain market participants and consumer representatives who participated in the roundtables believe that certain objectives of POS disclosure documents should include the following: (i) key information about a product presented in a concise written manner including its risks and benefits or other features, (ii) plain language, and (iii) the same type of information to facilitate product comparisons by consumers. The Joint Forum however heard diverging views from certain other roundtable participants as to the necessary degree of sectoral harmonisation and in relation to the level of regulatory prescription that is advisable in order to encourage useful disclosure.

113 P a g e 113 Determining whether a specific model of regulation achieves its intended results, either from a consumer protection or prudential perspective is both a considerable challenge and outside the scope of the Joint Forum s mandate for this report. The Joint Forum has therefore focused its recommendations largely on the significant differences and objectives, which were identified above. What is important is the outcome, not necessarily the method by which the outcome is achieved. Recommendations The Joint Forum has identified a number of key recommendations for use mainly by policymakers and supervisors, which are intended to assist them in considering, developing or modifying POS disclosure regulations. The Parent Committees may also wish to consider whether some of the recommendations may be relevant to their work as standard setters. Although the recommendations focus on POS disclosure, it is important to note that a strong consumer protection regime consists of many elements. Recommendation 1: Jurisdictions should consider implementing a concise written or electronic POS disclosure document for the product sample identified in this report, taking into account the jurisdiction s regulatory regime. Recommendation 2: The POS disclosure document should be provided11 to consumers free of charge, before the time of purchase. Recommendation 3: A jurisdiction considering POS disclosure should consider requiring that a POS disclosure document disclose key characteristics including costs, risks and financial benefits or other features of a given product and any underlying or referenced assets, investments or indices, irrespective of the financial sector from which the products are derived.

114 P a g e 114 Recommendation 4: The POS disclosure document should be clear, fair, not misleading and written in a plain language designed to be understandable by the consumer. Recommendation 5: The POS disclosures should include the same type of information to facilitate comparison of competing products. Recommendation 6: The POS disclosure document should be concise, set out key information about a product and may include, as appropriate, links or refer to other information. It should make clear that it does not provide exhaustive information. Recommendation 7: Allocation of responsibility for preparing, making available and/or delivering the POS disclosure document should be clearly established, and the POS disclosure document should identify which entity is responsible for its content. Recommendation 8: A jurisdiction considering POS disclosure should consider how to use its capabilities and powers to implement these POS recommendations, taking into account the jurisdiction s regulatory regime. Implementation: There are numerous ways to implement a POS disclosure regime. The above recommendations have been developed with the goal of enhancing consumer protection by providing guidance to regulators/supervisors and Parent Committees that are considering developing or reviewing their POS disclosure requirements. These recommendations are intended to allow for a wide range of application and adaptation in different jurisdictions.

115 P a g e 115 Reasons for action Consumer protection A continuing desire by the Joint Forum to consider the state of the market for retail investment products and of potential gaps in consumer protection leads to an examination of POS disclosure regimes. A wide range of products sold to consumers are often subject to different product disclosure requirements. From a consumer protection perspective, some products, such as CIS products, generally are more highly regulated while others are less so. The degree of regulation may vary as a function of the product's legal structure and of its specificities, and may diverge not only across Joint Forum member jurisdictions, but also across the range of product types within many jurisdictions. Although most products considered by the Joint Forum that are offered to consumers are covered by some basic disclosure regulation, the differences in requirements may contribute to the inability of consumers to properly compare products when deciding which product to purchase. Potential gaps in regulation also may create opportunities for regulatory arbitrage. Traditional product producers also compete with market participants that are less regulated or in some instances not regulated at all in some jurisdictions. These unregulated participants and/or products may at times emerge on the market without having to conform to the same level of regulatory requirements, thereby heightening the risk of misselling and consumer confusion. The Joint Forum wishes to stress that POS disclosure is not a cure-all in the area of consumer protection.

116 P a g e 116 Even if armed with clear and relevant POS disclosure, consumers may nevertheless encounter misleading or high-pressure sales tactics aimed at inducing inappropriate transactions. The availability of clear and accurate disclosure should not relieve financial services salespersons of their other sales practice obligations, or result in a caveat emptor oversight standard in which the appropriateness or suitability of a salesperson s recommendation is rendered less important or relevant. Instead, the Joint Forum notes that good POS disclosure is only one possible aspect of a strong consumer protection regime. Prior reports In addition to the potential consumer protection gaps discussed above, the Joint Forum s mandate to undertake this project emanated from questions and concerns identified in several prior reports. First, the Joint Forum s January 2010 Review of the Differentiated Nature and Scope of Financial Regulation highlighted that different supervisory and regulatory standards set by sectors for similar activities, while at times appropriate, could pose risks to financial stability and create regulatory arbitrage opportunities. In particular, the report recommended that the BCBS, IOSCO and the IAIS work together to develop common cross-sectoral standards where appropriate so that similar rules and standards are applied to similar activities. Second, the issue of different cross-sectoral approaches to regulation was raised subsequently by IOSCO in its February 2011 repor. That report has set out six high level principles for disclosure of key information for retail consumers with specific relevance to CIS. It further touched on the impact of different cross-sectoral approaches to POS disclosure.

117 P a g e 117 It has noted specific industry concern that enhanced POS disclosure requirements for CIS products may place those products at a competitive disadvantage relative to other financial products that are subject to less stringent requirements. IOSCO encouraged further work by appropriate bodies on POS disclosure regarding products similar to CIS. It has also encouraged supervisors to review conditions within their jurisdiction and, where possible, consider the adoption of the six principles to products similar to CIS (refer to Annex 1). Sectoral principles on POS disclosure Several financial products are covered by international regulatory principles recommending sound practices regarding information disclosures provided to consumers. These principles are the IOSCO CIS Principles (Principle 4), the IAIS Core Principles (especially ICP ) and the G20 High Level Principles on Financial Consumer Protection (Principle 4). Moreover, there are also international principles being considered relating to the delivery of the information to the consumer including the timing of disclosure. These principles are the IOSCO CIS Principles (Principles 2 and 3), the IAIS Core Principles (in particular ICP 19.5 and its related guidance). The Joint Forum s efforts were also guided by certain basic considerations regarding the nature and effect of POS disclosure as explicitly set forth in its mandate for this work: Disclosure standards and requirements particularly those at the point of sale are important regulatory tools in promoting consumer protection by enhancing transparency in financial products/markets. Robust disclosure regimes which provide information in a form consumers (ie, deposit holders, policy holders, investors) can use

118 P a g e 118 practically focussed on clear, unbiased communication of key information serve to reduce the information asymmetries which exist between product issuers and consumers, empowering the latter to make better-informed decisions about their investments. They also foster greater comparability (especially given an increasing number of products being distributed on an international basis), making it easier for consumers to choose between different products irrespective of their domicile. In particular when products are very similar, inconsistent sectoral approaches to disclosure can pose risks to these regulatory objectives, including consumer protection While the Joint Forum s mandate included identifying whether regulatory approaches to POS disclosure need to be further aligned across sectors, the Joint Forum recognises that there will still be differences among applicable regulators, and that differences in regulatory approaches can arise from differences in sectoral regulatory objectives and differences in product features and terminology. The term POS disclosure document, when used in this report, refers to a summary disclosure of the main or key information relating to the product, whether prepared separately or as part of a more comprehensive disclosure document. Thus, broadly speaking, the term POS disclosure as used in this report refers to disclosure of key information to consumers relating to products and their distribution both prior to or at the point of sale. Additional considerations Additional considerations were based on the experience of Joint Forum members who expected variations in POS disclosure regimes for participating jurisdictions. In part, this expectation was based on the awareness of the breadth of supervisory systems and practices in participating jurisdictions.

119 P a g e 119 For instance, because product regulation often follows a sectoral approach (for example, with securities supervisors responsible for CIS and securities, banking supervisors overseeing structured deposits and insurance supervisors overseeing unit-linked life insurance products), a certain difference in approach seems inevitable without explicit efforts at coordinating between sectoral supervisors. Even for jurisdictions following a twin-peaks approach, in which prudential oversight is housed in one regulator, although consumer protection is the explicit responsibility of another supervisor, differences between product disclosure regulations can occur, in some cases, because of product specificities. Also, historical supervisory approaches or the reliance on other documents widely used in the sector can engender different regulatory outcomes. Methodology Mapping exercise The Joint Forum conducted a mapping exercise engaging members of the Joint Forum, members of the IOSCO Standing Committee on Investment Management and members of the IAIS Market Conduct Subcommittee. In total, regulators responded to the questionnaire. The Joint Forum received eight responses from banking regulators, 10 from insurance regulators and eight from securities regulators. The objective of the mapping exercise was to solicit input regarding the sample of products identified, and to answer a broad range of questions regarding their regulation. However as the mandate focuses on products that compete with CIS for consumer savings, the mapping exercise primarily addressed disclosures associated with products rather than those associated with distributors, such as conflicts of interest or compensation schemes.

