1200 G Street NW Suite 800 Washington, DC USA Tel: Web:

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1 P a g e G Street NW Suite 800 Washington, DC USA Tel: Web: Dear Member, You can find some very interesting Basel III jobs (from Manager, Corporate Regulatory Reporting with Basel ii/iii knowledge / experience and salary $170,000 - $236,000 a year + bonus + benefits to Senior Java Software Developer with Basel ii/iii knowledge / experience and salary $145,000 - $160,000 per year + bonus + benefits) at: Dear Member, As our association becomes larger, you can explore some new opportunities.

2 P a g e 2 This is what we offer: 1. Membership - Become a standard, premium or lifetime member. You may visit: 2. Monthly Updates - Subscribe to receive (at no cost) Basel II / Basel III related alerts, opportunities, updates and our monthly newsletter: 3. Training and Certification - Become a Certified Basel iii Professional (CBiiiPro). You must follow the steps described at: tification.html Become a Capital Requirements Directive IV / Capital Requirements Regulation Professional (CRDIV/CRR/Pro). Reduced price, $297. You may visit: ification.html For instructor-led training, you may contact us. We can tailor all programs to your needs. We tailor Basel III presentations, awareness and training programs for supervisors, boards of directors, service providers and consultants. 4. Authorized Certified Trainer, Certified Basel iii Professional Trainer Program (BiiiCPA-ACT / CBiiiProT) - Become an ACT. This is an additional advantage on your resume, serving as a third-party endorsement to your knowledge and experience. Certificates are important when being considered for a promotion or other career opportunities. You give the necessary assurance that you have the knowledge and skills to accept more responsibility.

3 P a g e 3 To learn more you may visit: 5. Approved Training and Certification Centers (BiiiCPA-ATCCs) - In response to the increasing demand for Basel III training, the Basel iii Compliance Professionals Association (BiiiCPA) is developing a world-wide network of Approved Training and Certification Centers (BiiiCPA-ATCCs). This will give the opportunity to risk and compliance managers, officers and consultants to have access to instructor-led Basel III training at convenient locations that meet international standards. ATCCs deliver high quality training courses, using the BiiiCPA approved course materials and having access to BiiiCPA Authorized Certified Trainers (BiiiCPA-ACTs). To learn more: Best Regards, George Lekatis President of the General Manager, Compliance LLC 1200 G Street NW Suite 800, Washington DC 20005, USA Tel: (202) lekatis@basel-iii-association.com Web: HQ: 1220 N. Market Street Suite 804, Wilmington DE 19801, USA Tel: (302)

4 P a g e 4 Basel Committee on Banking Supervision Basel III: the net stable funding ratio I. Introduction 1. This document presents the net stable funding ratio (NSFR), one of the Basel Committee s key reforms to promote a more resilient banking sector. The NSFR will require banks to maintain a stable funding profile in relation to the composition of their assets and off-balance sheet activities. A sustainable funding structure is intended to reduce the likelihood that disruptions to a bank s regular sources of funding will erode its liquidity position in a way that would increase the risk of its failure and potentially lead to broader systemic stress. The NSFR limits overreliance on short-term wholesale funding, encourages better assessment of funding risk across all on- and off-balance sheet items, and promotes funding stability. This document sets out the NSFR standard and timeline for its implementation. 2. Maturity transformation performed by banks is a crucial part of financial intermediation that contributes to efficient resource allocation and credit creation. However, private incentives to limit excessive reliance on unstable funding of core (often illiquid) assets are weak. Just as banks may have private incentives to increase leverage, incentives arise for banks to expand their balance sheets, often very quickly, relying on relatively cheap and abundant short-term wholesale funding. Rapid balance sheet growth can weaken the ability of individual banks to respond to liquidity (and solvency) shocks when they occur, and

5 P a g e 5 can have systemic implications when banks fail to internalise the costs associated with large funding gaps. A highly interconnected financial system tends to exacerbate these spillovers. 3. During the early liquidity phase of the financial crisis starting in 2007, many banks despite meeting the existing capital requirements experienced difficulties because they did not prudently manage their liquidity. The crisis drove home the importance of liquidity to the proper functioning of financial markets and the banking sector. Prior to the crisis, asset markets were buoyant and funding was readily and cheaply available. The rapid reversal in market conditions showed how quickly liquidity can dry up and also how long it can take to come back. The banking system came under severe stress, which forced central banks to take action in support of both the functioning of money markets and, in some cases, individual institutions. 4. The difficulties experienced by some banks arose from failures to observe the basic principles of liquidity risk management. In response, the Committee in 2008 published Principles for Sound Liquidity Risk Management and Supervision ( Sound Principles ) as the foundation of its liquidity framework. The Sound Principles offer detailed guidance on the risk management and supervision of funding liquidity risk and should help promote better risk management in this critical area, provided that they are fully implemented by banks and supervisors. The Committee will accordingly continue to monitor the implementation of these fundamental principles by supervisors to ensure that banks in their jurisdictions adhere to them.

6 P a g e 6 5. The Committee has further strengthened its liquidity framework by developing two minimum standards for funding and liquidity. These standards are designed to achieve two separate but complementary objectives. The first is to promote the short-term resilience of a bank s liquidity risk profile by ensuring that it has sufficient high-quality liquid assets (HQLA) to survive a significant stress scenario lasting for 30 days. To that end, the Committee has developed the liquidity coverage ratio (LCR). The second objective is to reduce funding risk over a longer time horizon by requiring banks to fund their activities with sufficiently stable sources of funding in order to mitigate the risk of future funding stress. To meet this second objective, the Committee has developed the NSFR. 6. In addition to the LCR and NSFR standards, the minimum quantitative standards that banks must comply with, the Committee has developed a set of liquidity risk monitoring tools to measure other dimensions of a bank s liquidity and funding risk profile. These tools promote global consistency in supervising ongoing liquidity and funding risk exposures of banks, and in communicating these exposures to home and host supervisors. Although currently defined in the January 2013 document, Basel III: The Liquidity Coverage Ratio and liquidity risk monitoring tools, these tools are supplementary to both the LCR and the NSFR. In this regard, the contractual maturity mismatch metric, particularly the elements that take into account assets and liabilities with residual maturity of more than one year, should be considered as a valuable monitoring tool to complement the NSFR.

7 P a g e 7 7. In 2010, the Committee agreed to review the development of the NSFR over an observation period. The focus of this review was on addressing any unintended consequences for financial market functioning and the economy, and on improving its design with respect to several key issues, notably: (i) the impact on retail business activities; (ii) the treatment of short-term matched funding of assets and liabilities; and (iii) analysis of sub-one year buckets for both assets and liabilities. 8. In line with the timeline specified in the 2010 publication of the liquidity risk framework, the NSFR will become a minimum standard by 1 January II. Definition and minimum requirements 9. The NSFR is defined as the amount of available stable funding relative to the amount of required stable funding. This ratio should be equal to at least 100% on an ongoing basis. Available stable funding is defined as the portion of capital and liabilities expected to be reliable over the time horizon considered by the NSFR, which extends to one year. The amount of such stable funding required ("Required stable funding") of a specific institution is a function of the liquidity characteristics and residual maturities of the various assets held by that institution as well as those of its off-balance sheet (OBS) exposures.

8 P a g e The NSFR consists primarily of internationally agreed-upon definitions and calibrations. Some elements, however, remain subject to national discretion to reflect jurisdiction-specific conditions. In these cases, national discretion should be explicit and clearly outlined in the regulations of each jurisdiction. 11. As a key component of the supervisory approach to funding risk, the NSFR must be supplemented by supervisory assessment work. Supervisors ***may require an individual bank to adopt more stringent standards*** to reflect its funding risk profile and the supervisor s assessment of its compliance with the Sound Principles. 12. The amounts of available and required stable funding specified in the standard are calibrated to reflect the presumed degree of stability of liabilities and liquidity of assets. 13. The calibration reflects the stability of liabilities across two dimensions: (a) Funding tenor The NSFR is generally calibrated such that longer-term liabilities are assumed to be more stable than short-term liabilities. (b) Funding type and counterparty The NSFR is calibrated under the assumption that short-term (maturing in less than one year) deposits provided by retail customers and funding provided by small business customers are behaviourally more stable than wholesale funding of the same maturity from other counterparties. 14. In determining the appropriate amounts of required stable funding for various assets, the following criteria were taken into consideration, recognising the potential trade-offs between these criteria:

9 P a g e 9 (a) Resilient credit creation The NSFR requires stable funding for some proportion of lending to the real economy in order to ensure the continuity of this type of intermediation. (b) Bank behaviour The NSFR is calibrated under the assumption that banks may seek to roll over a significant proportion of maturing loans to preserve customer relationships. (c) Asset tenor The NSFR assumes that some short-dated assets (maturing in less than one year) require a smaller proportion of stable funding because banks would be able to allow some proportion of those assets to mature instead of rolling them over. (d) Asset quality and liquidity value The NSFR assumes that unencumbered, high-quality assets that can be securitised or traded, and thus can be readily used as collateral to secure additional funding or sold in the market, do not need to be wholly financed with stable funding. 15. Additional stable funding sources are also required to support at least a small portion of the potential calls on liquidity arising from OBS commitments and contingent funding obligations. 16. NSFR definitions mirror those outlined in the LCR, unless otherwise specified. All references to LCR definitions in the NSFR refer to the definitions in the LCR standard published by the Basel Committee. Supervisors who have chosen to implement a more stringent definition in their domestic LCR rules than those set out in the Basel Committee LCR standard have discretion over whether to apply this stricter definition for the purposes of implementing the NSFR requirements in their jurisdiction. A. Definition of available stable funding 17. The amount of available stable funding (ASF) is measured based on the broad characteristics of the relative stability of an institution s funding sources, including the contractual maturity of its liabilities

10 P a g e 10 and the differences in the propensity of different types of funding providers to withdraw their funding. The amount of ASF is calculated by first assigning the carrying value of an institution s capital and liabilities to one of five categories as presented below. The amount assigned to each category is then multiplied by an ASF factor, and the total ASF is the sum of the weighted amounts. Carrying value represents the amount at which a liability or equity instrument is recorded before the application of any regulatory deductions, filters or other adjustments. 18. When determining the maturity of an equity or liability instrument, investors are assumed to redeem a call option at the earliest possible date. For funding with options exercisable at the bank s discretion, supervisors should take into account reputational factors that may limit a bank s ability not to exercise the option. In particular, where the market expects certain liabilities to be redeemed before their legal final maturity date, banks and supervisors should assume such behaviour for the purpose of the NSFR and include these liabilities in the corresponding ASF category. For long-dated liabilities, only the portion of cash flows falling at or beyond the six-month and one-year time horizons should be treated as having an effective residual maturity of six months or more and one year or more, respectively. Calculation of derivative liability amounts 19. Derivative liabilities are calculated first based on the replacement cost for derivative contracts (obtained by marking to market) where the contract has a negative value. When an eligible bilateral netting contract is in place that meets the conditions as specified in paragraphs 8 and 9 of the annex of Basel III

11 P a g e 11 leverage ratio framework and disclosure requirements, the replacement cost for the set of derivative exposures covered by the contract will be the net replacement cost. 20. In calculating NSFR derivative liabilities, collateral posted in the form of variation margin in connection with derivative contracts, regardless of the asset type, must be deducted from the negative replacement cost amount. Liabilities and capital receiving a 100% ASF factor 21. Liabilities and capital instruments receiving a 100% ASF factor comprise: (a) the total amount of regulatory capital, before the application of capital deductions, as defined in paragraph 49 of the Basel III text, excluding the proportion of Tier 2 instruments with residual maturity of less than one year; (b) the total amount of any capital instrument not included in (a) that has an effective residual maturity of one year or more, but excluding any instruments with explicit or embedded options that, if exercised, would reduce the expected maturity to less than one year; and (c) the total amount of secured and unsecured borrowings and liabilities (including term deposits) with effective residual maturities of one year or more. Cash flows falling below the one-year horizon but arising from liabilities with a final maturity greater than one year do not qualify for the 100% ASF factor. Liabilities receiving a 95% ASF factor 22. Liabilities receiving a 95% ASF factor comprise stable (as defined in the LCR in paragraphs 75 78) non-maturity (demand) deposits and/or term deposits with residual maturities of less than one year provided by retail and small business customers.

12 P a g e 12 Liabilities receiving a 90% ASF factor 23. Liabilities receiving a 90% ASF factor comprise less stable (as defined in the LCR in paragraphs 79 81) non-maturity (demand) deposits and/or term deposits with residual maturities of less than one year provided by retail and small business customers. Liabilities receiving a 50% ASF factor 24. Liabilities receiving a 50% ASF factor comprise: (a) funding (secured and unsecured) with a residual maturity of less than one year provided by non-financial corporate customers; (b) operational deposits (as defined in LCR paragraphs ); (c) funding with residual maturity of less than one year from sovereigns, public sector entities (PSEs), and multilateral and national development banks; and (d) other funding (secured and unsecured) not included in the categories above with residual maturity between six months to less than one year, including funding from central banks and financial institutions. Liabilities receiving a 0% ASF factor 25. Liabilities receiving a 0% ASF factor comprise: (a) all other liabilities and equity categories not included in the above categories, including other funding with residual maturity of less than six months from central banks and financial institutions; (b) other liabilities without a stated maturity. This category may include short positions and open maturity positions. Two exceptions can be recognised for liabilities without a stated maturity:

13 P a g e 13 first, deferred tax liabilities, which should be treated according to the nearest possible date on which such liabilities could be realised; and second, minority interest, which should be treated according to the term of the instrument, usually in perpetuity. These liabilities would then be assigned either a 100% ASF factor if the effective maturity is one year or greater, or 50%, if the effective maturity is between six months and less than one year; (c) NSFR derivative liabilities as calculated according to paragraphs 19 and 20 net of NSFR derivative assets as calculated according to paragraphs 34 and 35, if NSFR derivative liabilities are greater than NSFR derivative assets;11 and (d) trade date payables arising from purchases of financial instruments, foreign currencies and commodities that (i) are expected to settle within the standard settlement cycle or period that is customary for the relevant exchange or type of transaction, or (ii) have failed to, but are still expected to, settle. 26. Table 1 below summarises the components of each of the ASF categories and the associated maximum ASF factor to be applied in calculating an institution s total amount of available stable funding under the standard.

14 P a g e 14 B. Definition of required stable funding for assets and off-balance sheet exposures 27. The amount of required stable funding is measured based on the broad characteristics of the liquidity risk profile of an institution s assets and OBS exposures. The amount of required stable funding is calculated by first assigning the carrying value of an institution s assets to the categories listed. The amount assigned to each category is then multiplied by its associated required stable funding (RSF) factor, and the total RSF is the sum of the weighted amounts added to the amount of OBS activity (or potential liquidity exposure) multiplied by its associated RSF factor. Definitions mirror those outlined in the LCR, unless otherwise specified. 28. The RSF factors assigned to various types of assets are intended to approximate the amount of a particular asset that would have to be

15 P a g e 15 funded, either because it will be rolled over, or because it could not be monetised through sale or used as collateral in a secured borrowing transaction over the course of one year without significant expense. Under the standard, such amounts are expected to be supported by stable funding. 29. Assets should be allocated to the appropriate RSF factor based on their residual maturity or liquidity value. When determining the maturity of an instrument, investors should be assumed to exercise any option to extend maturity. For assets with options exercisable at the bank s discretion, supervisors should take into account reputational factors that may limit a bank s ability not to exercise the option. In particular, where the market expects certain assets to be extended in their maturity, banks and supervisors should assume such behaviour for the purpose of the NSFR and include these assets in the corresponding RSF category. For amortising loans, the portion that comes due within the one-year horizon can be treated in the less-than-one-year residual maturity category. 30. For purposes of determining its required stable funding, an institution should (i) include financial instruments, foreign currencies and commodities for which a purchase order has been executed, and (ii) exclude financial instruments, foreign currencies and commodities for which a sales order has been executed, even if such transactions have not been reflected in the balance sheet under a settlement-date accounting model, provided that (i) such transactions are not reflected as derivatives or secured financing transactions in the institution s balance sheet, and

16 P a g e 16 (ii) the effects of such transactions will be reflected in the institution s balance sheet when settled. Encumbered assets 31. Assets on the balance sheet that are encumbered for one year or more receive a 100% RSF factor. Assets encumbered for a period of between six months and less than one year that would, if unencumbered, receive an RSF factor lower than or equal to 50% receive a 50% RSF factor. Assets encumbered for between six months and less than one year that would, if unencumbered, receive an RSF factor higher than 50% retain that higher RSF factor. Where assets have less than six months remaining in the encumbrance period, those assets may receive the same RSF factor as an equivalent asset that is unencumbered. In addition, for the purposes of calculating the NSFR, assets that are encumbered for exceptional central bank liquidity operations may receive a reduced RSF factor. Supervisors should discuss and agree on the appropriate RSF factor with the relevant central bank, which must not be lower than the RSF factor applied to the equivalent asset that is unencumbered. Secured financing transactions 32. For secured funding arrangements, use of balance sheet and accounting treatments should generally result in banks excluding, from their assets, securities which they have borrowed in securities financing transactions (such as reverse repos and collateral swaps) where they do not have beneficial ownership. In contrast, banks should include securities they have lent in securities financing transactions where they retain beneficial ownership.

17 P a g e 17 Banks should also not include any securities they have received through collateral swaps if those securities do not appear on their balance sheets. Where banks have encumbered securities in repos or other securities financing transactions, but have retained beneficial ownership and those assets remain on the bank s balance sheet, the bank should allocate such securities to the appropriate RSF category. 33. Securities financing transactions with a single counterparty may be measured net when calculating the NSFR, provided that the netting conditions set out in Paragraph 33(i) of the Basel III leverage ratio framework and disclosure requirements document are met. Calculation of derivative asset amounts 34. Derivative assets are calculated first based on the replacement cost for derivative contracts (obtained by marking to market) where the contract has a positive value. When an eligible bilateral netting contract is in place that meets the conditions as specified in paragraphs 8 and 9 of the annex of Basel III leverage ratio framework and disclosure requirements, the replacement cost for the set of derivative exposures covered by the contract will be the net replacement cost. 35. In calculating NSFR derivative assets, collateral received in connection with derivative contracts may not offset the positive replacement cost amount, regardless of whether or not netting is permitted under the bank s operative accounting or risk-based framework, unless it is received in the form of cash variation margin and meets the conditions as specified in paragraph 25 of the Basel III leverage ratio framework and disclosure requirements. Any remaining balance sheet liability associated with (a) variation margin received that does not meet the criteria above or (b) initial margin received may not offset derivative assets and should be assigned a 0% ASF factor.