120 P a g e 120 The mapping questionnaire dealt with three topics: The scope of the Joint Forum s inquiry; The regulatory product disclosure document; and The marketing materials. Roundtables In addition to the mapping exercise, two hearings/roundtables were organised in Paris and Toronto; the former to obtain the views primarily of European representatives and the latter to obtain the views primarily of North American and Asian representatives. Thirty-five representatives of industry (including the insurance, banking and securities industries and their counsel) and five consumer representatives (including associations and university professors) participated in the roundtables. One of the main considerations of the Joint Forum in the organisation of the roundtables was to ensure adequate participation of consumer representatives. Due to their sometimes limited financial resources, consumer representatives may not always have the same level of visibility as industry representatives. Nevertheless, as noted above, five consumer representatives were able to attend the roundtables. To ensure that their participation was as valuable as possible, during the roundtable the Working Group particularly encouraged their full participation and directly solicited their response to opinions expressed by industry representatives.

121 P a g e 121 III. Scope As discussed in Section II, the Joint Forum focused its efforts on differences in POS disclosure regimes for a sample of retail products competing with CIS for consumer savings. All products sold with the objective of attracting consumer savings could have been in the scope of this initiative. However, a manageable list of competing products needed to be created for purposes of the mapping exercise. Accordingly, one of the first steps was to identify, in participating member jurisdictions, a sample of competing products. In identifying the sample, one of the difficulties faced by members was that product terminology and structure differs from one jurisdiction to another. For example, the characteristics and terminology associated with some insurance products varied considerably from jurisdiction to jurisdiction. As a result, the Joint Forum had to choose simplified definitions for purposes of the sample that are not common to all member jurisdictions. These definitions are for purposes of this report only and do not override any national or international product definitions. Characteristics of CIS CIS are a form of collective investment vehicle that raises money from consumers to invest it following a specific formalised and disclosed investment strategy. In order to create the sample of products competing with CIS and to conduct its analysis, the Joint Forum started by identifying the main characteristics of CIS that would be found in these competing products.

122 P a g e 122 The Joint Forum considered the most common characteristics of CIS offered to consumers in member jurisdictions. Consumer assets are pooled by the CIS and invested in other securities or assets. For example, in most cases CIS expose consumers to the possibility of a variable return. The return often depends on the performance of other securities or assets, such as a stock market index, or a basket of securities or other assets. Furthermore, CIS are nearly always packaged or manufactured products, in that consumers never hold the underlying assets of the CIS (eg stocks, bonds) directly, as they might do with common shares. The packaging of CIS can include methods such as wrapping or bundling together a number of CIS s or other assets to create different degrees of exposure, product features and cost structures. Sometimes the product holding the underlying assets is also referred to as the wrapper. Finally, even though some CIS provide a degree of capital protection, for purposes of this report the Joint Forum considered that unlike pure insurance risk products where there is no investment aspect a key objective of a CIS is its investment return. Sample of products which compete with CIS In line with the mandate, the Joint Forum concentrated on products from the banking, securities and insurance sectors, and focused on the products that both broadly share the characteristics identified above and that are, in the Joint Forum s opinion, most commonly offered as an alternative to, or in competition with, CIS. There are many products that may serve as alternatives to CIS for consumer savings, which have not been included in the sample.

123 P a g e 123 For example, a consumer seeking exposure to the bond market may be offered the direct purchase of plain vanilla corporate bonds rather than a CIS. However, as plain vanilla corporate bonds are not packaged, but are instead held directly, they were excluded from the sample. Similarly, a risk-averse consumer may be offered a fixed term deposit (which may be covered by a national deposit insurance scheme) or a non-insured CIS money-market fund. However, as the primary characteristic of a fixed term deposit is its stable return and guaranteed return, where applicable, rather than market exposure, these were also excluded from the sample. Finally, although the Joint Forum considered products with the main objective of insuring consumers against a particular event (eg term life, death, illness or disability insurance), these were excluded because the focus is on the product s risk insurance component and/or the return is generally not linked to market results. Many roundtable participants, Joint Forum members and mapping exercise respondents, identified products or asset classes that shared one or more characteristics with CIS and that were either offered as an alternative through financial services firms, or as a physical asset (eg gold coins advertised as an investment) and competed with CIS for consumer savings. Nevertheless, the broadly consistent reaction from both industry participants and consumer representatives was that the products identified in the sample were an appropriate cross-sectoral selection of retail products most often competing with CIS for consumer savings. Roundtable participants also emphasised the importance of avoiding an uneven playing field between highly regulated products and less regulated products. The chosen sample is not a suggestion that other products do not compete with CIS or share some of their characteristics.

124 P a g e 124 It simply reflects the constraints of the Joint Forum s mandate and the practical considerations of how best to fulfil that mandate. However, as discussed in more detail below, many of this report s recommendations could be applicable to products beyond those in the sample. That is, although this report makes no recommendations beyond the scope of the sample products, supervisors could decide to apply some or all of the report s recommendations to products beyond the sample to the extent that their application would be appropriate or beneficial. Finally, while this report makes no such recommendation, the Joint Forum notes that all the consumer representatives and some industry representatives recommended basic written disclosure requirements for non-packaged products which, although they are not included in the sample, may compete with CIS for consumer savings. For example, required information on such products could include the specific characteristics of such products, including costs, implied guarantees, financial benefits, liquidity and related risks, interest rates and redemption rights. Definition of the products in the sample In light of the above considerations, the following products were selected for the sample. As noted above, defining these products is sometimes challenging because product terminologies and definitions vary across jurisdictions. Accordingly, the definitions below are for the purposes of this report only and do not override any national or other international product definitions. Insurance contract with a strong investment component refers to any insurance product18 that includes an investment component that is

125 P a g e 125 expected to provide a variable rate of return and where the consumer does not hold the underlying investments or assets directly. These include the products which follow. Unit-linked and index-linked insurance contracts are insurance contracts where benefits are wholly or partly determined by reference to the value of, or the income from, property or assets of any description (whether or not specified in the contract) or by reference to fluctuations in, or in an index of, the value of property or assets of any description (whether or not specified). Fixed index annuities are insurance contracts, where the investor purchases an insured contract where the credited interest rate is tied to the growth of a major stock market index. Variable annuities (VAs) are unit-linked insurance contracts with investment guarantees, which allow the policyholder to benefit from the upside of when the unit increases in value but be partially or totally protected when the unit loses value. Guarantees entailed in VAs can vary considerably and imply an increase of risks for insurers relative to pure (non-guaranteed) unit-linked products. The existence of various forms of guarantees might be helpful in classifying unit-linked products as VAs. Certificates/Structured notes are debt obligations of the issuer usually an investment bank, in which payments are based on the performance of various asset classes such as single security, baskets of securities, commodities, currencies or indices, etc. Structured deposits or variable rate certificates of deposit or market linked certificates of deposit are deposits with interest rates derived from or based on a single security, a basket of securities, an index, a commodity, debt insurance and/or a foreign currency.

126 P a g e 126 In simpler terms, a structured deposit is essentially a contract between the investor and the issuer, usually a bank, which promises to repay capital at a certain time plus interest based on a formula. Most of the time, only banks are permitted to issue deposits. The table below presents the generalised key characteristics, combinations of which can typically be found in each of the sample products. Regulatory Overview and Analysis The mapping exercise and the roundtables provided a significant amount of information that has been categorised into four parts for analysis: whether or not POS disclosure documents are required in general, the format and language of POS disclosure documents, the content of POS disclosure documents, and whether or not prior approval is required for the documents by the supervisory authority and whose responsibility it is to provide POS disclosure documents to consumers. In each case, the Joint Forum focused on cross-sectoral differences rather than differences between jurisdictions.

127 P a g e 127 Information was also collected on regulatory considerations and discussions that have not yet been put into law but are currently being discussed. Summary of responses of the mapping exercise As mentioned in the section above on methodology, 16 regulators responded to the mapping questionnaire20 (15 of which are Joint Forum members). The results are not considered as an exhaustive study. However, in spite of this limited sample, many differences in POS disclosure across products whatever the jurisdictions can be observed. Discussions of the questions asked and the participants responses are presented in more detail further below however in summary the mapping exercise revealed a variety of regulatory approaches: In Australia, the regulatory framework requires that retail consumers be given a clear, concise and effective product disclosure statement for all financial products, regardless of sector. In Europe, UCITS directive, Prospectus Directive, MiFID Directive, Insurance Mediation Directive and Solvency II require the producer or the distributor to disclose information to consumers. All these directives have a sectoral approach so they use their own vocabulary and terminology. For structured deposits, at this stage, no specific European legislation requires the producer or the distributor to disclose information. In certain European jurisdictions, general consumer regulation is also applied to structured deposits. In Japan, as a means of protecting consumers, the same level of investor protection is applied to products and transactions with the same economic characteristics. The Japanese regulation obligates the delivery of documents in a written format before finalising a contract.

128 P a g e 128 Québec s insurance and deposit-taking institutions regimes have requirements to deliver key information at point of sale. It takes the form of a disclosure document (named the information folder ) describing the product and includes a summary information document (named Fund Facts ) for insurance, and a synopsis to be delivered both orally and in writing by deposit-taking institutions. In the United States, sectoral regulation, depending on the type of offering and product, mandates the disclosure of certain minimum information with details of the disclosure differing for each sector. In South Africa, different levels of minimum disclosure requirements apply to product producers in different sectors, while distributors (advisers and intermediaries) are required to comply with detailed, prescribed disclosure obligations regardless of the type of product they recommend. These disclosure obligations are particularly rigorous for any product with an investment component. Summary of responses from consumers expressed at the roundtables During the roundtables, most consumer representatives favoured the use of a short document with common content that focuses only on key information, in language a consumer can understand. Consumer representatives also consistently expressed the view that disclosure made at the POS should permit consumers to more easily compare similar product offerings. Several consumer representatives questioned whether consumers would even contemplate comparing products if the disclosures appeared and/or were named differently. These representatives suggested that the ability for consumers to compare basic information for products across sectors could be particularly useful where banks, insurance companies, or other financial

129 P a g e 129 services providers offer products with different disclosure requirements, such as unit-linked insurance, CIS, structured notes or structured deposits. Accordingly, for products that are not yet subject to POS disclosure requirements it could be helpful to introduce at least broad regulatory disclosure recommendations that foster comparability of basic information. They also suggested that regulation could be more effective in terms of consumer protection if the industry was subject to consistent rules for product disclosure for all products offered to consumers. They noted that this could help reduce an additional source of complexity for consumers and could be less costly for the industry. In addition, all consumer representatives expressed a need for a short document or a short summary document with common content, which enables consumers to compare products without unnecessary, unclear, or too difficult to understand information. While the roundtable participants generally agreed with the sample of products identified by the Working Group as competing with CIS, they also emphasised that it is important to avoid an uneven playing field between highly regulated products and less regulated products. Current POS disclosure document requirements One of the main goals of the mapping exercise was to identify for the sample of products whether or not there is a regulatory obligation for some form of written disclosure document be provided to persons purchasing or considering the purchase of a product. This disclosure could be either a comprehensive regulatory document such as a prospectus that describes the product, or an abbreviated summary information document (with key information for consumers, summary of the prospectus, etc).

130 P a g e 130 Even though there is no common POS disclosure document required for all sectors, there seems to be a relatively broad requirement in the surveyed jurisdictions that some basic level of information for all sample products is disclosed to consumers. The mapping exercise revealed no product in the sample, for which no disclosure was required across all participating jurisdictions at all. However, it may not always be required that such disclosures be in writing or documented. In addition, the disclosure requirement is sometimes contained in sectoral regulation (ie required by banking, insurance or securities supervisors) and sometimes mandated by broader consumer regulation requirements covering all goods and services. In many jurisdictions a POS disclosure document is provided or is available to the consumer before or at the time of the purchase of a product. In many cases, the document is provided or is available in an electronic manner (internet or ) and a paper copy is sent or provided to the consumer on request. In some countries the POS disclosure document is provided in written, hard copy format and/or electronically on request of the consumer.

131 P a g e 131 Consumer representatives pointed out at the roundtables that when a disclosure document is required, the name of the document currently varies depending on the nature of the product and the jurisdiction or sector requiring the disclosure. While each jurisdiction may have different names, names used include a summary of the prospectus, a key information document, an information folder, or a notice for insurance products. The results of the mapping exercise, the roundtables and discussions among the Joint Forum s members, revealed that it is important for regulators to consider, whenever appropriate, POS disclosure requirements and that it is generally helpful for consumers to receive a concise POS disclosure document that provides key information relating to the product, whether separate or as part of a more comprehensive disclosure document.

132 P a g e 132 Credit Valuation Adjustment This letter that clarifies the application of the Credit Valuation Adjustment (CVA) capital charge in Chapter 4 of the Capital Adequacy Requirements guideline and the treatment of market risk hedges used for the purposes of mitigating CVA risk. These changes will be reflected in the next revision of the CAR guideline. In the interim, the annex of this letter will reflect the new CVA methodology. To: Banks, Bank Holding Companies, Federally Regulated Trust and Loan Companies Subject: CVA Grandfathering and Market Risk Hedges This letter clarifies the application of the Credit Valuation Adjustment (CVA) capital charge in Chapter 4 of the Capital Adequacy Requirements (CAR) guideline. As specified in the CAR Guideline, the CVA capital charge will take effect as of January 1, To ensure an implementation similar to that in other countries, the CVA capital charge will be phased in over a five year period beginning in 2014 according to either Option 1 or Option 2 discussed in the annex to this letter. OSFI would also like to clarify that, although market risk hedges of CVA are not recognized in the CVA capital charge, market risk hedges of CVA used for the purposes of mitigating CVA risk, and managed as such, are exempt from market risk capital requirements. All of these changes will be reflected in the next revision of the CAR guideline. In the interim, the annex of this letter will reflect the new CVA methodology.

133 P a g e 133 Questions concerning the calculation of CVA RWA or the treatment of market risk hedges of CVA should be addressed to Patrick Tobin, Capital Division, at (613) , or by at Patrick.Tobin@osfi-bsif.gc.ca. Sincerely, Mark Zelmer Assistant Superintendent Regulation Sector Annex Deposit Taking Institutions (DTIs) must choose one of two possible options for calculating CVA RWA for purposes of calculating the CET 1, Tier 1 and Total capital ratios during the period starting on January 1st 2014 and ending on December 31st, Option 1 CET 1 Ratio = CET 1 capital/cet 1 Capital RWA Tier 1 Ratio = Tier 1 Capital/Tier 1 Capital RWA Total Ratio = Total Capital/Total Capital RWA Where: CET 1 Capital RWA = RWA (Non-CVA) + RWA (CVA) * CET 1 scalar Tier 1 Capital RWA = RWA (Non-CVA) + RWA (CVA) * Tier 1 scalar Total Capital RWA = RWA (Non-CVA) + RWA (CVA) * Total scalar The values for CET 1 scalar, Tier 1 scalar and Total scalar vary by year and can be found in Table 1 below.

134 P a g e 134 In the years after 2019, the scalar of 1.00 will be applied (i.e. no modification to the CAR Guideline Rules). Option 2 CET 1 Ratio = CET 1 capital/total Capital RWA Tier 1 Ratio = Tier 1 Capital/ Total Capital RWA Total Ratio = Total Capital/ Total Capital RWA Where, Total Capital RWA = RWA (Non-CVA) + RWA (CVA) * Total scalar

135 P a g e 135 Systemic risks of shadow banking Speech by Dr Andreas Dombret, Member of the Executive Board of the Deutsche Bundesbank, at the Salzburg Global Seminar Out of the shadows: should non-banking financial institutions be regulated?, Salzburg. When talking about shadow banking we should be clear what we mean. I subscribe to the FSB s definition of credit intermediation involving entities and activities outside the regular banking system. What I deem to be relevant from my financial stability perspective is that such entities create bank-like risk without being subject to banking regulation. Obviously, the non-banking financial sector is composed of a very heterogeneous set of agents. Some of them such as insurance corporations and pension funds usually have very long-term investment horizons and can therefore potentially serve as a stabilising element for the financial system. To be clear on this point: I firmly believe that insurance corporations can be systemically important institutions, too. Thus, effective resolution regimes for Global Systemically Important Insurance corporations need to be developed and implemented. The overall effects of the so-called shadow banking system and its activities on financial stability are ambiguous. Theoretically, non-banking financial institutions that perform banklike activities are associated with diversification and specialization benefits.