18 P a g e 18 Assets assigned a 0% RSF factor 36. Assets assigned a 0% RSF factor comprise: (a) coins and banknotes immediately available to meet obligations; (b) all central bank reserves (including required reserves and excess reserves); (c) all claims on central banks with residual maturities of less than six months; and (d) trade date receivables arising from sales of financial instruments, foreign currencies and commodities that (i) are expected to settle within the standard settlement cycle or period that is customary for the relevant exchange or type of transaction, or (ii) have failed to, but are still expected to, settle. Assets assigned a 5% RSF factor 37. Assets assigned a 5% RSF factor comprise unencumbered Level 1 assets as defined in LCR paragraph 50, excluding assets receiving a 0% RSF as specified above, and including: marketable securities representing claims on or guaranteed by sovereigns, central banks, PSEs, the Bank for International Settlements, the International Monetary Fund, the European Central Bank and the European Community, or multilateral development banks that are assigned a 0% risk weight under the Basel II standardised approach for credit risk; and certain non-0% risk-weighted sovereign or central bank debt securities as specified in the LCR. Assets assigned a 10% RSF factor

19 P a g e Unencumbered loans to financial institutions with residual maturities of less than six months, where the loan is secured against Level 1 assets as defined in LCR paragraph 50, and where the bank has the ability to freely rehypothecate the received collateral for the life of the loan. Assets assigned a 15% RSF factor 39. Assets assigned a 15% RSF factor comprise: (a) unencumbered Level 2A assets as defined in LCR paragraph 52, including: marketable securities representing claims on or guaranteed by sovereigns, central banks, PSEs or multilateral development banks that are assigned a 20% risk weight under the Basel II standardised approach for credit risk; and corporate debt securities (including commercial paper) and covered bonds with a credit rating equal or equivalent to at least AA ; (b) all other unencumbered loans to financial institutions with residual maturities of less than six months not included in paragraph 38. Assets assigned a 50% RSF factor 40. Assets assigned a 50% RSF factor comprise: (a) unencumbered Level 2B assets as defined and subject to the conditions set forth in LCR paragraph 54, including: residential mortgage-backed securities (RMBS) with a credit rating of at least AA; corporate debt securities (including commercial paper) with a credit rating of between A+ and BBB ; and exchange-traded common equity shares not issued by financial institutions or their affiliates;

20 P a g e 20 (b) any HQLA as defined in the LCR that are encumbered for a period of between six months and less than one year; (c) all loans to financial institutions and central banks with residual maturity of between six months and less than one year; and (d) deposits held at other financial institutions for operational purposes, as outlined in LCR paragraphs , that are subject to the 50% ASF factor in paragraph 24 (b); and (e) all other non-hqla not included in the above categories that have a residual maturity of less than one year, including loans to non-financial corporate clients, loans to retail customers (ie natural persons) and small business customers, and loans to sovereigns and PSEs. Assets assigned a 65% RSF factor 41. Assets assigned a 65% RSF factor comprise: (a) unencumbered residential mortgages with a residual maturity of one year or more that would qualify for a 35% or lower risk weight under the Basel II standardised approach for credit risk; and (b) other unencumbered loans not included in the above categories, excluding loans to financial institutions, with a residual maturity of one year or more that would qualify for a 35% or lower risk weight under the Basel II standardised approach for credit risk. Assets assigned an 85% RSF factor 42. Assets assigned an 85% RSF factor comprise: (a) cash, securities or other assets posted as initial margin for derivative contracts18 and cash or other assets provided to contribute to the default fund of a central counterparty (CCP).

21 P a g e 21 Where securities or other assets posted as initial margin for derivative contracts would otherwise receive a higher RSF factor, they should retain that higher factor. In light of the on- going implementation of regulatory requirements related to the margining and settlement of derivatives, the Basel Committee will continue to evaluate the treatment of margining in the NSFR. During this period, the Basel Committee will conduct quantitative analysis and consider alternative approaches, if necessary and appropriate. (b) other unencumbered performing loans that do not qualify for the 35% or lower risk weight under the Basel II standardised approach for credit risk and have residual maturities of one year or more, excluding loans to financial institutions; (c) unencumbered securities with a remaining maturity of one year or more and exchange- traded equities, that are not in default and do not qualify as HQLA according to the LCR; and (d) physical traded commodities, including gold. Assets assigned a 100% RSF factor 43. Assets assigned a 100% RSF factor comprise: (a) all assets that are encumbered for a period of one year or more; (b) NSFR derivative assets as calculated according to paragraphs 34 and 35 net of NSFR derivative liabilities as calculated according to paragraphs 19 and 20, if NSFR derivative assets are greater than NSFR derivative liabilities; (c) all other assets not included in the above categories, including non-performing loans, loans to financial institutions with a residual maturity of one year or more, non-exchange-traded equities, fixed assets, items deducted from regulatory capital, retained interest, insurance assets, subsidiary interests and defaulted securities; and

22 P a g e 22 (d) 20% of derivative liabilities (ie negative replacement cost amounts) as calculated according to paragraph 19 (before deducting variation margin posted). 44. Table 2 summarises the specific types of assets to be assigned to each asset category and their associated RSF factor.

23 P a g e 23 Interdependent assets and liabilities 45. National supervisors have discretion in limited circumstances to determine whether certain asset and liability items, on the basis of contractual arrangements, are interdependent such that the liability cannot fall due while the asset remains on the balance sheet, the principal payment flows from the asset cannot be used for something other than repaying the liability, and the liability cannot be used to fund other assets. For interdependent items, supervisors may adjust RSF and ASF factors so that they are both 0%, subject to the following criteria: The individual interdependent asset and liability items must be clearly identifiable. The maturity and principal amount of both the liability and its interdependent asset should be the same. The bank is acting solely as a pass-through unit to channel the funding received (the interdependent liability) into the corresponding interdependent asset.

24 P a g e 24 The counterparties for each pair of interdependent liabilities and assets should not be the same. Before exercising this discretion, supervisors should consider whether perverse incentives or unintended consequences are being created. The instances where supervisors will exercise the discretion to apply this exceptional treatment should be transparent, explicit and clearly outlined in the regulations of each jurisdiction, to provide clarity both within the jurisdiction and internationally. Off-balance sheet exposures 46. Many potential OBS liquidity exposures require little direct or immediate funding but can lead to significant liquidity drains over a longer time horizon. The NSFR assigns an RSF factor to various OBS activities in order to ensure that institutions hold stable funding for the portion of OBS exposures that may be expected to require funding within a one-year horizon. 47. Consistent with the LCR, the NSFR identifies OBS exposure categories based broadly on whether the commitment is a credit or liquidity facility or some other contingent funding obligation.

25 P a g e 25 Table 3 identifies the specific types of OBS exposures to be assigned to each OBS category and their associated RSF factor. III. Application issues for the NSFR 48. This section outlines two issues related to the application of the NSFR: the frequency with which banks calculate and report the NSFR, and the scope of application of the NSFR. A. Frequency of calculation and reporting 49. Banks are expected to meet the NSFR requirement on an ongoing basis. The NSFR should be reported at least quarterly. The time lag in reporting should not surpass the allowable time lag under the Basel capital standards. B. Scope of application 50. The application of the NSFR requirement in this document follows the scope of application set out in Part I (Scope of Application) of the Basel II framework. The NSFR should be applied to all internationally active banks on a consolidated basis, but may be used for other banks and on any subset of entities of internationally active banks as well to ensure greater consistency and a level playing field between domestic and cross-border banks. 51. Regardless of the scope of application of the NSFR, in line with Principle 6 as outlined in the Sound Principles, a bank should actively monitor and control liquidity risk exposures and funding needs at the level of individual legal entities, foreign branches and subsidiaries, and the group as a whole, taking into account legal, regulatory and operational limitations to the transferability of liquidity.

26 P a g e 26 Welcoming remarks at the 2nd Conference on Standard-Setting Bodies and Financial Inclusion Welcoming remarks delivered by Mr Jaime Caruana, General Manager of the BIS, on the occasion of the 2nd Conference on Standard-Setting Bodies and Financial Inclusion - "Standard-setting in the changing landscape of digital financial inclusion", Basel, Switzerland Ladies and gentlemen, good morning. It is my pleasure and privilege to welcome all of you to this unique gathering, which brings together key representatives from financial sector standard-setting bodies, multilateral organisations and national authorities on a most timely topic of common interest: that is, the fast-changing landscape of digital financial inclusion. That we gather once again under the joint auspices of the G20 Global Partnership for Financial Inclusion (GPFI) and the BIS's Financial Stability Institute is particularly appropriate. The theme of this event reflects growing recognition of the power and importance of bringing formal financial services to the estimated 2.5 billion adults who have limited or no access to them - and the vital role digital technology plays in making this possible. I am amazed how much things have advanced in just the last few years. I recall that the BIS discussed the issue of digital financial inclusion in a May 2011 working paper. At the time, the authors urged risk-proportionate regulation of innovations such as M-Pesa, the mobile phone-based digital transaction platform in Kenya. This service had already captured international attention for its financial inclusion potential.

27 P a g e 27 But on the issue of whether viable business models would emerge that could be replicated globally, the authors judged that the jury was still out. Since then, the jury has returned, and its verdict is positive. Similar digital financial services have now been launched in more than 80 countries. As of June 2013, there were over 60 million active mobile money accounts. But the potential is arguably much greater than this figure, given the huge number of people who now have access to a mobile phone but do not yet have a bank account or access to credit from a formal financial institution. The proliferation of ever cheaper smartphones, such as a $33 model that went on sale in India just a couple of months ago, can be a game changer for unserved and under-served low-income households as well as micro- and small enterprises. It is predicted that, by the year 2020, smartphones will account for two out of every three mobile connections globally, and that many of those will be in the developing world. That amounts to six billion out of the nine billion mobile connections forecast by that time. The regulatory, supervisory and standard-setting challenges - and likewise the solutions - include those we currently face, and others we can only imagine as billions of new digital finance users go online. The representatives of standard-setting bodies, public authorities and development partners gathered here today are all trying to assess the impact of these changes, to predict what lies ahead, and to determine how innovations will play out in various economies. For example, in Myanmar, where only an estimated 20% of the population currently has access to formal financial services, as the

28 P a g e 28 country opens up the largely disconnected population will probably bypass earlier technology and go directly to smartphones. As we will hear from our keynote speaker Dr Nachiket Mor, reforms in India are well under way to establish a new category of digital transactional platform, which is to come under the country's regulatory and supervisory system. It combines with India's much watched "Unique ID" initiative to realise the stated goal of extending financial services to the country's entire population - the second largest in the world. The implications for standard-setting bodies of technology-enabled connectivity among retail customers are exciting, yet also cross-cutting. The discussions today and tomorrow are likely to highlight that banking and retail payments can no longer be seen as separate domains - nor are they the exclusive province of traditional players such as universal banks. The often specially tailored products in savings, credit, insurance and investment - even micro-pensions - that are already reaching low-income households via innovative digital transactional platforms pose new questions, and even challenges, to all the standard setters in the room. I am mindful of the G20 Leaders' call to all the standard-setting bodies at the 2013 summit in Saint Petersburg. On that occasion, the Leaders endorsed the recommendations of the GPFI, which included three aspects quite relevant to this gathering: - First, the standard-setting bodies should continue their impressive progress on financial inclusion - consistent, of course, with their important core mandates. - Second, they should participate in GPFI activities related to financial inclusion and also engage GPFI representatives in their activities where relevant.

29 P a g e 29 This conference is an excellent example of that commitment. - Third, they should give attention to emerging issues in financial inclusion that are relevant to multiple standard-setting bodies. Digital financial inclusion may be one of the most important issues in this regard. We will need more of this kind of forum - and the one provided by the third meeting of standard-setting bodies' Chairs and Secretaries General on financial inclusion. That meeting was convened here at the BIS earlier this month by Her Majesty Queen Máxima of the Netherlands, in her capacity as the UN Secretary General's Special Advocate for Inclusive Finance for Development and Honorary Patron of the GPFI, together with the Basel Committee Chairman. At that gathering, the commitment to ongoing engagement was palpable. We need to be proactive in recognising the customer protection and financial stability implications of the exciting and radical changes ahead. Addressing this future will call for the kind of foresight we had in the 1990s when dealing with the emergence of global financial conglomerates. In that context, the Basel Committee on Banking Supervision, the International Association of Insurance Supervisors, and the International Organization of Securities Commissions were brought together to establish the Joint Forum. In the financial inclusion context, the standard-setting bodies will again need to work together. But when it comes to digital financial inclusion, those represented in this room alone are not likely to cover all of the relevant landscape.

30 P a g e 30 In December, for example, the International Telecommunications Union will launch a new Focus Group on Digital Financial Services, and other collaborative forums are likely to emerge. In the context of international cooperation, I often refer to the "Basel Process" - that is, the synergies that result from the interaction among the standard-setting bodies and committees hosted by the BIS here in Basel. The proximity of these groups at the BIS and the long tradition of joint work make the BIS an excellent venue for exchanging ideas and information on topics that range beyond the day-to-day work of any single standard setter or committee. Over the next day and a half, we have the opportunity - and indeed the responsibility - to prepare the standard-setting world for both the risks and the rewards of the digitisation of financial services. Once again, I am honoured that the BIS can offer such an appropriate venue for this gathering. I wish you all a successful meeting.

31 P a g e 31 On a sound and growth-enhancing financial sector in Europe Keynote speech by Mr Erkki Liikanen, Governor of the Bank of Finland, at the joint Conference "The Comprehensive Assessment, the ECB's New Role and Limits of a Common Supervision in the EU", organised by the Financial Risk and Stability Network, Deutsches Institut für Wirtschaftsforschung (DIW Berlin), European School of Management and Technology (ESMT), Jacques Delors Institut Berlin and Bruegel, Berlin The social costs of the financial crisis - such as the losses in the GDP and the increases in unemployment - have been very high. If policymakers - in central banks and in governments - had not learned from the policy mistakes made during the Depression in the 1930s, the crisis could have been even more destructive. To avoid such crises in the future, or to at least limit their likelihood, we need a more stable and resilient banking and financial system in Europe. To that end, we need better regulation and supervision of banks and other financial institutions than before. Well-designed regulation provide banks with the right incentives to choose their business model, scope, and size efficiently to best serve the society. It is a key responsibility of our generation to make the financial system much safer than it has been. To be sure, we do not need to return to the repressive regulation of the post-war period, and we need to ensure that the financial system does not prevent the recovery from the global crisis. But we do need to find a better balance between rules and flexibility in regulation than we have had.

32 P a g e 32 The rest of this speech is organised as follows. First, I take a brief look at the European financial sector and especially the banking sector before the crisis. Then I discuss the main building blocks of reforms to European financial system. Finally, I provide views on the next steps: future developments in the financial sector and necessary policy actions. The European financial sector before the crisis The banking sector has traditionally been and still is the dominant component in the European financial sector, and developments in banking have also been of clear relevance to the emergence of the financial crises in Europe. As the recent report by the Advisory Scientific Committee of the European Systemic Risk Board tells us, over the past years banking systems in Europe had become too leveraged, too concentrated, and sometimes also too big. As documented by the ESRB report, banks' domestic private lending as well as their total balance sheets had ballooned. The total assets of the EU banking sector were over three times the EU GDP in In several EU countries, the ratio is much bigger. As to the concentration, the report points out that since 2000, the share of the three largest domestic banks of the national banking system total assets had increased in all major EU countries except Italy. The increase in leverage is illustrated by the decline in the median equity to assets ratio of the largest listed EU banks to only just over 3% by 2008 from around 6% in the late 1990's.

33 P a g e 33 The increases in bank sizes and bank lending were not matched by an equivalent increase in market-based financial intermediation. For example, the ratios of stock market capitalisation to bank credit decreased considerably in the 2000s in the biggest EU countries. As a result, the European financial structure became even more bank-based than before. The large reliance of European firms - especially the SMEs - on bank finance has recently been a drag on the recovery of the European economy as banks' ability to lend has been weak in many EU countries in the aftermath of the crises. It is now obvious that many of the developments in the European banking since the 1990's sowed the seeds of the banking and sovereign debt crisis: - Too-big-to-fail and too-big-to-save problems became more severe; - Banks misallocated too much funds in asset markets fostering unsustainable bubbles; - Weakly capitalised banks' resilience to shocks became poorer; - Increased concentration of the banking system made banks more interdependent and vulnerable to contagion. What has been done to develop the financial sector? - Lessons from the crisis With this background in the banking sector, Europe faced the dramatic events of the financial crisis. A wide-ranging discussion emerged and has continued on the reasons and lessons of the crisis. One of the early, and one of the best accounts of the crisis was provided by Nobel Laureate Jean Tirole.

34 P a g e 34 Professor Tirole accentuated the role of the inappropriate and poorly implemented regulation as one of the critical factors explaining the emergence of the crisis. In response to the crisis, a large number of international and EU wide regulatory reforms have been launched. I will focus on three key areas of reform. These are new prudential regulatory requirements for banks mainly following the standards set by the Basel Committee of Banking Supervision; structural reforms planned for banks; and finally the introduction of the Banking Union in Europe, especially the Single Supervisory Mechanism, or the SSM. New prudential requirements Prudential requirements set for the banking sector are undergoing a thorough reform. A lot has already been achieved especially in the area of capital requirements developed by the Basel Committee and implemented in Europe by EU legislation. New capital requirements can go a long way to reduce incentives to take excessive risks across different banking operations. Above all, they will improve banks' loss absorbing capacity. These effects reduce the probability of bank failures. At the same time, sounder capital requirements support banks' credibility and ability to intermediate funding also in difficult market conditions. Importantly, prudential regulatory requirements are increasingly set to address macroprudential, system wide vulnerabilities and risks - in addition to targeting institution-specific risks. As also pointed out in the IMF's most recent Global Financial Stability Report, 2 the introduction of macroprudential policy is a key step to

35 P a g e 35 promoting the soundness of the financial sector especially in times of asynchronous economic and financial risks. Within the euro area, country-specific macroprudential policy seems particularly useful as single monetary policy is conducted for the entire euro area. While EU Member States have designated macroprudential authorities, and the ECB also has been assigned a new role in macroprudential policy in the SSM Regulation, it is important to note that the financial system would benefit more if all actors in the financial sector, supervisors, banks and their customers alike, paid more attention to systemic risks emanating for example from excessive credit growth and leverage or misaligned incentives in the financial system. Closely linked and complementary to prudential requirements, the introduction of the new recovery and resolution regime will help avoid bank bail-out or make it a rare exception. When successfully implemented, it will provide for a set of tools to enable an orderly "failure" of banks. The main tool will be the possibility to "bail-in" bank debt holders to absorb losses. Moreover, the new recovery and resolution tools, provided that they are credible, will reduce the implicit government guarantee and distortive risk-taking incentives created by bail-out expectations and artificially low funding costs. Structural reform While the improved capital and liquidity requirements and the new resolution regime take us a long way in addressing the too-big-to-fail problem, they do not take us all the way. In October 2012 the High-level Expert Group on reforming the structure of the EU banking sector proposed mandatory separation of

36 P a g e 36 a deposit bank and a trading entity within the banking group to complement, not to substitute the ongoing regulatory reform. The motivation for our decision to propose separation was the following: - First, to limit the spill-over of benefits from the deposit guarantee system and any implicit government guarantees to certain trading activities of banks. - Second, to simplify the structure of large, complex banks. Reducing complexity by means of separation facilitates management and implementation of incentives and it facilitates supervision and monitoring by outside stakeholders such as shareholders, bank creditors and other market participants, thus reinforcing market discipline. - Third, to make it easier to impose recovery and resolution measures if a bank would nevertheless get into severe problems. Simplifying the structure of the bank ex-ante would also serve this purpose. It is crucial to make credible the resolution also of the largest and most trading-intense banks. - Fourth, to reduce the mixing of two very different management cultures in 1) the customer-based retail and commercial banking and 2) the transaction-based trading activities. The aim was to shift the focus from short-term to long-term, which is more in line with the interests of the real economy and society at large. The choice of where to draw the line between the deposit bank and the trading entity was made so as to enable banks to service the real economy in the best way possible, while separating the activity that should not enjoy the benefit of the implicit government guarantee.