136 P a g e 136 Therefore, it could be assumed that they contribute to efficiency gains and greater financial system resilience. However, empirical evidence from the financial crisis suggests that the activities of shadow banking entities might often be driven by the motive of exploiting regulatory arbitrage. Altogether, the economically beneficial attributes and systemically stabilising effects of entities and activities of the shadow banking system are not always that obvious. In particular, developments prior to the financial crisis revealed that the activities and entities of the shadow banking system can also pose a threat to the stability of the financial system as a whole. The risks inherent in the shadow banking system pertain to both dimensions of systemic risk: The cross-sectional (interconnectedness) dimension as well as the time-serial (procyclicality) dimension. I see these potential threats as being caused mostly by maturity and liquidity transformation, the build-up of leverage and credit risk transfer conducted by the shadow banking system. All of those activities are not evil per se, but the ensuing systemic risks need to be contained. All activities must be made transparent, in particular vis-à-vis supervisory authorities, and they must be adequately regulated. In that regard, I welcome the global regulatory initiative on shadow banking under the leadership of the FSB and I am closely following initiatives at the regional and national level. I want to comment on three specific aspects of the systemic risk posed by shadow banking: First, the risk of runs on money market funds (MMFs);

137 P a g e 137 Second, the potential procyclicality of securities financing transactions; Third, the linkages between banks and shadow banking entities. Regarding money market funds liquidity risk: due to their perceived deposit-likeliness, constant net asset value MMFs face a relatively high risk of investor runs in times of crisis. Thus, the mandatory move to variable net asset value MMFs might be the single most important regulatory action to make the MMF segment more stable. I expect the European Commission to implement that move in Europe soon in line with the ESRB s recommendation of December It was with keen interest that I also observed the recent proposal by the US Securities and Exchange Commission to adopt similar measures. Regarding securities financing transactions: In an environment of ample liquidity, securities financing transactions can obviously contribute to a procyclical build-up of leverage in the financial system. Going one step further in a typical chain of transactions, the practice of collateral re-hypothecation intensifies interconnections in the financial system, while at the same time lacking the necessary transparency for clients and supervisors. Therefore, I support the recommendations envisaged at global level to increase regulatory reporting and public disclosure requirements for financial institutions securities financing activities. With the results of thoroughly conducted impact assessments at hand, the imposition of somewhat tougher regulatory measures, such as minimum standards for calculating collateral haircuts, can be considered. The last issue I want to cover are the interconnections between banks and entities of the shadow banking system. With the global implementation of Basel III capital and liquidity

138 P a g e 138 requirements for the banking sector, there are increasing incentives to shift risky activities to shadow banking entities, where regulation is less stringent. However, such regulatory arbitrage poses risks to the stability of the entire financial system. To effectively regulate the direct ownership links between banks and shadow banking institutions, the scope of regulatory consolidation needs to be internationally harmonised. Also, minority participations of banks, such as investments in the equity of funds belonging to the shadow banking system, require an internationally consistent, risk-sensitive application of Basel capital standards. And, last but not least, large exposures of banks vis-à-vis counterparties of the shadow banking system need to be adequately measured and controlled by looking through complex investment structures. Finally, the effectiveness of regulatory requirements with regard to shadow banking must be constantly assessed and their implementation should be peer reviewed at the global level. As outlined, addressing the liquidity risk of money market funds, procyclical credit expansion via securitised financing, and interconnections between banks and shadow banks are key regulatory reforms. Adequately regulated, it should be possible to effectively mitigate systemic risks posed by such non-banking financial institutions and enable them to affect financial stability more positively.

139 P a g e 139 Global Consistency in Financial Regulation: Is the glass half full, half empty, or just more transparent? Remarks by Wayne Byres, Secretary General, Basel Committee on Banking Supervision, at the RiskMinds Risk and Regulation Forum, Nice, France3 Thank you very much for the opportunity to speak this morning on what is a very important, and much discussed, topic. I would usually describe bankers as 'glass half full' people, and regulators as their 'glass half empty' counterparts. To take an obvious example, where banks might first see opportunity for reward, regulators will first see exposure to risk. The two perspectives are, of course, just different sides of the same coin. But they are perspectives that define and create the healthy tension in the bank/regulator relationship. When it comes to recent regulatory reforms, though, I find the situation strangely reversed - bankers are somewhat despondent, lamenting gaps and inconsistencies, while regulators are focusing on the good and steady progress that has been made. We are looking at the same objective facts, so when it comes to the consistency in the implementation of global regulatory reforms, should we see the glass as half full or half empty? And what is our benchmark when we say that things are getting better or worse? When we look at prudential and regulatory outcomes, how much of any problem is caused by regulators, and how much stems from banks themselves?

140 P a g e 140 I plan to offer some thoughts on these questions in my remarks this morning. The steady path to increasing cross-border consistency in financial regulation This year marks the 25th birthday of the first Basel Capital Accord. Since its delivery, there has been a continuous effort to improve and enhance global policy-making and coordination. In more recent years, the work of the Basel Committee and other international standard-setters has produced a large number of agreements on a wide range of issues. It is something of a pity that it took a global financial crisis to deliver, for example, the world's first global liquidity standard for banks, but we now have one where there was nothing previously, and that is a big step forward on the path to increased consistency in financial regulation. The quest for consistency does not, however, imply the eventual development of a single global rulebook that can be applied without exception to all activities of all banks in all jurisdictions at all times. National differences in financial regulation continue to exist, and many of them are there for very good reasons. We therefore need to think carefully about our benchmark for any report card on global consistency - if we aspire to complete and absolute consistency in all cases, we will inevitably be disappointed. For many this will be self-evident, but it is worth listing a few of the key benefits that consistent cross-border financial regulation can offer to society (and note that it is the benefits to society, and not to banks per se, for whom the benefits need to be measured). For example: - most obviously, it promotes global financial stability

141 P a g e it supports cross-border trade, by promoting international financial markets to match those in goods and services - it improves the efficiency of capital allocation, by allowing capital to flow more readily across national boundaries to find its most productive use - it facilitates more competitive financial markets, allowing consumers and investors access to the greatest range of financial services at the lowest cost. Of course, there can also be reasons why complete harmonisation would be sub-optimal: - national financial systems are at different stages of economic development, and may need differences in regulatory and supervisory approaches even if their financial stability objectives are the same - financial regulation does not exist in isolation, and needs to be blended with national tax, accounting and legal frameworks, amongst others, to achieve appropriate outcomes; and - it would not provide room for macro-prudential (or micro-prudential) adjustments to regulatory requirements to deal with vulnerabilities and risks arising from the different stages of business and financial cycles in individual jurisdictions. Furthermore, international standards such as those produced by the Basel Committee are typically minimum standards. It has never been the Committee's goal to try to constrain national authorities who want to go beyond the internationally agreed minimums for their own domestic reasons. So there are clearly limits to the complete harmonisation of regulation. Over the past few decades, however, as banking and finance have become more global, the balance has shifted in favour of increased cross-border consistency to support the benefits that global financial markets can offer to society.

142 P a g e 142 And in a world in which, more recently, there has been legitimate concern about fragmentation, it is robust and consistently-applied international standards that provide the means by which fragmentation can be resisted. That does not mean the task of international policy-making is getting any easier. The challenge can be no better demonstrated than by looking at recent correspondence to the Basel Committee. I recently received a letter from a prominent industry association, claiming that divergences in national regulation are on the increase, and that the Basel Committee, along with other international bodies, must do more to force convergence. Yet, as we publicly consult on regulatory proposals, a phrase that often appears in the submissions we receive is "one size doesn't fit all", usually accompanied by a request that Basel proposals grant more flexibility to account for domestic specificities. The more amusing requests manage to combine both - these boil down to 'I want consistency, as long as everyone does it my way.' Let me assure you that within the Basel Committee, as well as in other international groups that I participate in, the commitment is undiminished to developing robust standards that can be implemented consistently across major markets. International policy-making is not easy, and proposals simply don't get off the ground without a strong buy-in from everyone at the table. The fact that all international groups continue to have active agendas should be taken as a clear sign that the momentum for internationally-consistent financial regulation remains strong. If we look simply at what Basel III has done to promote greater cross-border consistency, we have made some major steps forward: Beyond the primary objective of strengthening bank capital, Basel III also included important measures to improve the consistency of bank

143 P a g e 143 capital measurement (eg by standardising deductions made from banks' capital bases) and disclosure. Before the crisis, some jurisdictions operated with leverage ratios, some did not, and accounting differences clouded what reporting there was of bank leverage. Now we are working towards a consistent definition, and minimum requirement, against which bank leverage can be monitored and compared. As with capital, these will be accompanied by standardised minimum disclosure requirements. Almost all jurisdictions had some form of short-term liquidity requirement, and some also had a structural funding measure. The only consistent thing was that all were different. In the Liquidity Coverage Ratio and the Net Stable Funding Ratio, we will have agreed standard measures and disclosures that will apply to banks in all key markets. Beyond Basel III, the regulatory community has also agreed, or is working towards: - an internationally agreed framework for dealing with global systemically important banks, an agreed set of principles for domestic SIBs, and an emerging framework for systemically important insurers - principles for financial market infrastructure, designed to promote the safe and efficient operation of FMIs - international agreement on the key attributes for resolution frameworks - standardised margin requirements for non-cleared OTC derivatives - internationally agreed minimum haircuts for repos

144 P a g e consistent large exposure limits - improved disclosure requirements, designed to provide more meaningful and comparable information to key stakeholders. All of these initiatives are greatly strengthening the global consistency of financial regulation. Greater focus on consistent implementation of global standards I don't think there is any disagreement that international policymakers have been busy. If there is, I hope that list dispels the idea. But - and I hear this regularly - that may be all well and good: what really counts is whether global agreements are being faithfully implemented in national regulations. That message is well understood. Indeed, it is why, for example, every communiqué from the G20 Leaders since 2009 has stressed the importance of implementing internationally agreed reforms; more recently, the G20 Leaders have regularly endorsed the full, timely and consistent implementation of Basel III. And it is why the post-crisis role of standard-setting bodies is changing. That is, standard setters are tasked not only with forging agreement on international standards, but also with actively monitoring their implementation - a very important new mandate. In the case of the Basel Committee, this is being done in a number of ways through its Regulatory Consistency Assessment Programme (RCAP). First, there are our simple semi-annual reports showing how jurisdictions are tracking relative to the agreed implementation timetable for Basel III. Even this simple device has had positive effect;

145 P a g e 145 I know of a number of examples where the imminent release of another Basel Committee 'report card' has caused national regulators to make sure they moved forward with the next step of their rule-making process so as to be seen to be making progress. More substantially, the Committee has established a programme of peer assessments of national regulations against the Basel standards. At present, this involves a comprehensive and detailed assessment of the risk-based capital requirements; in due course, it will expand to cover leverage, the LCR, NSFR and SIB requirements as well. These assessments, as anyone who has read one will know, are essentially a line-by-line assessment of the national regulations, and where a difference is found that is potentially less stringent than the minimum Basel standard, an assessment of the actual or potential materiality. Again, these assessments are having a real and positive impact: not only does the prospect of a subsequent peer review mean that jurisdictions have often sought views on the consistency of their draft regulations before implementing them, but the peer reviews of final regulations completed thus far have all led to national authorities making changes to their local requirements to correct unintended divergences from the Basel standards. The third leg of the work is operating at the level of individual banks, looking at the consistency of bank-level capital calculations (specifically, of risk-weighted assets determined using internal models). I will say more about this shortly. I hesitate to call this new monitoring initiative a policing role, since we have no enforcement power beyond the power of peer pressure and public disclosure. But it is nevertheless a strong demonstration of the commitment to international consistency and, where this cannot be perfectly achieved, to much greater transparency.

146 P a g e 146 In particular, if an individual jurisdiction departs from internationally-agreed standards, the nature and materiality of that divergence should be well understood. What we doing can be thought of as encouraging greater 'truth in advertising' - if a bank does not operate under regulations that are consistent with Basel standards, any difference should be much more transparent when it reports a 'Basel ratio'. That way markets can provide something of a policing role, where necessary offsetting regulatory differences in their assessment of banks' financial ratios. The advent of this monitoring work makes me wonder whether regulations are really getting more disparate, as many claim. Maybe it is possible to count more instances where jurisdiction X differs from internationally-agreed standards but, then again, there are now more standards to be complied with. I have already heard grumbling about marginally inconsistent implementation of the LCR, but this needs to be considered against a pre-2010 world in which there was no standardisation of liquidity requirements whatsoever. That is not meant to sound blasé about the need to pursue greater consistency. Since regulation ultimately remain in the hands of national authorities, domestic perspectives will tend to outweigh international ones without due care and attention. Continual effort to emphasise the need for international consistency, where it can be achieved, is important if the benefits to society that I spoke about earlier are to be maximised. Different differences When looking at the international consistency of financial regulation, differences essentially arise in four circumstances.

147 P a g e 147 These variations derive from: - considerations related to the systemic importance of individual institutions - examples include the so-called 'Swiss finish' to Basel III, and recent proposals with respect to higher leverage ratios for the very largest US banks; - macro-prudential considerations - examples include the capital buffer (Switzerland) and higher risk weights (eg Hong Kong SAR, Sweden) for residential mortgage lending; - super equivalent/gold plating of international standards - examples include the many jurisdictions (particularly in Asia) that have set higher minimum capital ratios than called for in the Basel framework; and - shortcomings in implementation - for example where the standards have not been implemented (or are slow to be implemented), or where they have been modified in a way that makes them weaker than the internationally agreed minimums. Here is where the apparent disconnect between the industry's 'glass half empty' view and the regulator's 'glass half full' view becomes understandable. Regulators focus primarily on the last category - gaps in the framework that mean minimum standards are not being met, creating risks to both financial stability and the level playing field. By contrast, we tend to hear much more from industry participants on the competitive and operational problems caused by the other three sources of variation. In the current environment, there is a particular concern about a range of initiatives that could be grouped under the broad heading of 'ring-fencing'. These potentially risk a degree of fragmentation in global markets, jeopardising the benefits that these markets bring.

148 P a g e 148 To the extent these initiatives go beyond the minimum standard prescribed by international standard setters - which in banking tend to focus on consolidated supervision of a global group - they create challenging issues for the regulatory community to debate. Standard setters such as the Basel Committee are tasked with agreeing what must be done, at a minimum. They are not structured to preclude or prevent domestic initiatives that go beyond this. Yet domestic regulatory initiatives such as ring-fencing, like other policies, can have spillover effects across national borders. Where these spillovers are significant, they provide a strong signal where increased international cooperation is needed, as domestic initiatives of this type will typically be in response to a perception that the international regulatory framework is lacking in some shape or form. The role of model-driven differences In defending the efforts of regulators to develop more consistent financial regulation, I am also the first to acknowledge that more could be done. But recent work by the Committee shows that whatever regulatory differences exist, they may well be outweighed by the differences in regulatory outcomes driven by the use of internal models. I am sure that many of you will be aware of the studies produced by the Committee on the consistency of risk-weighted asset calculations in the banking and trading books. These focus on the extent to which differences in the internal models used by banks to determine their regulatory capital are producing material differences that do not reflect differences in underlying risk. This was done by using hypothetical portfolio exercises (HPEs), which allowed the Committee to observe banks' estimated risk weights and capital requirements for identical portfolios.

149 P a g e 149 The studies are available on the Basel Committee's website, and contain far more material than I can present today. Let me just focus on the headline messages: - there are material differences from internal modelling practices that do not reflect underlying differences in risk; and - public disclosures are insufficient to allow investors and other interested parties to adequately understand the impact of these modelling choices. The chart below comes from the study on risk weighted assets in the banking book. It shows the hypothetical impact on bank capital ratios if a bank's actual risk weights for wholesale credit portfolios (sovereigns, banks and corporates) were replaced by the median risk weights used by the bank's peers. Clearly, differences in risk-weights can have a material impact on reported capital ratios. Even after allowing for the removal of an outlier bank at the bottom end, the range is wide.

150 P a g e 150 While some degree of variability in risk-weighted assets derived from internal models is expected - and indeed desirable - the current situation looks less than ideal, particularly if the model-driven differences are not transparent to the users of bank capital disclosures. Let me give you another, more micro, example of the problem. When looking at the risk weights applied to the four largest G-SIBs (that is, the G-SIBs currently in the top bucket of the G-SIB framework), the Basel Committee's study found a very wide degree of divergence in the risk weights being used by banks. If we drop off the bottom and top quartiles of the distribution and focus just on the inter-quartile range, we still find that the top of the range is around twice the bottom of the range. In other words, even if we forget half the sample and just focus on the banks that most agree with one another about the appropriate risk weights for each of these G-SIBs, some are still using risk weights half/twice that of their competitors.

151 P a g e 151 And this is for the largest, best known banks, ones that provide the market with substantial disclosures about their activities and financial health! I raise this point because, in looking at the problems of inconsistency in regulation, it is important to look not just at instances of different sets of regulations, but also at the inconsistency introduced by the use of models within the regulatory framework. Unlike impacts that stem from differences in the regulations that apply to individual jurisdictions (and are therefore at least consistently applied to all banks within that jurisdiction), modelling differences do not respect national borders. Indeed, the Committee's studies show that there can be substantial differences even within national boundaries. And unlike differences in national rules - which can be understood by anyone willing to read of individual regulations carefully - differences in modelling approaches are far more opaque, making the impact much more difficult to assess and quantify. For that reason, the Committee is currently looking at a range of measures to reduce undesirable practice-based variations in RWAs, and to improve the comparability of regulatory capital calculations by banks. These includes enhanced disclosures by banks to foster greater market discipline and prevent misperceptions as to the level and causes of RWA variations. In addition, use of standardised definitions and templates could support greater consistency and comparability of disclosures. Examples where additional clarity could be provided include capital floor adjustments, partial use of the standardised approach, definition of default, treatment of defaulted exposures, exemptions from the one-year maturity floor, and requirements related to the estimation of IRB parameters.