37 P a g e 37 Because the difference between proprietary trading and market making is hard to distinguish, the Group proposed to keep them together in the separated trading entity. In this way, market making would be provided on equal terms by trading units within banking groups and entities outside the regular banking sector. The High-level Expert Group also suggested that exposures to shadow banking entities such as hedge funds ought to be separated from deposit-taking and lending activities. Finally, we wanted to preserve the universal banking model and keep the trading activity within the bank supervisory umbrella. This would also reduce the risk of migration of activities to the shadow banking system. Having the deposit bank and trading entity under one roof would also allow "one-stop banking" to continue where it is to the benefit of customers. In January 2014 the European Commission presented its proposal for a Regulation on structural measures improving the resilience of EU credit institutions. The Commission proposal would cover the largest and most trading-intense banks in Europe. The proposal obliges the competent authority to review trading activities and empowers the competent authority to require separation of market-making, risky securitisation and complex derivatives when specific conditions prevail. The Commission proposal leaves an important role for the future judgment of the competent authorities (which in most cases would be the ECB), the EBA and the Commission itself in detailing the separation process and metrics to be used.

38 P a g e 38 Here transparency, predictability and public accountability are crucial. Moreover, the elements of discretion need to be implemented without compromising the level playing field in banking and the integrity of the internal market. In some respects, the proposed Regulation does also differ from the Group's recommendations. The Commission's proposal includes an outright ban on organised proprietary trading instead of requiring it to be assigned to a separate and separately capitalised legal entity. Even though the definition of proprietary trading is rather narrow, the Commission proposal resembles the structural reform implemented in the United States. The Commission proposal is now in the hands of the Council and the European Parliament. Banking Union Today, our focus is on the Single Supervisory Mechanism, an important element in the European Banking Union. The changeover to the Banking Union is definitely the biggest change in the European financial regulatory framework since the adoption of the euro. With the SSM taking its fully operative role in just a few days, this conference could not be better scheduled to discuss the developments in supervision. The decision on the creation of the common supervision was taken by the European Council only two years ago in June The idea of common European supervision was not new, but it had been debated in various forms and fora.

39 P a g e 39 One of the proponents of common supervision was Professor Jean Tirole who proposed integration of supervision with the ECB as an early lesson from the financial crisis. On Sunday, the first core project of the SSM was finalised, when the results of the comprehensive assessment were published. This exercise provides a very good starting point for both the European banking sector and the ECB as a common supervisor. For banks, the comprehensive assessment was intentionally designed to be very tough and demanding. In comparison to previous supervisory actions, the comprehensive assessment included not only the stress test, but an asset quality review to ensure that the basis for stress testing is robust and the results comparable. I believe that this strong exercise as a whole helps the European banking sector repair its credibility by enhancing transparency and improving the resilience of the banking sector through corrective measures. In this way, the comprehensive assessment supports banks' ability to provide funding to non-financial economy, which is a necessary condition for restoring growth in Europe. However, prompt action is vital to further harmonise banking regulations in Europe. In particular, making the quality of bank capital consistent across Member States should be a priority, also for the SSM. Also to make the SSM operational, the comprehensive assessment has been a very useful exercise. During the past months, the national competent authorities and the ECB have got the first flavour of acting closely together. The comprehensive assessment also provides the ECB with a deep knowledge of the major banks to be under its direct supervision.

40 P a g e 40 After thorough preparations since last year, the SSM will assume its supervisory tasks next week. I am confident that due to the SSM, we will have a more effective and efficient supervision, making the banking sector safer and helping it fulfil its tasks in the economy. ***** For the ECB, taking over the responsibility on banking supervision is a big challenge. An important question is how the ECB will reconcile its primary task of monetary policy and the tasks assigned to it by the SSM regulation. It is crucial that the tasks of the ECB related to micro-prudential banking supervision are clearly separated from the ECB's primary monetary policy function. The separation of the policy functions is essential for safeguarding the independence of monetary policy, and it also helps the supervisory function achieve its objectives. The separation of the supervisory function is required by the SSM legislation the provisions of which require, for instance, strictly separated decision-making arrangements of the Governing Council for different policy functions, but also separation of the supervisory staff from the staff for monetary policy and other policy functions. ***** The other main pillar of the banking union is the Single Resolution Mechanism, or SRM, that better enables the resolution also of banks operating across the Banking Union Member States. The legislation on the SRM was approved earlier this year. Now it is of utmost importance that the institutional framework is promptly implemented for the SRM to be fully operational by January 2016.

41 P a g e 41 The next steps for the financial sector in Europe? How is the European financial sector developing now, and what are the new policy challenges? Given the legacy of the crisis, the policymakers still face several challenges in financial market policies. In the short term, one challenge is that we must first find ways to boost bank lending especially to SMEs to invigorate economic growth in Europe. There are issues on the demand side but also on the supply side. A special market segment has drawn attention during last months, it is the state of the European securitisation markets. Public issuances in the European ABS markets remain low, trading is thin in some market segments and the whole market carries a stigma in spite of the fact that most European structured finance products performed well throughout the crisis. In the short term, we have a clear need to stimulate ABS markets to stimulate credit creation. In the longer-term the revitalisation of ABS markets would, among other things, (i) allow better risk sharing among investors (ii) help banks to diversify their funding structure thus increasing their resilience, and (iii) make firms less reliant on bank finance. Concerning short term-challenges in the economy, the Governing Council of the ECB has recently published decisions on targeted longer-term refinancing operations (TLTROs) as well as ABS and covered bond purchase programmes.

42 P a g e 42 Together, the aim of these measures is to further enhance the transmission of monetary policy. Their aim is to facilitate credit provision to the euro area economy. Turning to more longer-term developments, I am confident that if the planned regulatory reforms are properly implemented, they will make the European financial sector sounder and better able to fulfil its tasks in the economy, channelling funds from savers to borrowers in a healthy manner. Key financial sector reforms in the EU have focused on the banking sector. Banks' reputation and the public confidence towards banks have suffered since the financial crisis. While making banks more resilient, better structured and better supervised, the regulatory reforms also advance the aim of rebuilding the confidence on banks. At the same time, banking sector will very likely be complemented by financial markets and other institutions in allocating funds to final customers. The new ECB report on banking structures 3 points out that the expansion of the traditional banking sector in the euro area has slowed down since the beginning of the crisis whereas the growth has continued in the non-banking financial sector, especially in shadow banking. The diversification of the financial system in Europe is a healthy development. However, more attention needs to be drawn to the alternative funding channels to achieve two goals. To remove any undesirable impediments to their efficient functioning. And to ensure that they do not create new threats to financial stability.

43 P a g e 43 Several new initiatives have been taken in the areas that go beyond banking. These include the public consultation 4 in early summer by the ECB and the Bank of England to stimulate discussion on how to build a better functioning securitisation market in the European Union. In particular, this consultation highlighted a suggestion to create standards for the so-called qualifying securitisations to identify low-risk ABS products that are simple, robust and transparent. The responses, published earlier this month, 5 broadly supported this initiative. In January 2014, the Commission published a proposal for a regulation aimed at increasing transparency of certain shadow banking transactions. The aim of this proposal is to improve the reporting and increase the efficiency of supervision on securities financing transactions so that the links to the banking sector are properly understood. In his Political Guidelines for the next European Commission, President-Elect Jean-Claude Juncker called for a Capital Markets Union to develop and integrate capital markets, also with the aims of developing alternatives for bank funding, especially for SMEs, and making Europe a more attractive place to invest. These and other initiatives to develop functioning of shadow banking and financial markets are very welcome. Work on this field still needs more systematic and serious reflection, but we already have a good starting point. Concluding remarks Banks play a particularly important role in the financial sector in Europe, as the most important source of finance for small and medium-sized enterprises.

44 P a g e 44 Banks also played a critical role in the background for the financial crisis. The crisis initiated a comprehensive reform of regulatory and supervisory framework of the banking sector, including new capital requirements, structural changes, as well as the Banking Union with the Single Supervisory and Resolution Mechanisms. The regulatory and supervisory reforms are still partly ongoing, and they need to be carefully completed and implemented. With the good progress achieved this far, the banking sector seems to become more sound and resilient over time, thereby better able to provide loans and other services without compromising financial stability. At the same time, to complement bank finance in providing for adequate growth potential in the real economy, alternative ways of funding need to be enhanced. But we also need to improve our understanding of risks going beyond the traditional banking sector and to be able address any threat they create to financial stability. Both of these elements are important. Combining a better regulated and supervised banking sector with a strengthened non-bank financial sector will contribute to financial stability and improve the long-term growth prospects of the European economy and thus the welfare of European citizens.

45 P a g e 45 European Central Bank AGGREGATE REPORT ON THE COMPREHENSIVE ASSESSMENT The completion of the comprehensive assessment is a major milestone towards the operational start of the Single Supervisory Mechanism (SSM) in November It constitutes an exercise of unprecedented scope, and the publication of its outcomes provides a significant improvement in the depth and comparability of the information available on the condition of the participating banks. We are convinced that this substantial increase in transparency will benefit all stakeholders and are therefore glad to present the Aggregate Report on the comprehensive assessment, which complements the bank-level disclosure templates. The execution of the comprehensive assessment required extraordinary efforts and the mobilisation of substantial resources by all parties involved, including the national competent authorities of the participating Member States, the European Banking Authority, the ECB and the participating banks. Thanks to their professionalism, continuous hard work, and strong spirit of cooperation, this exercise was concluded successfully within a very demanding time frame. The SSM has shown its ability to mobilise resources to work together on a common project. At the ECB, experts from both the supervisory and central banking sides have cooperated extensively, especially on the stress test side of the exercise. Regarding the stress test, the ECB Directorate General of Macro-Prudential Policy and Financial Stability was particularly responsible, as in previous EBA stress tests.

46 P a g e 46 We are most grateful to everyone involved for their dedication and extremely hard work in finalising the exercise on time and with excellent quality. The completion of the comprehensive assessment marks the start of a new supervisory regime in the euro area, and the SSM will follow up on the results of the comprehensive assessment when taking up its day-to-day supervisory activities as of 4 November The exercise constitutes an important starting point for a process in which the SSM will use all instruments available within its mandate to foster harmonisation in key areas of banks' supervisory and regulatory treatment across the euro area. These efforts will contribute to achieving the SSM's overall objective of making a substantial contribution to the safety and soundness of the euro area banking system, and thus ultimately benefiting the economies and citizens of the participating Member States.

47 P a g e 47 1 EXECUTIVE SUMMARY The ECB conducted the comprehensive assessment to prepare for assuming banking supervision tasks in November This resulted in aggregate adjustments of 48 billion to participating banks' asset carrying values which will be reflected in their accounts or in supervisory capital requirements. Overall, the exercise has identified capital shortfalls for 25 banks, totalling 25 billion. 1.1 COMPREHENSIVE ASSESSMENT The European Central Bank (ECB) will assume banking supervision tasks in November 2014 in its role within the Single Supervisory Mechanism (SSM). In preparation, the ECB has conducted a comprehensive assessment of 1301 banks. The stated objectives of this exercise were to: Strengthen banks balance sheets by repairing the problems identified through the necessary remedial actions. Enhance transparency by improving the quality of information available on the condition of the banks. Build confidence by assuring all stakeholders that, on completion of the identified remedial actions, banks will be soundly capitalised. This report provides an overview of the approach taken and presents the results of the exercise. The comprehensive assessment was broad in scope. The 130 credit institutions included in the exercise (i.e. "the participating banks") had total assets of 22.0 trillion, which accounts for 81.6% of total banking assets in the SSM.

48 P a g e 48 The comprehensive assessment consisted of two components. 1) The asset quality review (AQR) was a point-in-time assessment of the accuracy of the carrying value of banks assets as of 31 December 2013 and provided a starting point for the stress test. The AQR was undertaken by the ECB and national competent authorities (NCAs), and was based on a uniform methodology and harmonised definitions. The scale of the exercise was unprecedented; it provided a thorough health check of the banks that will be subject to direct supervision by the ECB. The exercise was based on the Capital Requirements Regulation and Directive (CRR/CRD IV), on the definition of regulatory capital as of 1 January Under the AQR, banks were required to have a minimum Common Equity Tier 1 (CET1) ratio of 8%. 2) The stress test provided a forward-looking examination of the resilience of banks solvency to two hypothetical scenarios, also reflecting new information arising from the AQR. The stress test was undertaken by the participating banks, the ECB, and NCAs, in cooperation with the European Banking Authority (EBA), which also designed the methodology along with the ECB and the European Systemic Risk Board (ESRB). Under the baseline scenario, banks were required to maintain a minimum CET1 ratio of 8%; under the adverse scenario, they were required to maintain a minimum CET1 ratio of 5.5%. The AQR respected current accounting and prudential regulation, including the CRR/CRD IV capital rules. In some areas the ECB s methodology involved additional prudential prescription to accounting concepts in order to achieve consistency and adequate conservatism.

49 P a g e 49 The results are of a prudential nature. AQR-adjustments were made, often in cases where banks were not breaching accounting rules. However, it is expected that many banks will likely choose to reflect many of these changes in their accounts. Examples of areas in which additional prescription was provided include impairment triggers, the calculation of individual specific provisions, and collateral valuations. The stress test is not a forecast of future events, but a prudential exercise to address banks ability to withstand weaker economic conditions. In the stress test, banks projections were subject to centrally defined requirements in order to ensure appropriate conservatism and highquality output. For example, balance sheets were assumed to remain constant over the stress test horizon in terms of total exposure volume, maturity and product mix (i.e. the static balance sheet assumption). Within both components, the approach taken aimed for a rigorous and consistent exercise, emphasising a "level playing field" between banks. Within the AQR, a detailed asset-level review was performed for over 800 specific portfolios making up 57% of the banks' risk-weighted assets. This resulted in the detailed analysis of more than 119,000 borrowers; the assessment of the valuation of about 170,000 collateral items; the building of 765 models to "challenge" the banks' own estimates of collectively assessed provisions and over 100 models to assess their CVA calculation; the revaluation of over 5,000 of the most complex fair value exposures; and the review of over 100 complex valuation models.

50 P a g e 50 This in-depth review employed over 6,000 experts at its height. In order to maintain consistency and equal treatment across both the AQR and stress test, central ECB teams independently performed quality assurance on the work of the banks and NCAs. The ECB was in close contact with NCAs, responding to over 8,000 methodology and process questions. The ECB reviewed and challenged outcomes from an SSM-wide perspective using comparative benchmarking, as well as engaged with NCAs to investigate specific issues that arose. Over 100 experts from the ECB along with external support professionals were involved in this quality assurance activity. 1.2 OUTCOMES OF THE COMPREHENSIVE ASSESSMENT The AQR resulted in aggregate adjustments of 47.5 billion to participating banks' asset carrying values as of 31 December These adjustments originated primarily from accrual accounted assets, particularly adjustments to specific provisions on non-retail exposures. Additionally, non-performing exposure (NPE) stocks were increased by billion across the in-scope institutions, as NPE definitions were moved onto a harmonised and comparable basis, including the examination of forbearance as a trigger of NPE status. The prudential and accounting implications will be assessed by the SSM's new Joint Supervisory Teams (JSTs) along with the qualitative conclusions of the exercise regarding, for example, the soundness of banks' internal processes. This will mean that even where banks do not reflect adjustments in their accounts all conclusions will be captured in ongoing supervision and in supervisory capital requirements.

51 P a g e 51 As Figure 1 shows, the AQR adjustments differ by jurisdiction as consistent standards have been applied where previous approaches may have diverged. In addition to adjustments made directly to current carrying values, the AQR result was also reflected in the projection of banks' capital adequacy under hypothetical scenarios performed in the stress test. Under the adverse scenario, the banks' aggregate available capital is projected to be depleted by billion (22% of capital held by participating banks) and risk weighted assets (RWA) to increase by about 860 billion by 2016; including this as a capital requirement at the threshold level brings the total capital impact to billion in the adverse scenario. This capital impact leads to a decrease of the CET1 ratio for the median participating bank by 4.0 percentage points from 12.4% to 8.3% in The reduction in the median CET1 ratio projected for banks in each country is shown in Figure 2.

52 P a g e 52 Although not fully comparable, the median projected CET1 ratio reduction in the Comprehensive Capital Analysis and Review (CCAR) carried out in the United States in 2014 was 2.9%6; it was 3.9% in the AQR and stress test carried out in Spain in 20127, and 2.1% in the EBA stress test carried out in Overall, the comprehensive assessment identified a capital shortfall of 24.6 billion across 25 participating banks after comparing these projected solvency ratios against the thresholds defined for the exercise. The 24.6 billion shortfall can be disaggregated into three components. The amount of shortfall that arose from the stress test conducted by the banks and quality assured by the ECB was 11.2 billion before making any adjustments due to AQR results and after accounting for all existing capital buffers as of 31 December The inclusion of the reduction in starting-point available capital due to AQR adjustments increases this shortfall to 21.9 billion.

53 P a g e 53 Finally, the reflection of the new information on asset performance learned through the AQR in the stress test projections resulted in the full shortfall of 24.6 billion. These impacts are illustrated in Figure 3. The overall comprehensive assessment shortfall is shown again in Figure 4, split by country of participating bank. It is presented in terms of country-level RWA, i.e. reflecting the significance of the shortfall relative to the size of the banks included in the exercise and showing the direct impact on banks' CET1 ratio.