152 P a g e 152 Many of these drivers could be addressed through clarification of the framework, through efforts to harmonise national implementation requirements, or through review of the continued relevance of various aspects of national discretion; and constraints on model parameters could also be considered. For example, supervisory benchmarks for risk parameters could be created from the data collected through the Committee's work. Creation of such benchmarks could fill a valuable niche, for example, for low-default IRB portfolios, creating reference points for supervisors and banks. Other alternatives could include more explicit constraints, such as the creation of floors for certain parameters (such as LGD), or even fixed values of such parameters. As for when you will see the results of the Committee's thinking on these issues, it will vary. I expect that the Committee's response will entail a series of incremental steps, rather than a single 'big bang' policy response. This is because of the multi-faceted nature of the issue, and because some issues touch on policy work already underway. For example, the fundamental review of the trading book has been generating new proposals for market risk capital requirements; these are being refined with the findings of the recent study on trading book risk weights in mind. Similarly, the Committee recently established a working group to review the Pillar 3 framework; this will factor into its work the findings on the adequacy of existing disclosure. The staggered approach allows the Committee to respond to a number of the issues more promptly than if we waited for every piece of the puzzle to be fully specified, thereby generating continual, incremental

153 P a g e 153 improvements to the consistency of bank capital requirements as quickly as they can be achieved. Concluding remarks There are many reasons why there are differences in the national implementation of global standards. Some of these make good sense, others should be avoided if possible. We should not be aiming for a single, monolithic global rule book: there are very good reasons why complete and absolute harmonisation across all banks, all jurisdictions and all times is not a good idea if we want to maximise financial stability. If we were to seek complete harmonisation everywhere and at all times as the goal, our glass would always be seen as (at least) half empty. But my personal view is that the glass is more than half full. The advent of global liquidity, leverage and funding standards, for example, where previously these had been left entirely to national discretion, is a major step towards much greater consistency in financial regulation. Even if some minor differences of implementation remain within the standards, this is far better than the previous situation where there were differences in the existence of standards. Furthermore, the Basel Committee, along with other standard-setters, has embarked on a major new initiative to monitor the implementation of its standards. This has already had a positive effect of narrowing differences, and provides much greater visibility of the nature and materiality of national differences that remain. Whether you adopt a glass half full or half empty perspective, at the very least the glass is now much more transparent.

154 P a g e 154 If we are truly concerned about levelling the playing field internationally, then we cannot focus only on the shortcomings in the national implementation process. Another, potentially bigger problem - at least if we measure the impact of differences on the reported capital ratios of banks - may exist in the differences that arise from the use of internal models within the regulatory framework. Therefore all of us - regulators and industry - need to continue to work hard to ensure that the consistency we are all seeking is achieved, both in standards and in practice. Thank you.

155 P a g e 155 Stefan Avdjiev, Anastasia Kartasheva, Bilyana Bogdanova CoCos: a primer Contingent convertible capital instruments (CoCos) are hybrid capital securities that absorb losses when the capital of the issuing bank falls below a certain level. In this article, we go over the structure of CoCos, trace the evolution of their issuance, and examine their pricing in primary and secondary markets. CoCo issuance is primarily driven by their potential to satisfy regulatory capital requirements. The bulk of the demand for CoCos has come from small investors, while institutional investors have been relatively restrained so far. The spreads of CoCos over other subordinated debt greatly depend on their two main design characteristics the trigger level and the loss absorption mechanism. CoCo spreads are more correlated with the spreads of other subordinated debt than with CDS spreads and equity prices. Private investors are usually reluctant to provide additional external capital to banks in times of financial distress. In extremis, the government can end up injecting capital to prevent the disruptive insolvency of a large financial institution because nobody else is willing to do so. Such public sector support costs taxpayers and distorts the incentives of bankers.

156 P a g e 156 Contingent convertible capital instruments (CoCos) offer a way to address this problem. CoCos are hybrid capital securities that absorb losses in accordance with their contractual terms when the capital of the issuing bank falls below a certain level. Then debt is reduced and bank capitalisation gets a boost. Owing to their capacity to absorb losses, CoCos have the potential to satisfy regulatory capital requirements. In this article, we examine recent developments and trends in the market for CoCos. Our analysis is based on a data set that covers $70 billion worth of CoCos issued between June 2009 and June Several trends stand out. First, the main reasons for issuing CoCos are related to their potential to satisfy regulatory capital requirements. Second, the bulk of the demand has come from private banks and retail investors, while institutional investors have been relatively restrained so far. Third, CoCo yields tend to be higher than those of higher-ranked debt instruments of the same issuer and are highly dependent on their two main design characteristics the trigger level and the loss absorption mechanism. Finally, CoCo yields tend to be more correlated with those of other subordinated debt than with CDS spreads (on senior unsecured debt) and equity prices. The rest of this article is organised as follows. In the first section, we describe the structure and design of CoCos.

157 P a g e 157 We discuss the reasons for CoCo issuance in the second section. In the third section, we examine the main groups of investors in CoCos. In the fourth and fifth sections, we study the pricing of CoCos in primary and secondary markets, respectively. The final section concludes. Structure and design of CoCos The structure of CoCos is shaped by their primary purpose as a readily available source of bank capital in times of crisis. In order to achieve that objective, they need to possess several characteristics. First, CoCos need to automatically absorb losses prior to or at the point of insolvency. Second, the activation of the loss absorption mechanism must be a function of the capitalisation levels of the issuing bank. Finally, their design has to be robust to price manipulation and speculative attacks. CoCos have two main defining characteristics the loss absorption mechanism and the trigger that activates that mechanism (Graph 1). CoCos can absorb losses either by converting into common equity or by suffering a principal writedown. The trigger can be either mechanical (ie defined numerically in terms of a specific capital ratio) or discretionary (ie subject to supervisory judgment).

158 P a g e 158 Triggers One of the most important features in the design of a CoCo is the definition of the trigger (ie the point at which the loss absorption mechanism is activated). A CoCo can have one or more triggers. In case of multiple triggers, the loss absorption mechanism is activated when any trigger is breached. Triggers can be based on a mechanical rule or supervisors discretion. In the former case, the loss absorption mechanism is activated when the capital of the CoCo-issuing bank falls below a pre-specified fraction of its risk-weighted assets. The capital measure, in turn, can be based on book values or market values. Book-value triggers, also known as accounting-value triggers, are typically set contractually in terms of the book value of Common Equity Tier 1 (CET1) capital as a ratio of risk-weighted assets (RWA). The effectiveness of book-value triggers depends crucially on the frequency at which the above ratios are calculated and publicly disclosed,

159 P a g e 159 as well as the rigour and consistency of internal risk models, which can vary significantly across banks and time. As a result, book-value triggers may not be activated in a timely fashion. Market-value triggers could address the shortcoming of inconsistent accounting valuations. These triggers are set at a minimum ratio of the bank s stock market capitalisation to its assets. As a result, they can reduce the scope for balance sheet manipulation and regulatory forbearance. However, market-value triggers may be difficult to price and could create incentives for stock price manipulation. The pricing of conversion-to-equity CoCos with a market-value trigger could suffer from a multiple equilibria problem. More specifically, since CoCos must be priced jointly with common equity, a dilutive CoCo conversion rate could make it possible for more than one pair of CoCo prices and equity prices to exist for any given combination of bank asset values and non-coco debt levels. Furthermore, under certain circumstances, holders of CE CoCos may have an incentive to short-sell the underlying common stock in order to generate a self-fulfilling death spiral and depress the share price to the point at which the market-value trigger is breached. Finally, discretionary triggers, or point of non-viability (PONV) triggers, are activated based on supervisors judgment about the issuing bank s solvency prospects. In particular, supervisors can activate the loss absorption mechanism if they believe that such action is necessary to prevent the issuing bank s insolvency.

160 P a g e 160 PONV triggers allow regulators to trump any lack of timeliness or unreliability of book-value triggers. However, unless the conditions under which regulators will exercise their power to activate the loss absorption mechanism are made clear, such power could create uncertainty about the timing of the activation. Loss absorption mechanism The loss absorption mechanism is the second key characteristic of each CoCo. A CoCo can boost the issuing bank s equity in one of two ways. A conversion-to- equity (CE) CoCo increases CET1 by converting into equity at a pre-defined conversion rate. By contrast, a principal writedown (PWD) CoCo raises equity by incurring a writedown. For CoCos with a CE loss absorption mechanism, the conversion rate can be based on (i) the market price of the stock at the time the trigger is breached; (ii) a pre-specified price (often the stock price at the time of issuance); or (iii) a combination of (i) and (ii). The first option could lead to substantial dilution of existing equity holders as the stock price is likely to be very low at the time the loss absorption mechanism is activated. But this potential for dilution would also increase the incentives for existing equity holders to avoid a breach of the trigger. By contrast, basing the conversion rate on a pre-specified price would limit the dilution of existing shareholders, but also probably decrease their incentives to avoid the trigger being breached.

161 P a g e 161 Finally, setting the conversion rate equal to the stock price at the time of conversion, subject to a pre-specified price floor, preserves the incentives for existing equity holders to avoid a breach of the trigger, while preventing unlimited dilution. The principal writedown of a PWD CoCo could be either full or partial. Most PWD CoCos have a full writedown feature. However, there are exceptions. For example, in the case of the CoCo bond issued by Rabobank in March 2010, holders of CoCos would lose 75% of the face value and receive the remaining 25% in cash. One criticism of this type of loss absorption mechanism is that the issuer would have to fund a cash payout while in distress. CoCo issuance At the moment, the CoCo market is still relatively small, but it is growing. Banks have issued approximately $70 billion worth of CoCos since By comparison, during the same period they have issued around $550 billion worth of non-coco subordinated debt and roughly $4.1 trillion worth of senior unsecured debt. Nevertheless, CoCo issuance volumes have increased in each of the last two years and are on pace to grow once again in The regulatory treatment of CoCos against the background of the need to boost capital has been the main driver of the supply of those instruments. Under Basel III, CoCos could qualify as either Additional Tier 1 (AT1) or Tier 2 (T2) capital (Graph 2). The current Basel III framework contains two key contingent capital elements:

162 P a g e 162 (i) a PONV trigger requirement, which applies to all AT1 and T2 instruments; and (ii) a going-concern contingent capital requirement, which applies only to AT1 instruments classified as liabilities. The inclusion of PONV clauses in CoCos is primarily motivated by regulatory capital eligibility considerations. As the adoption of Basel III has progressed across jurisdictions, the share of CoCos that have a PONV trigger has increased substantially over the past couple of years. The selection of the trigger level is largely determined by the trade-off between regulatory capital eligibility considerations and cost of issuance. CoCos with low triggers have lower loss-absorbing capacity.

163 P a g e 163 As a result, they tend to be less expensive to issue, but are usually not eligible to qualify as AT1 capital. Nevertheless, low-trigger CoCos allow banks to boost their T2 capital in a cost- efficient manner. Over time, as banks felt more pressure from markets and regulators to boost their Tier 1 capital, they started to issue CoCos with trigger levels at or above the preset minimum for satisfying the going-concern contingent capital requirement. As a consequence, the volume of CoCos classified as AT1 capital has increased considerably since the start of 2012 (Graph 3, top left-hand panel). Under Basel III, the minimum trigger level (in terms of CET1/RWA) required for a CoCo to qualify as AT1 capital is 5.125%. As a result, over the past couple of years, there has been a trend towards issuing CoCos with a trigger set exactly at that level (Graph 3, top right-hand panel). CoCos with such triggers are attractive for issuing banks due to the fact that they qualify as AT1 capital, while simultaneously being cheaper to issue than CoCos with higher trigger levels. Regulatory capital eligibility considerations are a major factor not only in the selection of CoCo triggers, but also in the choice of their original maturity. In the Basel III framework, all AT1 instruments must be perpetual. That explains why over a third of all CoCos issued so far have no maturity date. The rest of the existing CoCos are dated and are therefore only eligible to obtain T2 capital status under Basel III. Most of them have an original maturity of approximately 10 years.

164 P a g e 164 Capital eligibility considerations are not as important in the selection of the loss absorption mechanism. Regulatory requirements can be met with either CE CoCos or PWD CoCos. Nevertheless, the former dominated the initial stages of CoCo issuance (Graph 3, bottom left-hand panel). The most likely explanation for this is that CE CoCos tend to be cheaper for issuers than PWD CoCos (see below).

165 P a g e 165 Nevertheless, issuance of PWD CoCos has picked up over time, in line with growing interest from fixed-income investors whose mandates often prevent them from holding CE CoCos. As a result, PWD CoCos have accounted for more than half of total CoCo issuance since the start of CoCo issuance patterns are largely driven by the way Basel III is applied, or supplemented, by national regulators. As a result, the geographical distribution of issuers mainly reflects the regulatory treatment of CoCos across jurisdictions. Approximately 80% of the issuance has been done by European banks (Graph 3, bottom right-hand panel). UK banks have been the most active, having issued $21 billion worth of CoCos so far. They have been primarily motivated by their need to satisfy the loss-absorbing capital requirements of UK regulators. Swiss banks have also issued a substantial amount ($15 billion) of CoCos during our sample period. This could largely be attributed to the fact that the new regulatory regime in Switzerland requires Swiss banks to have 9% of risk-weighted assets in loss- absorbing instruments. Finally, the July 2013 entry into force of the Capital Requirements Directive IV, which transposes Basel III into EU law, is expected to stimulate a new wave of CoCo issuance by EU banks. The issuance of CoCos is also affected by their tax treatment in different jurisdictions. If fiscal authorities treat CoCos as debt, then the interest expense associated with them is typically tax-deductible for the issuing bank.

166 P a g e 166 As a result, the tax classification of CoCos can have a significant impact on the after-tax interest expenses of issuing banks. While there is still considerable uncertainty in many jurisdictions, it appears that CoCos would not be tax-deductible in some countries. Preliminary estimates suggest that roughly 64% of CoCos have tax-deductible coupons, while approximately 20% do not. The tax treatment of the remaining 16% of CoCos is currently under review. Investors in CoCos The bulk of the demand for CoCos has come from retail investors and small private banks. Large institutional investors have been relatively timid so far. The main factors suppressing the growth of the investor base at the moment are the absence of complete and consistent credit ratings for most CoCos and the inherent tension between the objectives of issuers regulators and prospective buyers regulators. Main investor groups According to market participants, three investor groups have been most active on the demand side of the primary market for CoCos. The bulk of the demand has come from retail investors and private banks in Asia and Europe. They have been enticed primarily by the relatively high nominal yield that CoCos offer in the current low interest rate environment. The second group consists of US institutional investors that look for alternative investment classes.

167 P a g e 167 Even though the CoCo volumes these investors have purchased are considerable relative to the size of the market, they are fairly modest compared to the overall size of their portfolios. Finally, European non-bank financial institutions represent a third investor group that has shown substantial interest in CoCos. Nevertheless, their demand is currently held back by the lack of clarity about how CoCo assets on their balance sheets will be treated by their national regulators. Data from Dealogic on the institutional breakdown of investors for a sample of CoCo issues with a combined volume of roughly $13 billion provide further details on the major investors in CoCos. Private banks and retail investors were responsible for 52% of the total demand in the sample. Asset management companies accounted for another 27%. Hedge funds (9%) and banks (3%) were much less active. Finally, demand from insurance companies was also limited (3%), most likely reflecting the fact that Solvency II and National Association of Insurance Commissioners (NAIC) regulations are expected to apply a significant capital charge to CoCo investments. Factors influencing the size of the CoCo investor base Increasing participation of traditional institutional investors like asset management companies, insurance companies and pension funds is necessary for the CoCo market to become a deep and liquid source of capital for banks. However, several factors are holding back demand from these investors. The absence of a complete set of credit ratings for CoCos has been a significant hurdle on the growth path of this young market.

168 P a g e 168 The mandates of many institutional investors prevent them from holding financial instruments that do not have a credit rating or are rated below a certain level. In addition, an investment grade credit rating is a necessary condition for the inclusion of any security in many of the major bond indices. Three main factors can explain credit rating agencies initial reluctance to rate CoCos. First, the heterogeneity in the regulatory treatment of CoCos across jurisdictions hinders the creation of consistent rating methodologies. In addition, credit rating agencies are concerned that certain high-trigger CoCos have the potential to invert the traditional hierarchy of investors. Finally, the existence of discretionary triggers creates valuation uncertainty, which further complicates the ratings process. More than half of all CoCos are currently unrated. Until recently, only Standard & Poor s and Fitch rated (some, but not all) CoCos. Moody s did not rate them until May 2013, when it started rating some low-trigger CoCos. According to the S&P rating methodology, a CoCo rating should be at least two to three notches below the issuer s credit rating and cannot exceed BBB+. Further downward notching is applied to instruments with triggers near or at the point of non-viability and to those that have a discretionary trigger. On average, CoCo ratings are approximately one notch lower than those of other subordinated debt and more than five notches below those of senior unsecured debt of the same issuer.

169 P a g e 169 An additional factor limiting demand for CoCos is the inherent tension between the objectives of issuing banks regulators and the regulators of potential CoCo bondholders. On the one hand, issuing banks regulators aim to provide an automatic source of high-quality capital for banks in times of stress. This translates into a preference for instruments with greater loss absorption capacity. On the other hand, the regulators of prospective CoCo buyers are primarily concerned about the potential losses that those institutions might suffer on their CoCo holdings. As a result, they are likely to steer them towards instruments with a smaller loss absorption capacity. Increasing the congruency and clarity of the regulatory treatment of CoCos across jurisdictions and fine-tuning their design could help to enhance the investor base by attracting more traditional fixed income investors. However, the risk- sharing capacity of these instruments also depends on the scope for diversification they offer and on the systemic importance of their buyers. CoCos can provide strong diversification benefits only if the issuing banks tail risk has low correlation with the portfolios of CoCo bondholders. Insurance of natural catastrophes is a useful analogy to assess the capacity limits of CoCos. Though the monetary costs of such events are high, their occurrence is independent from the business cycle. This implies that exposure to natural disaster risk through securities like catastrophe bonds provides diversification benefits for traditional investors.