54 P a g e 54 This capital shortfall identified by the comprehensive assessment can be placed in the context of capital recently raised by the participating banks. Between the onset of the financial crisis in 2008 and 31 December 2013, capital in excess of 200 billion has been raised by banks participating in the exercise. Since 1 January 2014, a further 57.1 billion has been raised which is not counted in the results above, but which will be considered as mitigation of the shortfalls found. On a bank level, the capital needs identified are presented below, along with the capital raised by each institution since 31 December and the remaining capital shortfall.

55 P a g e 55 For each of the 25 institutions identified in Table 1, a capital plan will be submitted to the respective JST within two weeks of the publication of this document, detailing how the capital shortfall will be filled. The JSTs will check that any such plans are sound and include the capital raising already undertaken by the participating banks with shortfalls. When all of the capital that has been raised already (net of capital instrument buyback) is offset against the shortfalls, 9.5 billion remain to be filled, distributed across 13 banks. Two banks within this list that have a shortfall on a static balance sheet projection13 will have dynamic balance sheet projections (which have been performed alongside the static balance sheet assessment as restructuring plans were agreed with DG-COMP after 1 January 2014) taken into account by the JSTs in determining their final capital requirements. Under the dynamic balance sheet assumption, one bank has no shortfall and one bank has practically no shortfall.

56 P a g e 56 The calculation of CET1 used within the comprehensive assessment and reflected above has been performed based on the existing legal requirements and national transitional arrangements, with the

57 P a g e 57 notable exception of the removal of the prudential filter on unrealised gains and losses on sovereign exposures in available-for-sale (AFS), for which an EBA-defined harmonised phase-in has been applied. These national discretions over transitional arrangements introduce variation in the current definition of capital used across banks and countries. The resulting divergences will gradually diminish over the coming years as transitional arrangements are phased out. In the meantime, the ECB recognises the need to improve the consistency of the definition of capital and the related quality of CET1 capital. This will be an issue for the SSM to address as a matter of priority. The disclosure of the impact of the transitional provisions on CET1 allows for an objective comparison, where the impact of the national options is neutralised.

58 P a g e 58 BIS Working Papers, No 470 The Impact of Liquidity Regulation on Banks Ryan N. Banerjee and Hitoshi Mio Monetary and Economic Department Note: This paper was completed while Hitoshi Mio was on secondment at the Bank of England. We would like to thank David Aikman, Oliver Bush, Stephen Cecchetti, John Cunningham, Dietrich Domanski, Marc Farag, Rodrigo Guimaraes, Leo de Haan, Damian Harland, John Jackson, Sujit Kapadia, Michael Kiley, Antoine Lallour, Vasileios Madouros, Benjamin Nelson, Stephen Reynolds, May Rostom, Victoria Saporta, George Speight, Misa Tanaka, Philip Turner, Mark Walsh, Iain de Weymarn, Tomasz Wieladek, Matthew Willison and seminar participants at the Bank of England, Bank for International Settlements, De Nederlandsche Bank and Federal Reserve Board for the helpful comments and suggestions. Excellent data and research support was provided by Kirsty Rodwell and by the staff of Statistics and Regulatory Data Division of the Bank. All remaining errors are our own and the usual disclaimers apply. Corresponding author. Bank for International Settlements, Centralbahnplatz 2, CH-4002 Basel, Switzerland. Tel: Fax: ryan.banerjee@bis.org Bank of Japan. hitoshi.mio@boj.or.jp Abstract: To the best of our knowledge, this is the first study to estimate the effect of liquidity regulation on bank balance sheets. It takes advantage of the fact that not all banks were made subject to tighter liquidity regulation by the UK Financial Services Authority (FSA) in Under this new regulation a subset of banks operating in the UK were required to hold a sufficient stock of high quality liquid assets (HQLA) to withstand two scenarios of stressed funding conditions.

59 P a g e 59 We find that banks adjusted both their asset and liability structures to meet tighter liquidity requirements. Banks increased the share of HQLA and funding from more stable UK non-financial deposits while reducing the share of short-term intra-financial loans and short-term wholesale funding. We do not find evidence that the tightening of liquidity regulation had an impact on the overall size of bank balance sheets or a detrimental impact on lending to the non-financial sector either through reduced lending supply or higher interest rates on loans. Overall, in response to tougher liquidity regulation, banks replaced claims on other financial institutions with cash, central bank reserves and government bonds and so reduced the interconnectedness of the banking sector without affecting lending to the real economy. I. Introduction During the international financial crisis which started in mid-2007, liquidity in short- term money markets dried up and banks suffered severe funding problems, including secured funding for highly-rated assets. By September 2007, Northern Rock experienced the first bank run by retail depositors in the UK since The significant reduction in market liquidity forced major central banks across the globe to provide huge amounts of liquidity assistance to their banking systems. In 2010 the UK Financial Services Authority (FSA) introduced a new liquidity regulation called the Individual Liquidity Guidance (ILG). Internationally the Basel Committee on Banking Supervision agreed on a Liquidity Coverage Ratio (LCR) in 2013, which is similar in design to the ILG. The ILG aims to make the banking system more resilient to liquidity shocks by requiring banks to hold a minimum quantity of high quality liquid assets (HQLA) consisting of cash, central bank reserves and

60 P a g e 60 government bonds to cover net outflows of liabilities under two specific stress scenarios lasting 14 days and 3 months respectively. In these scenarios, it is assumed that banks that are more heavily dependent on short-term wholesale funding, especially from foreign counterparts would experience greater funding outflows and therefore need to hold higher ratios of HQLA to total assets to ensure immediate survival in stressed funding conditions. Although more stringent liquidity regulation can reduce the risk of bank runs and freezing of the interbank market, there has been a vigorous debate about the negative impact of liquidity regulation due to its impact on bank lending to the non-financial economy and bank profitability. The ILG is designed to encourage banks to either increase the ratio of HQLA to other assets, decrease the ratio of short-term wholesale funding to more stable deposit and equity funding or a combination of the two. Beyond that, the design does not provide predictions about how banks will respond along other dimensions such as the impact on the size of bank balance sheets. Banks can respond in a myriad of ways along these other dimensions to meet the ILG requirement which are likely to have significantly different implications for the real economy. For example a bank could increase the ratio of HQLA to stressed liability outflows by shrinking its balance sheet through a reduction in lending to the non-financial sector. Or a bank could attract more stable household deposit funding and use the proceeds to acquire HQLA, increasing the size of its bank balance. Banks could also meet the regulation without changing balance sheet size but instead increasing the share of HQLA to other assets by substituting liquidity held as intra-financial loans to government bonds without affecting lending to the non-financial sector while

61 P a g e 61 simultaneously increasing the share of funding from more stable household deposits and reducing short-term wholesale funding. In short, there are many possible ways for banks to meet tighter liquidity requirements. There are few historical episodes to evaluate the response of banks to a tightening of liquidity regulation. This has created a wide range of views about the impact of liquidity regulation. Financial industry groups have argued that liquidity regulation will substantially increase the cost of bank funding and damage the real economy as banks pass on higher costs and reduce credit supply to the real economy (IIF, 2010). Others have argued that liquidity regulation will have a more limited impact (MAG, 2010). This paper seeks to empirically identify the dimensions along which banks respond to liquidity regulation and thus shed light on the consequences for the broader economy. We estimate the average treatment effect of liquidity regulation on banks along multiple dimensions by exploiting the heterogeneous implementation of tighter liquidity regulation in the UK. In particular, when the FSA introduced the ILG in 2010 it exempted some banks from this new regulation. The granting of ILG waivers provides a control group which enables identification of the average effect. To the best of our knowledge, this is the first empirical study to estimate the causal effect of liquidity regulation on bank balance sheets. Additional consistency checks are applied to our estimates.

62 P a g e 62 We first estimate the average treatment effect on the shares of different asset and liability categories one-by-one. Because bank balance sheets must add-up any increase in the share of bank assets (liabilities) in one category must be offset by an equal and offsetting decrease in the shares of other assets (liabilities). If they did not, it would indicate that our estimates of the average treatment effect along the different dimensions are not internally consistent. We find that banks adjusted both their asset and liability structures to meet tighter liquidity regulation. However, we do not find evidence that the tightening of liquidity regulation had an impact on the overall size of bank balance sheets or a detrimental impact on lending to the non-financial sector. Despite each of our estimates being derived from separately estimated equations, we do find overall consistency across our results with equal and offsetting changes in the composition of assets and liability components. On the asset side of bank balance sheets, on average banks subject to the ILG increased the share of HQLA to total assets by 12 percentage points relative to those with waivers. The increased share of HQLA was matched by an almost equal reduction in the share of short-term intra-financial loans. Therefore, banks replaced private liquidity with official sector liquidity. Within the possible menu of HQLA, banks chose to hold central bank liabilities with over 75% of the increase in cash and central bank reserves and only a small fraction in UK T-bills and longer-maturity gilts. We do not find evidence that banks reduced their lending to the non-financial sector.

63 P a g e 63 On the liability side of bank balance sheets, banks increased funding from sources considered more stable under the ILG such as UK non-financial deposits and reduced their dependence on less stable short-term wholesale funding and non-resident deposits by a similar magnitude. Turning to the price impact of the ILG, for the limited balance sheet items for which data are available, we find that there is little evidence that banks increased interest rates on loans to the non-financial sector. Although ILG banks increased the share of funding from more stable UK non-financial deposits, surprisingly we do not find evidence that ILG banks increased the interest rate paid to attract those deposits. Our finding that the ILG had a significant impact on balance sheet composition but only a limited interest rate impact suggests that tougher liquidity regulation affects bank profitability primarily through the substitution towards lower yielding HQLA and more expensive non-financial deposit funding. Because the ILG significantly reduced intra-financial claims without having a measurable impact on the price or quantity of lending to the real economy, our results suggest that liquidity regulation could be a useful macro-prudential tool for reducing the transmission of shocks through a highly interconnected financial sector; an important factor that led to the evaporation of confidence in interbank markets during the financial crisis (Caballero and Simsek, 2009; Adrian and Shin, 2010). Furthermore, because the ILG encouraged banks to replace private sector liquid asset buffers with official sector assets this is likely to improve welfare in the presence of aggregate shocks (Holmstrom and Tirole, 1998). Because banks chose to meet their liquidity requirements in large part by increasing their holdings of central bank reserves, it is important to consider the influence of operational procedures related to the quantitative easing (QE) programme when interpreting our results.

64 P a g e 64 Changes to Bank of England operational procedures allowed commercial banks to deposit an unlimited quantity of reserves at the Bank of England that were remunerated at Bank rate. This facility created a perfectly elastic HQLA supply curve. If this facility had not existed, the tightening of liquidity regulation could have been more costly as the higher demand for other forms of HQLA such as T-bills and gilts would have increased the prices of those assets. There has only been limited empirical research which evaluates the impact of liquidity regulation on banks. The principal reason is the scarcity of recent instances of demanding prudential liquidity regulation. For example liquidity regulation was excluded from both Basel I and Basel II regulations. A notable exception is the Dutch Liquidity Ratio introduced in 2003 (DNB, 2003). Although there are a number of recent studies which have analysed this regulation, unlike our paper, none have examined the impact of policy interventions which changed liquidity regulation. Bonner (2012) and Bonner and Eijffinger (2012) test how the Dutch Liquidity Ratio affects corporate lending rates and interbank funding costs by exploiting the variation between banks that are just above or below their regulatory liquidity requirements. Consistent with our results they find that banks below their liquidity requirements do not charge higher interest rates on corporate loans. They also find that banks below their liquidity requirements pay higher interest rates on unsecured interbank loans, even though there is no public disclosure of this regulatory information.

65 P a g e 65 These studies, however, potentially suffer from endogeneity problems because the difference in behaviour between banks that comply and do not comply with existing regulation is crucially dependent on the preferences of bank supervisors to tolerate non-compliance of the regulation. Duijm and Wierts (2014) use a panel error correction framework to test how banks adjust their balance sheets to meet the Dutch Liquidity Ratio following liquidity shocks. They find that when the gap between a bank s actual liquidity ratio and its required ratio is below its long-term average, banks adjust their balance sheets by increasing the share of stable forms of funding, while the response of liquid assets is insignificant. This result is broadly in line with our study although we find adjustment to be more symmetric following a tightening of liquidity regulation, affecting both the composition of assets and liabilities. Other microeconomic studies about bank liquidity management have also examined liquidity regulation and bank cash holdings, Bonner et. al. (2013); the maturity transformation of banks, De Haan and van den End (2013a); the liquidity transformation of banks, Berger and Bouwman (2009), regulatory intervention and liquidity transformation, Berger et. al. (2014); the management of reserve requirements, Barotolini et. al. (2001), Jallath-Coria et al. (2005); and holdings of cash and liquid securities, Freedman and Click (2009), Acharya and Merrouche (2013) and De Haan and van den End (2013b). The remainder of the paper is organised as follows, Section II describes the institutional background and Section III the data. Sections IV and V present our empirical methodology and our main results. Section VI presents robustness checks and Section VII concludes.

66 P a g e 66 II. UK Liquidity Regulation The financial crisis of exposed the inadequacy of existing liquidity regulation. Liquidity problems in funding markets resulted in a run on Northern Rock and caused widespread liquidity hoarding across the entire banking system that eventually resulted in the Bank of England intermediating flows within the financial sector in In this section we outline the recent history of liquidity regulation in the UK prior to the financial crisis and the FSA s introduction of the ILG in 2010, highlighting important elements for our identification strategy. Before the 1980s, a central focus of bank regulators had been on various liquidity ratios. Banks had to provide regular reports on the maturity profiles of their assets and liabilities. Regulators paid particular attention to asset liquidity. Indeed, in 1975 George Blunden, the first Chairman of the Basel Committee on Banking Standards (BCBS) and head of banking supervision at the Bank of England stated that the [Basel] Committee s main objective was to help ensure bank solvency and liquidity. (p.317 Goodhart, 2011). During the 1980s, however, the emphasis on liquidity ratios waned. Monetary policy implementation became more centred on short-term interest rates and less on liquidity ratios. The Bank of England recognised that the abolition of bank reserve asset ratios left a prudential gap noting that the Bank will seek to develop the single comprehensive measurement [of the overall liquidity of banks] (p.40 Bank of England, 1981).

67 P a g e 67 However, this single comprehensive measurement proved to be elusive. Similarly, there was no agreement on international liquidity standards in Basel I and II. As Goodhart (2011) notes, If one takes the twenty years from 1967 until 1987, both capital and liquidity ratios were declining sharply in most countries. If one takes the next twenty years from 1987 until mid- 2007, capital ratios recovered, but liquidity ratios continued to plummet. Goodhart (2011) goes on to discuss that a key reason for the neglect of liquidity regulation relative to solvency regulation was the absence of banking liquidity crises during this period. At the time of the financial crisis, liquidity regulation in the UK consisted of three different regimes depending on the type of financial institution. The Sterling Stock Liquidity Regime applied to the major sterling clearing banks. It required banks to hold a stock of Bank of England eligible assets to meet wholesale sterling outflows over the next five days and cover 5% of maturing retail deposits withdrawable over the same period. Allowable certificates of deposit could be used to offset wholesale sterling liabilities by up to 10% with a 15% haircut. The Mismatch Liquidity Regime applied to all other banks which included most foreign banks operating in the UK. Under the Mismatch Regime, the FSA reviewed bank cashflows to determine the required stock of liquid assets. Liquid assets were defined as assets having regularly quoted prices which are regularly traded and can be readily sold for cash.

68 P a g e 68 Banks were able to determine the type of liquid assets on a case-by-case basis with the supervisor. The Building Society Regime required building societies to hold 3.5% of liabilities in high quality marketable assets, which extended beyond the Bank of England s eligible collateral list to include commercial paper from Sterling Stock banks. In addition, some UK branches of non-resident banks received Global Liquidity Concessions (GLC) which transferred day-to-day supervision of liquidity to the home state regulator. In early 2007, prior to the financial crisis, the FSA had already commenced a review of existing liquidity regulation. In August 2007, there was a significant reduction in short- term money market liquidity which caused severe funding difficulties for many banks. On 14th September 2007, Northern Rock experienced a run by retail depositors, the first in the UK since These liquidity problems in funding markets added extra impetus to the existing review with the FSA publishing Discussion Paper (07/7) in December 2007, examining the liquidity requirements of banks and building societies (FSA, 2007). The discussion paper outlined preliminary ideas for the reform of UK liquidity regulation and indicated that it would consist of a quantitative liquidity requirement that measured maturity mismatch and would require a buffer of highly-liquid assets to ensure the immediate survival of banks in stressed funding conditions. The paper also indicated that liquidity regulation would be extended to a wider range of banks. The discussion paper solicited feedback on the proposals. One year later the FSA published Consultation Paper (08/22) Strengthening liquidity standards (FSA, 2008).

69 P a g e 69 The consultation paper outlined the Individual Liquidity Adequacy Standards (ILAS) regime, a framework to assess the liquidity of UK banks, building societies and full scope investment firms. It also outlined the quantitative Individual Liquidity Guidance (ILG) requirement which would require banks to hold a sufficient stock of high quality liquid assets to meet a hypothetical stress scenario set along the lines of the formula where X is the minimum firm-specific target set by the FSA. Although no quantification of the ILG asset haircuts and liability runoff rates were given, Consultation Paper (08/22) anticipated that the ILG would be tougher than existing regulation and that banks would need to hold a higher quantity and quality of liquid assets, including a greater proportion of assets held in the form of government debt. Also banks would need to be less reliant on short-term wholesale funding, especially from foreign counterparts and it would provide greater incentives for firms to attract a higher proportion of retail time-deposits. The Consultation Paper anticipated that the new rules would be finalised by April 2009 and would be brought into force in October 2009, promising to consult banks during Q on the transitional arrangements. Importantly for the identification strategy in this paper, Consultation Paper (08/22) explained that the ILG would be applied at the legal entity level. It also outlined the planned approach for granting exemptions from the new liquidity regulation, known as ILG waivers.

70 P a g e 70 The FSA announced two types of waivers for legal entities, Whole-firm Liquidity Waivers which would replace the existing GLC framework and Whole-firm Liquidity Modifications. The paper discussed how ILG waivers would formalise existing Global Liquidity Concessions while ensuring the FSA had day-to-day knowledge of liquidity risks in foreign branches in the UK and of the consolidated banking group to which the branch belonged. The Consultation Paper stated that it expected the vast majority of foreign branches to apply for a waiver. The conditions listed for granting such waivers included the liquidity regime of the home state regulator being in accordance with the Basel Committee on Bank Supervision (BCBS) Principles of Sound Liquidity Management and Supervision and that liquidity support from the whole-firm/parent would be made available to the branch at all times. FSA Consultation Paper (09/13) (FSA, 2009a) published in April 2009 stated that the policy statement on the new regime would be published in Q with the rules and guidance on the regime coming into effect in Q It indicated that the new liquidity reporting arrangements would go live in Q with a phased implementation set by supervisors on a firm-by-firm basis. Consultation Paper (09/13) clarified some details about the whole-firm liquidity waiver stating, all elements of the proposed regime would be switched off. However, in granting the waiver we intend to request whole-firm liquidity data at a frequency and format acceptable to us. (p. 29 FSA, 2009a). Nevertheless, the feedback from banks on Consultation Paper (09/14) (FSA 2009b) documented in Policy Statement (09/16) (FSA 2009c) indicated that at this stage there was still considerable uncertainty about the FSA s policy for granting ILG waivers. Finally in October 2009, the FSA published Policy Statement (09/16) Strengthening Liquidity Standards (FSA, 2009c) which finalised the far-reaching overhaul of the UK framework on liquidity regulation.

71 P a g e 71 The policy statement stated that banks were required to hold a sufficient stock of high quality liquid assets (HQLA) to withstand two scenarios of stressed funding conditions, an acute bank specific funding shock lasting 14 days and less acute but more generalised deterioration in funding conditions lasting 3 months. The policy statement further clarified that a waiver would exempt branches almost entirely from the new tougher liquidity regime, [t]he overall effect of a whole-firm liquidity modification will be that a branch will no longer be subject to our quantitative Individual Liquidity Adequacy Standards (ILAS) regime and systems and control requirements, as set out in BIRPU of the final rules. (p. 54 FSA PS09/16). The Policy Statement also announced that the final timetable for the new regime would be pushed back slightly from April 2010 to 1st June 2010 for sterling stock banks and standard ILAS building societies, to 1st October for banks under the existing Liquidity Mismatch regime and banks and building societies subject to the simplified ILAS and to 1st November 2010 for investment firms and branches. This timetable was followed during the implementation period.

72 P a g e 72 Figure I illustrates the decline in liquidity ratios discussed in Goodhart (2011). Between 1968 and the early 1980s HQLA declined from around 30% to less than 5% of total assets. There was a further reduction after 1996 when the liquidity regime which prevailed at the time of the financial crisis was introduced. However, since 2008, the share of HQLA to total assets has increased substantially. Independent of tighter liquidity regulation, there are a number of reasons which might have contributed to the post 2008 increase in HQLA. In the aftermath of the financial crisis, banks endogenously increased their liquid asset buffers to meet stressed outflows, a widespread phenomenon that has been documented in other banking systems that did not experience changes in liquidity regulation (e.g. den Haan and van den End, 2013b). Also, asset purchases from the Bank of England s QE programme, which started in 2009, mechanically increased the quantity of central bank reserves in the UK banking system. Despite these other influences, because our identification strategy uses banks that were granted waivers from the ILG requirement as a control group, we are able to isolate the contribution of tighter liquidity regulation on bank balance sheets from these other factors. III. DATA Our dataset is mainly constructed from entity level statistical returns collected for the production of the Bank of England s monetary statistics. Because the ILG regulation is applied at the legal entity level (e.g. branch or subsidiary) this data source accurately captures the entity subject to the regulation unlike data collected at the consolidated bank-level.

73 P a g e 73 However, because many of the legal entities considered are not separately capitalised, interpreting the full impact of liquidity regulation on the liability structure is not possible. We do however, control for the effects of bank capitalisation in our regression by using the ratio of Tier 1 capital to risk-weighted assets of the entity s consolidated banking group which is collected from Bankscope and regulatory returns from the FSA. For banks that were allowed to pool liquidity across some of their UK entities, we aggregate the entity level statistical data into groups that are defined as separate entities for UK liquidity regulation (we call these entities banks hereinafter). Our entity-level data are derived from three specific forms. Form BT covers basic balance sheet information and has the largest coverage of more than 300 banks. However, Form BT does not record information on the sectoral decompositions for UK loans and deposits such as UK loans to and UK deposits from households and PNFCs. To extract sectoral decompositions, we use Form BE, which has more limited coverage of around 100 larger banks. Form PL contains information about the interest income and interest payable by banks and has the most restrictive coverage among the three forms. Forms PL and BE are used to calculate the average interest rate on UK non-financial loans and the average interest rate on UK non- financial deposits. Due to constraints on data availability, we analyse the impact of liquidity on sterling balance sheets. The focus on sterling balance sheets alone is not necessarily problematic because the ILG requires banks to consider currency mismatches.

74 P a g e 74 Moreover, in terms of the ILG impact on the domestic UK economy, the sterling balance sheet is likely to be the most important. The Data Appendix shows the list of dependent variables and explains the data sources used in this analysis. Examining the descriptive statistics about the control and treatment groups, Figure II shows the evolution of HQLA in banks prior to and after the implementation of the ILG. In 2008, the mean share of HQLA to total sterling assets were very similar in banks that would become subject to the ILG regulation and those that would be granted waivers. During 2009, when the FSA finalised the key details of the tougher ILG requirements and uncertainty remained about the granting of ILG waivers, the mean share of HQLA to total assets in both the treatment and control groups increased at a similar rate to around 4%. However, in early 2010, soon after the FSA had clarified which banks would be subject to the requirement and which would receive waivers, a persistent divergence emerged between the two groups.

75 P a g e 75 Mean HQLA for banks subject to the ILG increased to 8% of total assets by Q4 2010, while mean HQLA for banks with ILG waivers remained virtually unchanged. Between Q and Q banks subject to the ILG increased HQLA by a further 3 percentage points as more banks received specific quantitative ILG targets from the FSA. The evolution of HQLA to total assets suggests that before the ILG, the behaviour of banks in both the treatment and control groups was broadly similar and that when the ILG was introduced it had a significant impact on banks in the treatment group relative to banks in the control group. In 2010/Q1 just before the introduction of the ILG, our sample consists of 171 banks after truncations, of which 90 are subject to the ILG while 81 received ILG waivers. The distribution of key variables of the ILG and non-ilg banks in Q are summarised in Table I. It shows that the size distribution, given by log total assets of ILG banks and non- ILG banks prior to the ILG was broadly similar except for the 90th percentile which shows that there are larger banks in the treatment group. The distribution of Tier 1 capital shows that capital is in general higher in ILG banks compared to non-ilg banks. Turning to balance sheet composition, the distribution of HQLA to total assets across the two groups is broadly similar. However, ILG banks have a greater share of loans to UK non-banks and smaller share of short-term financial loans than non-ilg banks. There are also important differences on the liability side: ILG banks have a greater share of funding from UK non-bank deposits and a smaller share of non-uk deposits funding than non-ilg banks.

76 P a g e 76 Overall, these descriptive statistics indicate that there are differences in the concentration on the UK businesses between ILG banks and non-ilg banks. Below we discuss our regression adjustment method to control for the different concentration of UK business when estimating the average treatment effect. We also perform robustness checks to determine the sensitivity of our results to these differences. To continue reading:

77 P a g e 77 List of Identified Financial Conglomerates As per 31 December 2013 figures Financial conglomerates with head of group in the EU/EEA

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84 P a g e 84 Financial conglomerates with head of group outside the EU/EEA

85 P a g e 85 The theoretical background for macroprudential policy Speech by Mr Amund Holmsen, Executive Director of Norges Bank (Central Bank of Norway), at Norges Bank's Finance Workshop, Oslo Thanks to Henrik Borchgrevink. This speech does not contain any assessments of the current economic situation or policy-related statements. Songs about financial stability are few and far between. But Odd Nordstoga has written a song about just that, entitled Lykkeliten (Happy Times): "Happiness is a time without debt, and reading the end of a book when in bed". That financial stability can be so directly associated with a feeling of happiness is an encouraging point of departure for macroprudential policy. Nordstoga has actually turned economic theory upside down. Happiness - or utility as we economists tend to call it - is usually associated with consumption. We can borrow to finance consumption. Credit provides an opportunity to advance consumption in time. In that respect, more credit engenders more happiness - not the opposite. But after the goods have been consumed, the loan still exists. Debt creates risk in the financial system. Nordstoga may then prove to be right. A time without debt may be a happier one.

86 P a g e 86 The business of banking is such that it can trigger or amplify an economic downturn. Subsequent to the financial crisis, macroprudential policy has evolved into a supplement to both traditional banking regulation and stabilisation policy. Even if individual banks comply with the applicable regulations, they can engage in herd behaviour and topple both their own business and the rest of the economy. While traditional banking regulation seeks to restrict an individual bank's risk-taking, macroprudential measures seek to limit the risk that the financial system inflicts on the wider economy. Somewhat simplified, we can say that traditional banking regulation focuses on the risk that goes into banks, while macroprudential policy focuses on the risk that comes out of banks. The aim is to strengthen the resilience of the financial system and curb financial vulnerabilities that build up in the economy. Since the establishment of banks some centuries ago, banking regulation has largely been the result of learning by experience. The subject field and reality have evolved hand in hand. The field of economics, like other scientific subjects, has evolved in leaps - or paradigms shifts, and the shifts have often followed in the wake of international economic breakdowns. The world economic crisis that erupted at the end of the 1920s entailed such a breakdown, and ushered in a paradigm shift in the field of economics and in economic policy. In the US, the Glass-Steagall Act was adopted, separating commercial and investment banking. Deposit insurance was introduced and banks that managed clients' savings were subject to new restrictions.

87 P a g e 87 In Norway, the banking crises in the 1920s also prompted the authorities to establish a supervisory framework for commercial banks. The global economic recession paved the way for Keynes' concept of demand management and active government intervention, and the rewriting of textbooks began. After the war, universities produced a new generation of economists filled with ideas of planned economies and regulation. The interest rate was regulated downwards to promote distributional aims. Other regulations had to be tightened to curb the consequences of distorting market prices. And new regulations were then added to alleviate the consequences of the former ones. One regulation came on top of the other and so on. That was the case not only in Norway, but also in many other countries. Detailed regulation - or fine-tuning - prevailed until the 1970s. The scale of regulation was summarised in a speech by Norges Bank Governor Knut Getz Wold at the Norwegian School of Economics in 1972: "Pursuant to the Act relating to access to regulating monetary and credit conditions of 1965, the King can decide to use a wide spectrum of instruments, such as liquidity reserves, foreign exchange reserves, supplementary reserves, investment obligation, direct lending regulation for certain credit institutions, interest rate caps on loans and issuance control in addition to reporting requirements in certain areas.

88 P a g e 88 All these instruments, with the exception of foreign exchange reserves and interest rate caps, have been used or are being used in practice." Milton Friedman had already predicted five years earlier that this system of managing the economy would collapse because economic policy expectations reduced the scope for pursuing the objective of permanently low unemployment. Friedman proved to be right. The Great Inflation in the 1970s and into the 1980s, combined with an economic management crisis, spurred a new paradigm shift in the field of economics. Regulations and planned economies had to give way to economic thinking guided by the central role of well-functioning markets. The shift also occurred in Norway, but it took somewhat longer than in other countries. The US banks that had been harnessed in the 1930s were freed up. The trend gradually pervaded Europe. The freeing up of the banking sector was a bit too abrupt for many and banking crises again made their appearance in western countries, not least here in the Nordic countries. The big picture is nonetheless one of a long period of stable growth and low inflation from the 1990s and into the 2000s. At the same time, debt levels rose in many countries. Deregulation fuelled the flow of capital across borders. Banking regulation had to be coordinated at an international level. The Basel regulatory framework came into place towards the end of the 1980s and represented a breakthrough. But the regulations would prove to be too weak.

89 P a g e 89 The next version, Basel II, came in 2004 and was more extensive and refined, but also contained a source of the instability that ensued, at least in Europe. The new framework allowed the denominator of the capital adequacy ratio to shrink if the banks themselves estimated loss probability as low. And they did. The reported capital ratio could rise without increasing the real capital base. The financial crisis of 2008 was the biggest global economic setback since the 1930s. The banking sector had contributed to fuelling the economic upturn in the years leading up to the crisis, but triggered and amplified the downturn. The financial crisis brought with it a fiscal crisis in many countries, following the exact pattern of earlier crises as described by Reinhart and Rogoff. Euro area GDP is still below the pre-crisis level, and in some countries far below that level. The course of history should then be that we are now facing a new paradigm shift in the field of economics. So far, the Basel II framework has been replaced by Basel III. That is something, but can hardly be called a paradigm shift. That does not, however, exclude the possibility that greater concepts are in the making. It is food for thought that paradigm shifts - as described by Thomas Kuhn - do not come about because the defenders of old truths see the light, but rather because they eventually die.

90 P a g e 90 If we take a closer look at the Basel III framework, there are still signs of innovation. Macroprudential policy is a new element of the framework, aimed at containing systemic risk in banks and financial institutions. For the first time, international banking regulation includes requirements grounded in the interplay between the banking sector and the rest of the economy. We must acknowledge that in the run-up to a financial crisis, the authorities, banks and other economic agents often confuse good times with normal times. Strong growth in real estate prices, credit and tax revenues are perceived as normal. Statistical filtering methods confirm that trend growth is high and that debt growth is sustainable. This time is different. We should know better - because we have fairly extensive knowledge about the economic background leading to financial crises. Analyses, including our own, show that a rapid accumulation of debt almost always precedes a financial crisis. Empirical studies document that high debt growth increases the probability of a crisis and results in a deeper crisis. Debt is at the core of all financial crises. Real estate prices also rise rapidly ahead of a crisis. And it is warning signal when banks have to run to securities markets to finance growth faster than deposits alone allow them to do. Systemic risk increases when imbalances build up.

91 P a g e 91 Macroprudential policy is designed to address the systematic features of financial crises, strengthen bank resilience and curb the probability of a crisis. Policy rules and transparency are aimed at avoiding complacency in good times. For example, the Basel III framework specifies that the ratio of credit to GDP should be a conditioning variable when setting the level of the countercyclical capital buffer for banks. The authorities must explain and justify their actions, or their inaction. If banking regulation is to be effective, not only must we be able to identify imbalances that are building up, but we must also understand the interaction between banks and other economic agents and how systemic risk arises. Lessons from the 1960s and 1970s showed that detailed regulation was not very effective. If we are to intervene in the markets, we must understand how the market functions and why the market cannot be left to its own devices. This provides a basis for regulating markets and insight into regulatory effects. From the textbooks we are well aware of the ingredients of market failure - or the preconditions for regulating markets. Environmental economics is often used as an example. If a polluter does not bear the costs it inflicts on others, a fee should be imposed on the polluter. The financial system is also exposed to such external effects, which we could perhaps call pollution. The external effects can be classified by the resulting symptom; excessive risk or excessive credit.

92 P a g e 92 Moral hazard arises when a bank's owners take a big gamble with creditors' money. While the owners might earn a huge profit by investing depositors' savings, depositors will never earn more than the interest on their deposits. As long as the owner takes the upside and the depositor is left with the downside, the bank has an incentive to take greater risk than socially desirable. The distortion is amplified by deposit guarantees or public guarantees. When many banks or big banks play moral hazard, risk in the financial system becomes excessive. Contagion effects between banks can also lead to a vulnerable financial system. Banks lend each other money in interbank markets and can become more closely intertwined than is socially desirable. Losses at one bank can spread through the system, creating a domino effect. The contagion effect can also be indirect. When a bank has to sell assets to redeem debt, the value of equivalent assets of other banks decline, as many experienced during the financial crisis. Individual banks do not have an incentive to take into account a fall in value that it inflicts on its counterparties. Contagion effects are externalities between banks that can lead to a situation where the risk in the financial system becomes greater than the sum of what individual banks believe their risk to be.

93 P a g e 93 Over the past years, I have travelled around the country and visited many savings banks in Norway, and without exception they report that risk management has improved considerably at their banks. That is no doubt true, but I cannot without a doubt conclude on that basis that systemic risk has been fully eliminated. Herd behaviour amplifies risk in the financial system. The more banks' portfolios are alike, the more they are exposed to indirect contagion through a fall in the market value of their portfolios. When banks have similar portfolios, they are also vulnerable to the same external shocks. The banking system as a whole becomes vulnerable. The assumption that banks are intertwined and alike can lead to problems spreading between banks through expectations alone. If depositors see problems in one bank, they will run to their own bank and withdraw their funds before it is too late. Paradoxically, banks become more alike when they apply the same diversification strategies. The savings banks I mentioned may have become more alike if they are using the same risk management systems. That banks become more similar may also be a sought-after result on the part of banks. They may want to move in herd. When many banks encounter problems at the same time, history shows that the authorities have little recourse other than to help them. In that case, being different brings little gain.

94 P a g e 94 When they are all in the same boat, bank executives can easily argue that the problems were not self-inflicted. However, the loss associated with being different is considerable if a bank is alone in encountering problems. The result is that banks engage in herd behaviour and the risk in the financial system becomes excessive. So far I have spoken about how various forms of market failure in the banking system lead to systemic risk that is higher than what is socially optimal. The level of credit in the economy may also become excessive. The economy then becomes vulnerable. The reason is external effects between banks and the wider economy. Loan collateral can give rise to such external effects. One reason banks demand collateral is because they do not have complete information about loan applicants. The collateral value is a security and a restriction on the amount that can be borrowed. When overall credit increases, the value of residential and non-residential property rises. Other economic agents experience a rise in their own collateral values, which they then use to borrow more. But rapid credit growth increases the risk of a deep economic downturn. The interaction can go into reverse. Borrowers that have to sell the collateral to deleverage, push down the collateral values of other borrowers.

95 P a g e 95 Profitable projects no longer receive funding and the real economic costs may prove substantial. Individual borrowers do not take into account how collateral values will affect other economic agents, or in other words do not take into account the increased systemic risk they inflict on others. The parallel with environmental economics fits well here. When pollution has no cost, it becomes excessive. In addition to the contagion effects through loan collateral, costs may arise from the market failure that occurs in a crisis when some economic agents deleverage substantially and the real interest rate cannot be set sufficiently low to underpin aggregate demand for goods and services among other economic agents. This theory seems to fit well with the situation in the US and Europe after the financial crisis, where it has been difficult to set policy rates below zero. The result is amplification of the real economic costs associated with a financial crisis. Individual borrowers do not take into account that more credit during good times increases the risk that the economy ends up in such a situation. The theory can be briefly summarised. The financial system left to its own devices creates excessive debt and excessive risk in upturns and insufficient credit in downturns, giving rise to credit cycles that amplify fluctuations in the economy. That is the background for macroprudential policy of banks. Regulation should be tightened during goods times and relaxed during bad times. The mechanisms I have described are not new or unfamiliar.