170 P a g e 170 Unlike natural catastrophes, however, bank failures are correlated with the business cycle, limiting CoCos diversification capacity in that regard. The ability of CoCos to reduce systemic risks depends heavily on whether their buyers are themselves systemically important. As a consequence, regulators may want to discourage CoCo holdings by banks. At the same time, the systemic risk associated with other large institutional investors should also be taken into consideration. More specifically, CoCo holdings should be distributed not in a way that simply shifts the concentration of risk across different sectors of the financial system, but rather in a manner that reduces the amount of systemic risk. Primary market pricing of CoCos The main determinants of the pricing of CoCos are their position in the bank s capital structure, the loss absorption mechanism and the trigger. The yields on CoCos are consistent with their place in the bank s capital structure. CoCos are subordinated to other debt instruments as they incur losses first. Accordingly, the average CoCo yield to maturity (YTM) at issuance tends to be greater than that of other debt instruments (eg other subordinated debt and senior unsecured debt). The YTM of newly issued CoCos is on average 2.8% higher than that of non-coco subordinated debt and 4.7% higher than that of senior unsecured debt of the same issuer. The preferences of CoCo bondholders and equity holders diverge when it comes to the trigger level.

171 P a g e 171 All else the same, CoCos with relatively low triggers offer more favourable terms to holders of CoCos than to equity holders since the trigger is less likely to be breached and the former group is less likely to absorb losses. By contrast, for a given YTM level, equity holders prefer high-trigger CoCos since they are more likely to lead to early loss absorption by holders of CoCos. As a consequence, one can expect that the yields of high-trigger CoCos would on average be higher than those of low-trigger CoCos. The interests of CoCo bondholders and equity holders also differ when it comes to PONV triggers. Issuing banks prefer these triggers since they are a necessary condition for regulatory capital eligibility under Basel III. Conversely, holders of CoCo favour instruments without PONV triggers because, all else the same, they increase the probability of the loss absorption mechanism being activated. CoCo and equity holders also have conflicting interests when it comes to the loss absorption mechanism. All else the same, equity holders find PWD CoCos more attractive, since they avoid dilution and shift the cost of financial distress to CoCo bondholders. Conversely, for a given YTM level, holders of CoCos tend to prefer the CE clause over the PWD clause since the former gives them partial compensation, in the form of shares, when the trigger is breached, whereas the latter does not. That said, some CoCo holders seem to find the PWD feature attractive because it provides more clarity about the loss absorption amount than the CE feature.

172 P a g e 172 In addition, the PWD clause is favoured by those institutional fixed income investors that have mandates which prevent them from holding equity instruments. Table 1 presents data on the pricing of several groups of CoCo bonds, divided according to their two principal characteristics, ie the trigger level and the loss absorption mechanism. CoCos with a PWD clause tend to have higher YTMs at issuance than those with a CE clause. On average, the YTM of PWD CoCos is approximately 3.9% higher than that of non-coco subordinated debt of the same bank. By contrast, the comparable spread for CE CoCos is only 2.5%. Low-trigger CoCos tend to command a lower yield premium than high-trigger ones. The average YTM spread at issuance for high-trigger CoCos over other subordinated debt is 3.6%. By contrast, that spread is only 2.5% for low-trigger CoCos. Consistent with the preferences of issuers and investors, the CoCos that are least costly to issue are those that feature a combination of a low trigger and a CE loss absorption mechanism.

173 P a g e 173 The average spread on that CoCo type over other subordinated debt of the same bank is 2.3%. By contrast, the corresponding average spread for CE CoCos with a high trigger is 3.5%. High-trigger CoCos with a PWD feature are even costlier their average YTM spread at issuance over non- CoCo subordinated debt is 3.6%. Finally, the most expensive group of CoCos in our sample are those that have a PWD feature and a low trigger. Their average YTM spread at issuance is 4.8%. Table 1 contains a pair of relative pricing metrics that is puzzling at first glance. Namely, PWD CoCos with a low trigger command a higher yield than their high- trigger counterparts (column 1), even though economic intuition suggests that the opposite should be true. One possible explanation for that apparent pricing anomaly is that most of the low-trigger PWD CoCos in our sample have a PONV clause, whereas the majority of the high-trigger PWD CoCos do not. As discussed above, the PONV clause raises the probability that the loss absorption mechanism will be activated, which causes investors to demand a higher premium for holding CoCos with a PONV clause. Secondary market trading of CoCos The trading of CoCos on secondary markets can provide further insights into the properties of these instruments. In order to gauge the degree of co-movement between CoCos and other debt and equity instruments of the same bank, we have calculated the correlation between the daily changes in the CoCo bond spread, on the one hand, and the daily changes in the non-coco subordinated debt spread, the CDS spread (on senior unsecured debt) and the equity price of the same issuer, on the other hand (Table 2). Several patterns stand out.

174 P a g e 174 First, CoCo spreads are most strongly correlated with the spreads of other subordinated debt (Table 2, column1). The average correlation coefficient for that pair of instruments in our sample is The correlations of CoCos with CDS spreads and equity prices, although significant, are not as strong (0.38 and 0.25, respectively). These general observations are in line with the conclusions of a case study on the reactions of the share price of Credit Suisse and the spreads on its bonds to adverse news about the bank s level of capitalisation (see box). Second, non-coco subordinated debt spreads and CDS spreads tend to be more correlated with the spreads of low-trigger CoCos than with those of high- trigger CoCos (Table 2, columns 1 and 2). The average correlation coefficient between low-trigger CoCos and non-coco subordinated debt in our sample (0.50) is considerably higher than the one between high-trigger CoCos and non-coco subordinated debt (0.32). Similarly, the average correlation coefficient between low- trigger CoCos and CDS spreads (0.42) is substantially higher than the one between high-trigger CoCos and CDS spreads (0.30).

175 P a g e 175 Intuitively, low-trigger CoCos are likely to suffer losses at the same point as other subordinated debt the point of insolvency. By contrast, high-trigger CoCos are likely to suffer losses much earlier than non-coco subordinated debt. Finally, the trigger level does not appear to affect the correlations between CoCo spreads and equity prices (Table 2, column 3). This result is somewhat surprising since, all else the same, high-trigger CoCos should be more informationally sensitive than low-trigger ones due to the fact that the former are more likely to absorb losses. Therefore, one could expect that high-trigger CoCos would behave more like equity than low-trigger CoCos. Yet the average correlation coefficient between low-trigger CoCos and equity prices ( 0.25) is almost the same as the one between high-trigger CoCos and equity prices ( 0.26). Debt, CoCo and equity price reactions to news about capital On 14 June 2012, the Swiss National Bank (SNB) criticised in its Financial Stability Report the low level of capitalisation of Credit Suisse, urging the bank to increase its capital by suspending dividends and/or by raising fresh capital through a rights issue. We examine how the SNB announcement, which came as a surprise to financial markets, affected the prices of various debt and equity instruments issued by Credit Suisse. The reaction of CoCo bond spreads was consistent with the place of that type of instrument in the capital structure. Their market value was more sensitive to the news than the market values of other, more senior, debt instruments, but less sensitive than the market value of equity, which is a more junior claim.

176 P a g e 176 On the day the SNB report was published, the equity price of Credit Suisse dropped by more than 10% while the yield on the bank s CoCos maturing in February 2041 rose by 39 basis points or 5.8%. By comparison, the yield to maturity on non-coco subordinated debt with a similar remaining maturity as the CoCo increased by 23 basis points while the yields on more senior debt issues and CSD spreads hardly moved. Conclusion In this feature, we reviewed the structure, issuance patterns and pricing of CoCos. The design of CoCos is shaped by their primary goal of being a readily available source of bank equity in times of crisis. CoCo issuance is primarily driven by the need to satisfy regulatory capital requirements. The demand for CoCos has so far been held back by the scarcity of credit ratings and the lack of consistent regulatory treatment.

177 P a g e 177 The pricing of CoCos in primary markets is consistent with their position in banks capital structures. The main determinants of CoCo yields are the mechanical trigger level, the loss absorption mechanism, and the existence of a discretionary trigger. In secondary markets, CoCo bond yields are most highly correlated with those of other subordinated debt, albeit with a considerable degree of variation between high- and low-trigger CoCos. Looking ahead, CoCos have the potential to strengthen the resilience of the banking system. Their ability to do so will depend on the scope for diversification, the capacity for reducing systemic risk and the coordination of their treatment between the regulators of issuers and prospective buyers.

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