96 P a g e 96 But it is only in recent years that researchers have managed to incorporate banking behaviour and economic policy in a dynamic general equilibrium model. These are the same type of models we use in the conduct of monetary policy. These models are also useful for macroprudential policy because we must understand both what is happening in the financial system and the real economy - simultaneously. Important advances have been made in modelling systemic risk and how various instruments can be used. This will help us in our thinking - for example in distinguishing between credit growth that is good and credit growth that is bad. So, even though theory lags behind reality to some extent, it is useful. Perhaps we can draw a parallel to Isaac Newton. The force of gravity as a phenomenon was hardly unknown before he formulated his theories, but they nevertheless proved to be very useful. A number of macroprudential instruments can be applied. In Norway, Finanstilsynet (Financial Supervisory Authority of Norway) has tightened the guidelines for sound residential mortgage lending. The risk weights for the capital banks must hold for residential mortgage loans have been adjusted upwards. Liquidity buffer requirements for banks are in the pipeline and stable funding and leverage ratio requirements will be introduced. The Ministry of Finance has implemented a systemic risk buffer for banks and the biggest banks are required to hold additional capital.

97 P a g e 97 Norges Bank gives advice to the Ministry of Finance on the size of the countercyclical capital buffer for banks. Many other countries have applied macroprudential measures. The institutional framework and the formulation of the measures vary. Macroprudential policy will by its nature vary across countries. The credit cycle and systemic risk vary over time and across countries. That being the case, neither banks nor other economic agents should be surprised that macroprudential policy in Norway differs from that of surrounding countries. In many countries, the central bank has a prominent role in macroprudential policy. Monetary policy objectives and macroprudential objectives are not the same. Monetary policy is aimed at securing low and stable inflation and is the first line of defence against cyclical fluctuations. Macroprudential policy is aimed at strengthening the resilience of the financial system and curbing financial vulnerabilities that build up in the economy over time. Macroprudential policy and monetary policy nevertheless share many features. In Norges Bank, we can build on the experience of monetary policy when providing advice on the size of the countercyclical capital buffer for banks. Both macroprudential policy and monetary policy must be based on an assessment of the state of the Norwegian economy and developments in credit, inflation, output and employment. The buffer works through banks, as does monetary policy.

98 P a g e 98 The analysis of the capital buffer therefore has much in common with the analysis we perform when setting the key policy rate. In our monetary policy analysis, we must assess whether output and employment lie above or below their long-term trends; in our financial stability analysis, we must assess whether credit lies above or below its long-term trend. Both policy areas must give weight to the risk of a build-up of financial imbalances. The communication of monetary policy also offers some lessons. Whereas monetary policy was previously veiled in secrecy, we are now open about our view of the likely future interest rate path. The theoretical foundation for transparency builds on the notion that prices are sticky. Adjusting prices goes smoother if central banks' response pattern is known. Market participants then have a solid basis for forming expectations about future interest rates. The same line of reasoning may be valid with regard to transparency about our advice on the countercyclical capital buffer. It takes time for banks to adapt to changes in capital requirements. A predictable policy will facilitate the adjustment process. The size of the friction is difficult to assess. Banks tend to restrict themselves to a very limited number when they present their options for increasing capital ratios. If banks choose to raise new equity capital, the adjustment process will be considerably faster. Irrespectively, we believe that predictability will facilitate adjustment. Happiness is a time without debt and reading the end of a book when in bed

99 P a g e 99 Happiness is ours in a prosperous nation with a just appropriate level of inflation» Odd Nordstoga sings on. Nordstoga reminds us that happiness is not only about little debt, but also the other areas of Norges Bank's operations. A prosperous nation is also dependent on the sound management of the Government Pension Fund Global, which is operated by Norges Bank Investment Management. An appropriate level of inflation is also the objective of monetary policy. We call it inflation targeting. By just appropriate we mean that inflation should be not too high, nor too low. A balanced economic policy must first be in place in order to provide a sound basis for financial stability. Macroprudential policy can then make an important contribution to reducing the sizeable costs associated with financial crises.

100 P a g e 100 Basel III implementation: Progress, pitfalls, and prospects Keynote speech by Mr Stefan Ingves, Chairman, Basel Committee on Banking Supervision and Governor, Sveriges Riksbank at the High-Level Meeting for the Americas, Lima, Peru Introduction It is a pleasure to speak to you here today. The Basel Committee attaches great value to these high-level discussions at the regional level. They help deepen the Committee's engagement with regulators and supervisors around the world. As it happens, the Committee has recently welcomed Chile as an observer member to the Basel Committee meetings. The Basel Consultative Group 1 includes representatives from Chile, Peru, the Association of Supervisors of Banks of the Americas, and the Caribbean Group of Banking Supervisors. The engagement with the region thus continues to grow. I sincerely hope for a further strengthening in the relationships we are seeking to build between South American and Latin American banking regulators and the Basel Committee. In the four decades of the Committee's existence, Latin America's banks and banking regulators have witnessed their fair share of financial and macroeconomic stress. In meeting those challenges, they have provided several important policy and practical lessons for their fellow regulators and supervisors around the world.

101 P a g e 101 We all have learnt from them. But the Global Financial Crisis of which is still unfolding - has provided a painful reminder that financial sector strains bear close monitoring and that no region can insulate itself from a fragile, uneven global economic recovery and the attendant downside risks. It is therefore incumbent on each of us to remain cautious and vigilant while keeping in mind our respective socioeconomic imperatives. Collectively, we still face considerable challenges on the macrofinancial front. Sound, resilient, and well regulated and supervised banks will help us deal with the unexpected. I sincerely hope that our dialogue will advance our understanding and provide some practical solutions on matters of banking regulation and supervision. Today, I want to talk about "implementation" - a term that has gained even more attention as the policy design phase draws to a close. Regulators as well as supervisors are now accountable for the outcomes produced by the raft of new rules. At the Basel Committee, we have largely completed our post-crisis reform agenda. These include major improvements to the risk-based capital standards; requirements for global and domestic systemically relevant banks; prudential buffers; liquidity risk regulation; a leverage ratio; and new disclosure standards. Several areas of the Basel framework will remain as work in progress as we review some of its fundamental aspects to enhance the framework's purpose and assure its continued relevance.

102 P a g e 102 These include revisions to Pillar 3 disclosures, the securitisation framework, operational risk framework, and the market risk framework. The Committee is also considering whether the substantial national discretions of the Basel framework are still necessary. Of particular interest to several of you will be our ongoing work on revising the standardised approach for credit risk. We expect to publish proposed revisions later this year and we look forward to your feedback during the consultative process. All these efforts on the policy side aim to strengthen the banking system's resilience, improve market confidence in regulatory ratios and promote a level playing field internationally. But, how will this happen? Regulators should regulate; supervisors should supervise. But who takes responsibility for proper implementation and ensuring the desired or intended outcomes? Times are changing, as are the incentives for effective implementation. The triptych of regulation-implementation-supervision is becoming the way of life for those charged with ensuring banking system stability. Importance of implementation and progress made It goes without saying that consistency in implementation is imperative. It ensures a level playing field for banks and supports comparability of regulatory ratios, which are both essential if confidence in banks is to be restored.

103 P a g e 103 Yet achieving that consistency is a huge challenge and must be reflective of domestic factors. As a colourful palette of countries with many differences, the Basel Committee's membership spans a great variety of legal systems, accounting regimes, supervisory practices, banking structures and economic conditions. Consistent implementation of the global standards is key to realising the outcomes intended for international standards and also to supporting effective supervision. Supervision is handicapped by faulty implementation. We need to bring the focus on implementation closer to good supervision. Only then will the full benefits of Basel III be realised. Writing the Basel III requirements into domestic regulations brings little benefit by itself. Of central importance is the way in which the Basel standards are adopted, applied, enforced, and monitored at the local level. Implementation is a continuum and not a one-off event. To realise the full benefits, implementation requires a rigorous system of monitoring and analysis. To this end, the Basel Committee has initiated the regulatory consistency assessment programme ("RCAP" in short). Initiated in 2012, the programme consists of two distinct but complementary workstreams. The first monitors the timely adoption of Basel III standards and the progress made by banks in improving their capital and liquidity positions.

104 P a g e 104 The second assesses the consistency and completeness of the adopted standards, including the significance of any deviations in the regulatory framework. The assessment work is carried out on a jurisdictional as well as on a thematic basis. Regarding the monitoring work, the Basel Committee regularly issues reports on the adoption status of Basel standards by member jurisdictions and large banks. These reports are publicly available on the Committee's website, creating some peer pressure on members to align their domestic implementation with the agreed timelines. Adding to this incentive, we include numerical scores and colour codes in the reports. Just like a traffic light, "green" acknowledges jurisdictions that have issued final rules and have put them into effect; while "red" indicates that more work needs to be done. These reports are also regularly shared with G20 leaders and the broader public. The latest monitoring report was issued in October. It shows that member jurisdictions are making good progress in the adoption of the Basel III standards. By end-2013, all Committee members had implemented Basel III risk-based capital regulations. As of September 2014, 26 of the 27 Committee members had issued final or draft rules for the liquidity coverage ratio; 23 had issued final or draft rules on the leverage ratio; and 23 had issued final or draft rules on their G-SIB or D-SIB frameworks. Non-Basel Committee jurisdictions also report substantial progress in adopting Basel III standards.

105 P a g e 105 The Financial Stability Institute (FSI) - the co-hosts of this High-Level Meeting - publishes a yearly overview of that progress. Among the 109 surveyed jurisdictions, 94 have either implemented Basel II or are in the process of doing so. With respect to Basel III, 89 have implemented the framework or are in the process of doing so. It is good to see that many South American and Latin American countries are participating in the FSI survey and report progress in adopting the Basel standards. Often specific adaptations to local circumstances are made. Being transparent about these local adaptations helps to clarify how the standards are applied, which is important for markets and investors. The Basel Committee also regularly monitors the progress made by banks as they apply the rules. While a number of banks still need to improve their capital and liquidity positions, the latest numbers suggest that most banks already meet the fully phased-in Basel III minimum requirements. By the end of 2013, the average Common Equity Tier 1 capital ratio of large internationally active banks rose to above 10% and the capital shortfall declined to 15 billion, from 400 billion in The weighted average Basel III leverage ratio for large internationally active banks was 4.4% and the weighted average liquidity coverage ratio was 119%. Assessing implementation and addressing pitfalls Regarding the assessment work, the Committee conducts two types of assessments: (i) jurisdictional assessments and

106 P a g e 106 (ii) RWA assessments. The Committee has completed seven jurisdictional assessments, which are a close-up review of the domestic regulations that implement the Basel capital standards. A team of experts reviews the consistency of the local regulations and identifies any deviations from the Basel standards. We also assess the potential impact of any deviations on banks' prudential ratios. At the end of the assessment, the country receives a grade that summarises the view of the assessment team. By the end of this year, we expect to have completed all assessments for those jurisdictions with global systemically important banks. By 2016 we will have completed all other Basel Committee member jurisdictions. Note, however, that the assessments have thus far focused only on Basel III's risk-based capital standards. The scope of the assessments is expanding and will soon cover the liquidity coverage ratio and SIB requirements from 2015 onwards. The standard-setting process requires well informed, transparent development of policies followed by a thorough assessment of implementation. This is the first time that the Committee has taken this essential second step, and pointing out inadequacies is never easy. A parallel may be drawn with the early country assessments of the Basel Core Principles (BCP).

107 P a g e 107 Today, countries are undergoing a second and, in many instances, a third round of such reviews.4 Many are also opting to publish these assessments. Over time, these assessments have helped improve the quality of supervision, thus helping to mitigate specific banking system risks. Almost all of you present here today have undergone formal BCP assessments. Similarly, the RCAP assessments are continuing to evolve in scope and purpose. Like a BCP assessment, an RCAP also requires time and thoroughness. The discussions can be intense. But their value cannot be underestimated. Regulation is about details and that means that attention to narrow issues of implementation is vital. Banks and supervisors need to be able to determine how a regulation is meant to be applied and what the prudential expectations are. Governor Daniel Tarullo of the Federal Reserve Board has recently rightly said that what matters is not "mere" compliance but "good" compliance. The RCAP's focus on regulatory consistency takes on even greater significance, and this for several reasons. First, the Basel standards are only "soft law", not legally binding. As pointed out recently by Sir Jon Cunliffe - the Bank of England's Deputy Governor for Financial Stability - this soft law is powerful because it is grounded in the recognition that we can only have a globally integrated capital market if we can agree and implement key common minimum standards.

108 P a g e 108 To ensure consistent implementation a transparent review process is necessary. Members need to be willing to give and receive critical peer reviews, and to act when potential gaps are discovered. Second, the RCAPs offer a "quality certificate" for members that have been assessed as "compliant". This is good for fostering public trust and confidence. Third, the assessments can generate the needed pressure within the jurisdiction for a full implementation of the Basel rules, counterbalancing pressures from local banks or interest groups. In sum, the assessments provide discipline and address some of the pitfalls of implementation. For example, the bolthole of wording regulations vaguely is often tempting when there is pressure to assuage certain stakeholders. Another pitfall is to adopt the rules through inappropriate regulatory instruments that have no binding force in practice. Or there is the temptation to hope that deviations from the internationally agreed standards will go unnoticed or remain immaterial in practice. Loosely written standards or regulations will always provide an alluring but specious opportunity to "game" the rules. So far, the assessments have contributed demonstrably to improved consistency. Over 200 rectifications have been made by member jurisdictions in response to findings raised by the assessment teams. In addition, there is much more transparency about local implementation.

109 P a g e 109 We learn from each other, harmonise supervisory practices, including for model validations, and we draw the lessons for better drafting of standards. The assessments also increasingly feature in private sector analyses. In this context, I would like to remind you that the Basel framework is a minimum standard and members are free to go beyond the minimum. We actually encourage that, and most jurisdictions have adopted minimum requirements that exceed the global standard. Super-equivalences are often found in developing and emerging market economies, where banks have a higher risk profile. The local regulators therefore set higher minimum requirements. RCAP assessments help to identify areas where jurisdictions are super-equivalent and these areas are also explicitly noted in the assessment reports. So far, no elements of the Basel framework have been identified where all members are super-equivalent. This tentatively suggests there are no Basel capital standards that generally lack conservatism or that are calibrated too weakly in the collective judgment of the implementing authorities. Another positive side effect of these assessments is their contribution to Basel literacy. The detailed interaction between subject-area experts on the Basel framework is formative. In addition, topics are uncovered that might be subject to differences in interpretation. The Committee now has a process to examine and clarify such issues.

110 P a g e 110 The assessments are thus more than a double-edged sword: they train members in the Basel framework, help jurisdictions to bring domestic regulations into line with Basel standards, and spotlight areas that require cleaning up by the Basel Committee. Assessing risk-weighted assets and reducing variability Let me turn to the assessments of risk-weighted assets. Through the RCAP programme, the Committee has completed three studies that focus on banks' risk-weighting of banking and trading book assets. These studies have confirmed that material variances exist in banks' regulatory capital ratios arising from factors other than differences in the riskiness of banks' portfolios. These variances undermine confidence in capital ratios. Supported by its governing body, the Group of Central Bank Governors and Heads of Supervision (GHOS), the Committee is taking steps to reduce the level of observed variation in RWA measurement across banks. The Committee's response thus far has centred on the three areas: policies, disclosure and monitoring. On the policy front, we are developing prudential proposals related to the use of floors and benchmarks; providing additional guidance on those aspects of the Basel framework that are ambiguous or require clarity; and undertaking a more fundamental review of modelling practices. When it comes to disclosure, requirements related to risk weights are being strengthened by amending Pillar 3 of the Basel framework. And, finally, on the monitoring side, we are working to ensure proper implementation by reviewing the outcomes of risk-weighted asset variability through Hypothetical Portfolio Exercises under the Committee's RCAPs.

111 P a g e 111 The policy proposals will be presented in greater detail to the G20 Leaders for their upcoming summit in Brisbane later in November. However, I would like to give you a preview of the key measures that the Committee is taking with regard to standardised approaches. Standardised approaches are widely used by banks around the world. As I mentioned earlier, later this year we expect to publish a revised Standardised Approach for credit risk. Earlier, we published for consultation a revised Standardised Approach for operational risk; this followed the Committee's earlier consultations on the Standardised Approach for market risk, and the recent finalisation of the Standardised Approach for counterparty credit risk. These revisions and ongoing work in this area aim to improve the way all banks calculate risk-weighted assets. Moreover, the greater risk sensitivity embedded in the revised approaches will improve their use as a basis for the implementation of a capital floor. Regarding the advanced approaches for credit, market and operational risk that are based on banks' models, the Committee is developing specific policy proposals to reduce excessive variability. These will be further detailed in the paper to the G20. Prospects of implementation Let me look briefly ahead. The Committee will continue its programme of hypothetical portfolio exercises, and complete the analysis of material asset classes in the banking and trading book.

112 P a g e 112 The Committee will also expand the scope of its jurisdictional assessments, including liquidity and SIB standards from 2015 onwards. Further off, assessments of the leverage ratio and the NSFR are envisaged. These efforts will help promote convergence across member states, both in regulations and in practices relating to risk-weighting of assets in the banking and trading books. Today, implementation is the key challenge for standard setters. The Basel Committee's RCAP programme has already made substantial headway, and the initial results have been very strong. Nevertheless, good implementation has to be a loop: the lessons learned must feed back into better policymaking. For this reason, it is my firm expectation that the implementation agenda will become a core component of the Basel Committee's work. Thank you for your attention.

113 P a g e 113 Thomas Philippon's contribution to macro-finance Speech by Mr Vítor Constâncio, Vice-President of the European Central Bank, at the ceremony awarding the Germán Bernácer Prize for Promoting Economic Research in Europe to Thomas Philippon, Madrid I wish to thank Angela Maddaloni and Agnese Leonello, from the Directorate General Research, for their help in preparing this speech. Ladies and Gentlemen, I am delighted to be here today to award the 2013 Germán Bernácer Prize to Thomas Philippon, Professor of Finance at the Stern School of Business at New York University. Thomas Philippon is a renowned scholar with a wide-ranging research agenda, both theoretical and empirical. The numerous prizes he has won throughout his career, including "best paper" awards in several top journals, speak loudly about the academic quality of his contributions. Thomas's research - being right at the intersection between macroeconomics and finance - is also highly policy-relevant, not least from a central banker's perspective, as I will try to highlight today. In fact, many central banks and the ECB in particular have devoted considerable attention and actively contributed to the burgeoning literature on macro-finance. The financial crisis underscored the need for a better understanding of the linkages between the health of the financial sector and the performance of the real economy. Promoting economic research in this field is an essential step in the process of developing effective policies to ensure the stability of the financial sector and, ultimately, to foster economic growth.

114 P a g e 114 A prime example of this has been the Macro-prudential Research Network (MaRs), where researchers from the European System of Central Banks closely collaborated with experts from academia. The MaRs network was launched to develop core conceptual frameworks, models and tools providing research support to improve macro-prudential supervision in the EU. Its work, which was formally concluded last June, is summarised in a public report and represents a fine example of policy-relevant research. To foster a constant communication with academics, the ECB also regularly organises seminars, conferences and workshops. These enable researchers, policy-makers and practitioners to meet and discuss the latest research findings and their implications for policy. In addition, to stimulate research at the highest academic standards, the ECB invites leading scholars to visit and conduct their research at the ECB, for example via the Wim Duisenberg Fellowship, and offers support to young researchers by funding five Lamfalussy Fellowships every year. Thomas Philippon's contributions represent an excellent example of policy-relevant research. I will consider two main areas of his research which I find particularly interesting: the design of optimal interventions and the efficiency of the financial sector. In his 2012 paper, published as the lead article in the American Economic Review, Thomas and his co-author Vasiliki Skreta study the design of optimal public interventions in debt markets. The intervention aims at restoring an efficient level of investment when productive investments are forgone because firms face unfairly high interest rates due to adverse selection.

115 P a g e 115 The topic of the paper was - and still is - very timely since asymmetric information played a crucial role in the collapse of the financial markets in the autumn of Thomas Philippon's paper identifies some of the key issues associated with the intervention. In particular, he analyses the interaction between the intervention and the conditions that firms face in the market. Decisions by firms to participate in a support programme are influenced by these conditions - how difficult it is to raise funds from the market. At the same time, a firm's acceptance of public assistance may be perceived as a "bad" signal, thus limiting its incentive to participate. This is the problem of the stigma attached to support programmes. The paper spells out two clear implications for policy. First, it provides robust conceptual support to the idea that the choice of intervention depends crucially on the nature of the frictions and that it should resemble the contract used by market participants. For example, in the case of a freeze in a debt market due to adverse selection, the optimal intervention requires debt instruments, such as direct lending or debt guarantees. Second, it highlights that the stigma associated with the intervention can be a relevant issue and the design of a programme should take this into account. The ECB had to deal with this issue, for example, in the context of the first two longer-term refinancing operations announced in December When some bankers raised concerns that there might be stigma attached to the ECB's programme, we said that the decision to accept long-term loans from the ECB should have been seen as a rational business decision and not as a sign of bank distress.

116 P a g e 116 The importance of clearly identifying the nature of the frictions leading to the market failures before designing the intervention is also emphasised in another contribution by Thomas Philippon. In his 2013 paper in the Journal of Finance written with Philipp Schnabl, he characterises the optimal intervention in a financial industry plagued by the debt overhang problem. When banks are financed with too much debt, they forgo productive investments, i.e. lending, because in the event of bankruptcy the debt holders would appropriate most of the cash flows. Thomas Philippon and his co-author show that in this case the optimal intervention consists of capital injections against preferred stock (plus warrants) and it is conditional on sufficient bank participation. This design makes it possible to restore the efficient level of lending by providing capital to banks, and at the same time minimises the cost of intervention by controlling for the potential opportunistic behaviours of banks. In particular, the authors highlight two types of opportunistic behaviours induced by the intervention. First, since banks that do not directly participate may benefit from the overall improvement in the market conditions, a free rider problem arises. Therefore, intervention should be conditional on the participation of a critical mass of banks. Second, if the conditions are very favourable, banks may choose strategically to participate in the programme, thus increasing its overall cost. Hence, it is paramount that the intervention entails some costs for the current shareholders.

117 P a g e 117 I don't need to stress how relevant these issues became, especially in the aftermath of the financial crisis, when massive intervention in the banking industry had imposed very large costs on Europe's taxpayers and had significant consequences for the sovereigns. Indeed, a key concern for policy-makers is that the large support offered to the financial sector may spur opportunistic behaviour and generally distort financial institutions' risk-taking incentive, possibly magnifying the costs of the intervention while reducing its effectiveness. Thomas Philippon's analysis is timely and tackles a very relevant issue as new rules for intervention and resolution of banks are currently being implemented. The new EU rules surrounding bank resolution, which are founded on a strong change of culture - from easy public bailouts to a new culture of private bailing-in- clearly go in the direction of preventing these distortions, while retaining the possibility of direct recapitalisation to safeguard financial stability. The new resolution framework that is going to be implemented in Europe will help to support a sustainable growth of the financial sector by inducing financial institutions to internalise the negative spillovers originating from their failures. Thomas Philippon and his co-authors - among whom is the winner of the 2011 Germán Bernácer Prize, Lasse Heje Pedersen - have also contributed to the literature on systemic risk, a topic of particular policy relevance in which the ECB has also invested considerable research efforts. In this paper, the authors argue that a financial institution's contribution to systemic risk might be measured by its propensity to be undercapitalised when the system as a whole is undercapitalised - the "systemic expected shortfall". They also advocate the introduction of a "tax" proportionate to each bank's systemic expected shortfall which should cover losses in the event of a crisis.

118 P a g e 118 Let me now turn to Thomas's second research area, namely dealing with the efficiency of the financial sector. The crisis revived the debate about the optimal size of the financial industry and the finance-growth nexus. Often, and especially at the beginning of the recent crisis, public opinion has blamed the excessive growth of the financial industry and the extremely advantageous remuneration packages in the sector. One argument in the debate against the traditional finance-growth paradigm is that the high wages may draw talent away from other productive sectors in the economy since financial and non-financial sectors compete for the same scarce supply of human capital. Thus, an excessive growth of the financial sector may not be fully desirable. Thomas Philippon formally analyses this trade-off in his (2010) AEJ Macro paper and discusses the implementation of corrective taxes and subsidies to guarantee the optimal allocation of resources between the financial and the productive sectors. Thomas Philippon's paper published in the Quarterly Journal of Economics in 2012 analyses the allocation and compensation of human capital in the financial industry. Together with his co-author Ariell Reshef, he documents the pattern in wages and skill intensity in the financial industry in the US between 1909 and The authors show that this pattern is non-monotonic. High compensations in banking and the ability of the financial industry to attract the most skilled workers are not permanent features of this industry. As the paper shows, changes in financial regulation are important determinants of these patterns. Tighter regulation tends to lead to an outflow of resources from the financial sector.

119 P a g e 119 This line of research points to the wide range of subjects that interest Thomas Philippon already shown in his 2007 book "Un capitalisme d héritiers: la crise française du travail" where he musters a lot of empirical evidence to show that the labour crisis in France stems from bad employers-employees relations associated with a system that "preserves inheritance, direct or sociological". This capacity to link serious economic research with practical social problems is yet another sign of the excellence achieved by Thomas in his body of work. I am confident that Thomas Philippon will continue making extraordinary contributions to this and other research areas in the coming years. I extend my sincerest congratulations to him for winning the 2013 Germán Bernácer Prize.

120 P a g e 120 The G-SIB assessment methodology score calculation November Background Following the global financial crisis, there has been renewed scrutiny on the impact that the failure of large financial institutions could have on the broader financial system. The interconnected nature of today s global systemically important banks (G-SIBs) has contributed to a system where the potential failure of a single large institution can have wider effects that reverberate throughout the global economy. This in turn has led to the Basel III reforms, spearheaded by the Basel Committee on Banking Supervision (BCBS), which aim to improve the resiliency of banks and banking systems. Over and above the higher requirements for all internationally active banks, the Committee s G-SIB standards require additional going-concern loss absorbency for G-SIBs. This document will serve as a guide to calculating a bank s score from the financial information captured on the BCBS G-SIB reporting template. This template, as well as other information referred to below (such as exchange rates, sample totals), have been compiled on the Committee s G-SIB webpage. This score, which captures the global share of activity and systemic risk that a bank poses to the larger financial system, is used in determining the higher loss absorbency (HLA) requirement. This HLA requirement will be phased in starting on 1 January 2016.

121 P a g e Overview The G-SIB framework compares a bank s activity over 12 indicators (grouped into five categories of systemic importance) with the aggregate activity of all banks in the specified sample (see Section 3.2). The resulting numerical score represents a bank s activity as a percentage of the sample total and is used to determine the bank s overall HLA requirement. Higher scores result in higher HLA requirements. As a consequence, banks that are larger, more interconnected, less substitutable, more cross-jurisdictional, and/or more complex will have greater HLA requirements and thus be better positioned to withstand financial distress. 3. The score calculation 3.1 Indicators and categories

122 P a g e 122 A bank s score consists of a weighted average of 12 indicators across five categories. Table 1 provides the category, line item number (consistent with the number in column G of the G-SIB reporting template) and weight for each indicator. When calculating a bank s indicators, the data must be converted from the reporting currency to euros using the exchange rates published on the BCBS website. These rates should not be rounded in performing the conversions, as this may lead to inaccurate results. Note that there are different sets of currency conversions on the website, each corresponding to a different fiscal year-end. Within each set, there are two conversion tables. The first is a point-in-time, or spot, conversion rate corresponding to the following fiscal year-ends: 30 September, 30 October, 31 December, and 31 March (of the following year). The second set is an average of the exchange rates over the relevant fiscal year. The average rates over the bank s fiscal year should be used to convert the individual payments data into the bank s reporting currency. The 31 December spot rate should be used to convert each of the 12 indicator values (including total payments activity) to the G-SIB assessment methodology reporting currency (ie euros). 3.2 Denominators Sample totals are used to normalise the indicator values for the purposes of calculating a bank s score. These sample totals are published on the Committee s G-SIB webpage.

123 P a g e 123 The sample itself consists of the largest 75 banks as determined by the Basel III leverage ratio exposure measure, along with any banks that were designated as a G-SIB in the previous year but are not otherwise part of the top 75. The sample totals, or denominators, represent the total reported activity for each of the twelve indicators. For example, the denominator for normalising Level 3 assets is calculated by adding together the total amount of Level 3 assets held by all banks in the sample. 3.3 Indicator and category scores To calculate the score for a given indicator, the bank s reported value for that indicator is divided by the corresponding sample total, and the resulting value is then expressed in basis points (bps). To calculate the scores for the five categories, the scores for the indicators that fall within each category are averaged. For example, the complexity category score is the average of the three complexity indicator scores: OTC derivatives, trading and AFS securities, and Level 3 assets. Since the size category consists of only one indicator, the category score is simply the score for the total exposures indicator. Also, the substitutability/financial institution infrastructure category score is subject to a 500 bps cap. 3.4 The final score The final score is produced by averaging the five category scores and then rounding to the nearest whole basis point.

124 P a g e 124 Each of the five categories thus has an equal weight in determining the final score. The individual weights of the underlying indicators are provided in Table 1 above. 4. Supervisory judgment According to paragraph 30 of the Committee s G-SIB standards, a bank s score may be adjusted based on supervisory judgment. In these exceptional cases, the published bucket will not align with the calculated score. The decision to exercise supervisory judgment will generally reflect a variety of quantitative or qualitative factors not captured in the 12 indicators. For example, a set of ancillary indicators collected in Section 14 of the reporting template may be used in making such a determination. In the end, the Financial Stability Board and the relevant supervisory authorities, in consultation with the BCBS, make final decisions regarding the use of supervisory judgment. 5. HLA requirement The final score is translated into an HLA requirement using the score ranges shown in Table 2. The current cut-off score for G-SIB designation is 130 bps and the buckets corresponding to the different higher loss absorbency requirements each have a range of 100 bps. For example, a bank with a score of 346 would fall into the third bucket, which corresponds to a 2.0% increase in Common Equity Tier 1 capital (CET1). The bucket thresholds, together with the substitutability cap, will remain fixed for at least the end-2013, end-2014 and end-2015 G-SIB assessments.

125 P a g e 125 The bucket thresholds have been set such that bucket 5 is empty. If this bucket should become populated in the future, a new bucket would be introduced to maintain incentives for banks to avoid becoming more systemically important. Each new bucket will be equal in size and the HLA requirement for new buckets will include 1.0% increases in CET1 (eg a sixth bucket would have a score range of and correspond to an HLA requirement of +4.5% CET1). The G-SIB surcharge (along with other components such as the countercyclical capital buffer as applicable) expands the 2.5% capital conservation buffer, which is subject to a three-year phase-in period.

126 P a g e 126 The applicable buffer will increase each year, starting 1 January 2016, by one quarter of the total buffer. The total buffer will be completely phased in starting from 1 January 2019 (see Table 3). 6. Disclosure and data revisions According to the BCBS standards, banks with total exposures of more than EUR 200 billion are required to disclose, at a minimum, the 12 indicators used in the G-SIB assessment methodology. Banks that have been designated as a G-SIB in the previous year that do not otherwise meet the total exposures threshold are also subject to the disclosure requirement. This information should be released within four months of the financial year-end and, in any case, no later than end-july. Note that disclosed data are subject to revision. The data submitted to the BCBS must match the information provided in the public disclosure. Should the disclosed data be revised, national supervisors must submit the revisions to the BCBS prior to the final submission deadline (generally around 1 August) in order for the changes to be included in the official score calculation. If the data are amended after the final deadline, banks should ensure that the values used in the official calculation remain publicly available. 7. Example calculation This section provides an example score calculation using hypothetical data and is provided for illustrative purposes only. Note that the sample totals shown below should not be used to calculate actual bank scores.

127 P a g e 127 Refer instead to the sample totals posted annually on the BCBS website or calculate the totals as described in Section Indicator scores A bank s indicator values and the associated sample totals are required to calculate a bank s indicator scores. The indicators for the largest global banks are published by the bank or the relevant supervisory authority, while the sample totals are published on the BCBS website. For the purposes of this example, suppose the relevant data are as appears in Table 4. Since all values are provided here in billions of euros, no unit or currency conversion is required. The bank s indicator scores are calculated by dividing the bank s indicator values by the corresponding sample totals and expressing the result in basis points. The calculation and results are also depicted in the table.

128 P a g e Category scores The raw category scores are calculated by averaging the corresponding indicator scores. If binding, the substitutability cap must then be applied. The calculation and results are depicted in Table The final score and HLA requirement The final score is calculated by averaging the five category scores and then rounding to the nearest whole basis point (see Section 3.4). Using the data from Table 5, the raw final score is Rounding this result to the nearest whole basis point produces a final score of 283 bps. This score corresponds to a G-SIB HLA requirement of +1.5% CET1 (see Section 5). 7.4 Phase-in period During the phase-in period, the applicable portion of the capital conservation buffer will vary depending on the year (see Section 5). Table 6 shows how to calculate the buffer for an institution subject only to the minimum 2.5% and a 1.5% G-SIB HLA requirement in each

129 P a g e 129 year of the phase-in period; other components that extend the capital conservation buffer are assumed not to apply. Since the G-SIB HLA requirement is subject to change over time, buffers must be calculated using the requirement in effect for the given year. For example, the applicable capital conservation buffer for a bank subject to a 1.5% HLA requirement in 2016 is 1.0% (see table above). Should the bank be subject to a higher, 2.0% HLA requirement the following year, the applicable capital conservation buffer for 2017 would be

130 P a g e 130 A tiered approach to regulation and supervision of community banks Speech by Mr Daniel K Tarullo, Member of the Board of Governors of the Federal Reserve System, at the Community Bankers Symposium, Chicago, Illinois Earlier this year - also speaking to a conference at the Federal Reserve Bank of Chicago - I explained the need for an explicitly tiered approach to banking regulation and supervision. Today I would like to elaborate on those earlier remarks to suggest in more detail what a tiered approach would mean for community banks. Let me begin, though, by recapitulating my basic premise and the reasoning behind it. Rationale for regulatory tiering For more than 75 years following passage of the Banking Act of 1933, the motivation for banking regulation was fairly simple: the government had granted deposit insurance and access to the discount window to depository institutions to forestall runs and panics. The resulting moral hazard and the use of insured deposits as a funding source for these institutions justified prudential measures, including prohibitions on non-banking activities, aimed at maintaining safe and sound banks, which would in turn protect taxpayers. Prudential regulation of bank holding companies by the Federal Reserve under authority granted by the Bank Holding Company Act of 1956 was aimed primarily at protecting insured depository institutions and the federal deposit insurance fund from knock-on effects of problems at affiliated nonbank businesses. This approach is what we now characterize as microprudential - that is, the focus is on the soundness of individual banks rather than on the financial system more broadly.

131 P a g e 131 This is not to say that financial stability had not been important to financial regulators, but this stability was implicitly assumed to follow from having sound individual banks. Over the years, of course, banking regulation evolved. For example, regulation expanded to encompass fair and open access to financial services for consumers. And, as developments in financial markets and deregulation over the past several decades led to a more concentrated financial sector in which bank holding companies could engage in a much broader range of activities, supervision was tiered within the bank regulatory agencies based on the size and complexity of the regulated institutions. But the financial crisis provoked a fundamental rethink of the aims of prudential regulation. There is now more widespread agreement that these aims should vary according to the size, scope, and range of activities of banking organizations. Most significantly, banks of a size and complexity such that serious stress or failure could pose risks to the entire financial system need regulation that incorporates the macroprudential aim of protecting financial stability. There is also a good argument that very large banks that fall short of this level of systemic importance should nonetheless be regulated with an eye to macroprudential aims, such as the ability of the banking system as a whole to provide credit. Although individual community banks may be an important source of credit, particularly in local economies outside urban areas, neither systemic risk nor broad macroprudential considerations are significant in thinking about prudential regulation of community banks. So what should the aims of such regulation be?

132 P a g e 132 The basic answer is it should protect the deposit insurance fund. In other words, the traditional microprudential approach to safety and soundness regulation continues to be appropriate for these banks. To develop that basic answer, I think it useful to begin with an understanding of both the business model of community banks - that is, how their financial intermediation adds value to the economy - and the ways in which such banks are most likely to encounter problems. There are roughly 5,700 community banks in the United States, the vast majority of which have less than $1 billion in total assets. These banks represent 98 percent of insured U.S. commercial banks, but collectively hold just under 20 percent of aggregate banking assets. Moreover, the business model of most community banks, especially smaller and rural banks, is built substantially on relationship banking. While community banks have over the years found it increasingly difficult to compete with larger banks in types of lending that can be efficiently scaled through larger volumes and standardized credit models, they maintain a comparative advantage relative to larger competitors through knowledge of their local communities and their individual borrowers. This means that community banks play a unique role in their local economies, particularly with regard to lending to small- and medium-sized businesses. Numerous studies have documented this advantage and its value to economic development. One recent study found that loans extended by rural community banks to small businesses default less frequently than similar loans granted by their urban counterparts, and that the performance advantage is greater when the bank and the borrower are located in the same county.

133 P a g e 133 This finding suggests that the "soft" information obtained from their local relationships usefully informs rural community banks' underwriting. Federal Reserve research also suggests that many community banks that adhered to the traditional relationship banking model of funding local lending with customer deposits continued to thrive even during the worst years of the financial crisis. In contrast, many small banks that turned to a more transactional model and funded construction loans - often outside of their local market - with borrowings, rather than core deposits, failed. And, precisely because of their business model, community banks do have their vulnerabilities. They are more likely to have geographic and portfolio concentrations that can make them vulnerable to localized economic problems. Of course, the failure of a community bank in these circumstances will only exacerbate these problems. Especially in rural areas, the disappearance of community banks could result in a permanent reduction in this local kind of credit, as the slack may not all be picked up by larger banks. Additionally, of course, there will usually be issues requiring supervisory and management consideration for at least a time. At present, as I know you have been hearing from your supervisors, these issues include cybersecurity and interest rate risks. To return, then, to the aims of prudential regulation of community banks, it seems that we can fill out the basic aims of protecting the deposit insurance fund and supporting the availability of relationship lending across the country by concentrating on traditional capital regulation to ensure solvency and on traditional examination practice to monitor the basic soundness of the relationship lending practices.

134 P a g e 134 We may also need to increase scrutiny when community banks move beyond their traditional business model and enter lines or markets that are more complex or with which they may not be familiar. But many rules and examinations that are important for institutions that are larger, more complex, or both, do not make sense in light of the nature of the risks to community banks. We must avoid importing measures from large bank oversight that make relationship banking more costly. With that explanation of the purposes of community bank oversight, let me now turn to more specific discussion of how we are tailoring regulation and supervision of community banks to achieve those aims. Tiered regulation for community banks There are two complementary ways to implement a tiered approach to prudential regulation. One is to apply specific regulations only to those classes of banking organizations whose activities and scale require those measures. The second is to tailor the application of generally applicable measures based on the size, complexity, and possibly other characteristics of banking organizations. We are following both approaches in putting into place an explicitly tiered method of regulating community banks. 8 An example of tailoring generally applicable regulations is the revised capital guidelines that were issued in It was clear in the wake of the financial crisis that strong capital positions were essential for banks of all sizes, including community banks. But a number of changes that were appropriate for large banks did not make sense for community banks.

135 P a g e 135 As I am sure you all recall, community banks gave us quite a bit of help in identifying which portions of the originally proposed rule were, and were not, appropriate for community banks. Following publication of the final capital rule, the three federal banking agencies developed a streamlined, supplemental Community Bank Guide to assist bank management in understanding the applicability of the rules to smaller, non-complex institutions. This exercise is an example of a broader effort to be explicit as to how prudential regulations that are sometimes quite detailed apply to community banks. By including such explanations in the introductory portions of broadly applicable regulations, our hope is that community bankers will be relieved of the task of wading through extensive regulatory texts just to find out what portions apply to their banks. This is a good point at which to note that the federal banking agencies have, in accordance with the terms of the Economic Growth and Regulatory Paperwork Reduction Act (EGRPRA), recently launched a review to identify banking regulations that are outdated, unnecessary, or unduly burdensome. One theme that has already been notable is the belief of community bankers that many regulations could be tailored more appropriately for community banks. I encourage you to participate in the EGRPRA process by giving us specific examples of regulations that should be modified in this way and, even more helpfully, by suggesting specific ways in which they might be usefully be tailored. As to exempting community banks entirely from certain regulations, I should note first that many of the statutory requirements introduced by the Dodd-Frank Wall Street Reform and Consumer Protection Act do not by their own terms apply to community banks.

136 P a g e 136 So, for example, the extensive enhanced prudential standards required by section 165 of Dodd-Frank for bank holding companies with more than $50 billion in assets do not apply to smaller banks. Nor do the requirements for stress testing and resolution planning. Similarly, the banking agencies have used their discretion to exclude community banks from the coverage of some new regulations adopted following the crisis. For example, we recently approved a final rule implementing in the United States a Basel agreement that establishes a quantitative minimum liquidity requirement, but limited its coverage to banking organizations with more than $50 billion in assets. We excluded community and smaller regional banks, which generally have relatively simple funding profiles and do not pose a significant potential risk to the financial system. However, some statutory requirements by their terms apply to all banks. Even if we do not believe that they actually advance safety and soundness aims for community banks, or produce only a small benefit at a disproportionately large compliance cost, we must still enforce them. It would be worthwhile to consider amendments to these statutory provisions to carve out their applicability to community banks. I have previously suggested two candidates for consideration: the Volcker rule and the incentive compensation requirements in section 956 of Dodd-Frank. The risks addressed by these statutory provisions are far more significant at larger institutions than they are at community banks. Moreover, in the unlikely event that a community bank engages in practices in either of these areas that raise heightened concerns, we

137 P a g e 137 would be able to address these concerns as part of the normal safety-and-soundness supervisory process. While the banking agencies have used the other method of tiering and tried to tailor the Volcker rule (as we will do with section 956), I believe that both community banks and supervisors would benefit from not having to focus on formal compliance with regulation of matters that are unlikely to pose problems at smaller banks. Today I would like to add a third candidate for consideration - a statutory amendment that would permit the Federal Reserve Board to raise the size of banks covered by our Small Bank Holding Company Policy Statement. As background, the Board originally issued the policy statement in 1980 to facilitate the transfer of ownership of small community banks. The Board generally discourages the use of debt by bank holding companies to finance acquisitions, because debt can impair the ability of the holding company to serve as a source of strength to subsidiary banks. However, the Board also recognizes that limited access to equity funding by small institutions means that the transfer of ownership of small banks often requires the use of acquisition debt. The policy statement allows small, noncomplex bank holding companies to operate with higher levels of debt than would normally be permitted, subject to restrictions to ensure that higher debt does not pose an undue risk to subsidiary banks and that leverage is reduced over time. Bank holding companies that are subject to the policy statement are exempt from the Board's risk-based and leverage capital guidelines, and are subject to reduced regulatory reporting requirements. The original policy statement set the maximum size of qualifying holding companies at $150 million in total consolidated assets.

138 P a g e 138 This threshold was increased to $500 million in 2006 to address the effects of inflation, industry consolidation, and asset growth. The intervening eight years have obviously brought dramatic changes in the financial, business, and regulatory environments. Accordingly, I believe it is worth considering raising the asset threshold once again, this time to $1 billion. Approximately 85 percent of all bank holding companies qualified after the threshold was raised in 2006, a figure that has dropped to about 75 percent today. Raising the threshold to $1 billion would recoup that lost coverage and go a bit further, covering 89 percent of holding companies. Such an increase would entail some policy tradeoffs, of course, which obviously become of greater concern as the threshold rises further. But I think the balance of considerations argues for taking this action to facilitate transfers of ownership of small banks. For example, while exempting more bank holding companies could result in increased leverage, subsidiary banks remain subject to normal capital requirements. Supervisory and applications approval processes are available to limit instances in which holding companies could take on excessive debt. Similarly, because most bank holding companies under $1 billion have limited activities outside of their banks, and we will still receive detailed quarterly bank data, the reduced regulatory reporting requirements for qualifying holding companies should not be problematic for supervisors. Of course, the policy statement was issued by the Board and thus one might think the Board could raise the threshold on its own. However, the Collins amendment to Dodd-Frank effectively eliminates any authority of the Board to extend the capital treatment

139 P a g e 139 in the policy statement to holding companies with assets greater than the threshold in effect on May 19, 2010, or to savings and loan holding companies of any size. Thus, we would need legislative action to effect these changes. Tiered supervision Federal banking regulators have long organized supervision into portfolios of institutions based predominantly - though for larger firms, not exclusively - on asset size. Various provisions of Dodd-Frank motivated the Federal Reserve to modify the composition of the portfolios somewhat. We have four such groups: (1) community banks, (2) regional banking organizations, (3) large banking organizations, and (4) firms overseen by the Large Institution Supervision Coordinating Committee (LISCC). This arrangement is not simply a matter of organizational convenience. Nor is it only a means for promoting consistency of treatment among similar banks throughout the Federal Reserve System, important as that goal is. As with tiered regulation, this tiered approach to supervision is intended to take account of differences in business models, risks, relative regulatory burden, and other salient considerations. Where specific regulatory goals for the different portfolios vary, the supervisory programs should reflect those differences.

140 P a g e 140 And where the goals are similar across portfolios, supervisory programs should take account of the differences among banks noted a moment ago. A tiered approach to prudential regulation calls not for a single state of the art in supervision, but for distinct state-of-the-art approaches to each supervisory portfolio. Some important implications for community bank supervision follow from this principle. First, the characteristics and business model of community banks must be reflected in the supervisory program. Detailed rules, regulations, and supervisory expectations are clearly needed at times for overseeing the systems created in large, geographically dispersed organizations where the distance from head office to operating branches can be very far indeed. But in a well-run community bank where the president may oversee a relatively small staff and can communicate and enforce expectations and standards face-to-face, some kinds of supervisory expectations needed for larger banks may be unnecessary. In fact, such supervision can be burdensome, because community banks have a smaller balance sheet across which to amortize compliance costs. Such rules can also sometimes conflict with the flexibility that is important to community banks meeting their customers' needs. For instance, community banks should readily comply with expectations that they extend credit on safe and sound terms. However, to the extent that supervisors dictate the precise details of what terms are safe and sound, banks may find it more difficult to structure a loan in a way that matches a borrower's needs or credit situation. This can result in a lessening of credit availability and economic activity.

141 P a g e 141 Attention to a bank's practices in making its relationship lending decisions, and on the performance of the loans that have been made, may be supervisory time better spent. A similar observation can be made with respect to consumer compliance supervision of community banks, for which the Federal Reserve implemented a new examination program in January While we have traditionally applied a risk-focused approach to consumer compliance examinations, the new program more explicitly links examination intensity to the individual community bank's risk profile. Here again, the scale of community banks is directly relevant to supervisory choices. Community banks do not have large, standardized systems for dealing with many customers across a far-flung geographic footprint. They do have much more direct contact between customers and bank management. The new program calls for examiners to spend less time on low-risk compliance issues at community banks. In addition, we revised our consumer compliance examination frequency policy to lengthen the time between on-site consumer compliance and Community Reinvestment Act examinations for many community banks with less than $1 billion in total consolidated assets. A second implication of supervisory tiering is that supervision must not inadvertently undo the decisions made through regulatory tiering. This point raises the oft-cited concern about "supervisory trickle down," whereby supervisory expectations - or even regulatory requirements - formulated for larger banks are de facto applied in part to community banks. The concern has been particularly acute in the context of capital stress testing, though it is by no means limited to that area.

142 P a g e 142 Let me repeat here what all three federal banking agencies have explained in the clearest possible terms, both publicly, in examiner training, and in one-on-one discussions with bankers: that Dodd-Frank Act Stress Test (DFAST) and Comprehensive Capital Analysis and Review requirements and expectations for enterprise-wide capital stress testing do not apply to community banking organizations, either explicitly or implicitly. For example, while it may be sensible supervisory practice to inquire of a growing $9 billion bank if it has begun thinking about how it would meet DFAST requirements should it reach the current $10 billion statutory threshold, that bank does not need to start meeting those requirements until it has actually crossed the threshold. And there is simply no reason for examiners to make a $5 billion bank begin to develop capital stress testing capabilities. Third, the relatively straightforward business model of community banks, along with their relatively small scale and number of branches, provides the opportunity to increase the use of off-site supervisory oversight, in accordance with informing principles of risk-based supervision. For example, last year we pilot-tested a voluntary program under which some aspects of the loan review process were conducted off-site, relying on the bank's electronic records to assess loan quality and underwriting practices. Overall, community bankers that were part of the pilot expressed strong support for this approach, which reduced the time examiners needed to spend on-site at bank offices. As a result, we plan to continue using this approach in future examinations at qualified banks that maintain electronic loan records and wish to participate in this approach. This initiative could tangibly reduce burden on community banking organizations.

143 P a g e 143 More generally, the Federal Reserve has invested substantial resources in developing technological tools for examiners to improve the efficiency of both off-site and on-site supervisory activities. These tools should lead to greater consistency and more efficient, effective, and risk-focused examinations as they assist staff in tailoring the scope of examinations to the activities and risks at individual banks. The automation of various parts of the community bank examination process can also save examiners and bank management time, as a bank can submit requested pre-examination information electronically rather than mailing paper copies to a Federal Reserve Bank. These observations relate to another issue that I might note in passing. As you know, there have been questions raised as to whether the level of required reporting is itself a regulatory burden that might be mitigated for small banks. The banking agencies are considering these issues under the auspices of the Federal Financial Institutions Examination Council. I do think there may be some opportunities to streamline the content or frequency of reporting for smaller banks. However, I would observe that many of the efficiency improvements that I have previously described were dependent on the data collected each quarter in Call Reports. For example, the availability of this data was a factor in raising the threshold for eligibility for the 18-month examination cycle from $250 million to $500 million. Similarly, the regular Call Report data for subsidiary banks buttress the case for increasing the threshold for application of the Small Bank Holding Company Policy Statement.

144 P a g e 144 Thus, there may be some tradeoffs among various possible simplifying supervisory measures. Conclusion As I noted in my speech six months ago, the old unitary approach to prudential oversight has in practical terms been supplanted by various statutory, regulatory, and supervisory measures, particularly since the financial crisis. Tiered regulation and supervision is a reality. My hope is that by acknowledging and, indeed, applauding that reality, legislators and prudential regulators can shape an oversight regime that most effectively realizes the complementary goals of banking soundness, financial stability, and economic growth. Post-crisis attention has understandably been focused on too-big-to-fail issues and other sources of systemic risk. But now is a good time to look at the other end of the banking industry, where the contrast is substantial. Smaller banks present a very different set of business models. Their risks and vulnerabilities tend to grow from different sources. An explicit and sustained tailoring of regulation and supervision for community banks not only seems reasonable, it seems an important and logical next step in financial regulatory reform.

145 P a g e 145 The legacy of the financial crisis - what we know, and what we don't Remarks by Mr Stephen S Poloz, Governor of the Bank of Canada, to the Canadian Council for Public-Private Partnerships (CCPPP), Toronto, Ontario Introduction I am delighted to be here with you today, thank you. I applaud the Council's efforts to foster stronger partnerships between the public and private sectors in the development of infrastructure, which is absolutely critical to our economic future. I'll speak today from the perspective of a monetary policy-maker, whose mandate also is to contribute to the economic and financial well-being of Canadians. I'd like to talk about two subjects today: what we know, and what we don't know. I'm sure it won't be a surprise that the first part will be shorter than the second part. My goal is to help you understand better the risks that we face. If I do my job well, I'll leave you with a sense of how the Bank weighs the known and the unknown when setting monetary policy. What we do know Let's start with what we do know about our current situation. Most of us acknowledge that it all began with a period of exceptionally strong global economic growth in the mid-2000s, some creative financial engineering, an explosion of leverage and a speculative bubble that touched a lot of markets.

146 P a g e 146 The bubble burst when the U.S. housing market rolled over and some significant financial vulnerabilities were laid bare. The ensuing global financial crisis in the fall of 2008 was truly dire. Monetary policy and fiscal policy were quick to respond around the world, with collective G and G-20 announcements on Thanksgiving weekend that year. Since then, we've seen policy rates near zero in several countries and an unprecedented use of unconventional monetary policy, including quantitative easing. We will never know how bad things would have been without that aggressive, coordinated policy response. But as a student of economic history, I can say that all the ingredients of a second Great Depression were present. We've managed to avoid that extreme scenario, but the damage wrought by the Great Recession has been brutal nonetheless. By the end of last year, the loss to global output from the crisis was roughly US$10 trillion, which is close to 15 per cent of global GDP. Today, there are over 60 million fewer jobs around the world than had the crisis not occurred. Still, memories of that near-disaster are fading, and today people are wondering why our policies have so far failed to foster a true global recovery, one that is natural and self-sustaining. The G-20 has acknowledged this disappointing growth outlook, and has set out a plan to collectively boost global GDP by 2 per cent over the next five years. Success will hinge on such policy actions as reforms to improve the functioning of labour markets, international trade liberalization and investment in infrastructure - your favourite area - just to name a few.

147 P a g e 147 These things are clearly worth doing, and that boost to global GDP will be worth having. What we don't know Even so, when we see a world economy that is growing this slowly, despite the fact that interest rates are at historic lows, it is natural to ask some pretty basic questions. So, let's turn now to what we don't know. Let me focus on three questions that people have been asking me of late. First, what is preventing a full-fledged global economic recovery? Second, will there be any permanent damage to the economy due to the crisis and its aftermath? And third, by trying so hard to improve our situation, are policymakers simply sowing the seeds of the next financial crisis? What is preventing a full-fledged economic recovery? If interest rates are at zero or nearly zero, it follows that something is holding the economy back. Think of paddling a kayak against a strong headwind - it can take a lot of effort just to hold your position, let alone make real progress. It is widely agreed that the conditions that led to the financial crisis included taking on excessive leverage. As individuals and financial institutions have attempted to deleverage in the wake of the crisis, economic growth has been held back. It is difficult to say when the deleveraging process will be complete, at least at the global level. To illustrate, in the United States, private sector deleveraging was painful and swift as people cut back on debt and walked away from their over-mortgaged, devalued houses.

148 P a g e 148 In Europe, in contrast, this process is less well advanced, while in Canada, households continue to add to their debt loads. Another headwind has come from governments, which responded to the global recession with additional fiscal stimulus. As the situation stabilizes, though, it is natural for governments to aim to bring their fiscal situation back into balance. This reversal of fiscal stimulus creates a headwind for the economy as a whole, masking the private sector recovery that is happening underneath. Again, the status of this headwind varies from country to country, but it is clearly in play at the global level. The third, and probably the most important, headwind is lingering uncertainty about the future, whether from geopolitical developments, market volatility or just the trauma that companies have been through. Some people look at companies with strong balance sheets and wonder why they are not investing. Some have suggested that we have too much risk taking in financial markets, but not enough risk taking in the real economy. But that's not what we're hearing from the companies we talk to here in Canada. In this uncertain economic climate, companies actually feel like they are taking a lot of risk. And until the recovery is more certain, especially in export demand, for many, it is too risky to expand their businesses. What that seems to mean is that the expected risk-adjusted rate of return on a new investment can appear low to a company, and we can settle into a temporary low-confidence/low-investment equilibrium,

149 P a g e 149 even when borrowing costs are extraordinarily low, until uncertainty subsides and confidence returns. It seems to me that we must allow for the possibility that the combined effects of deleveraging, fiscal normalization and lingering uncertainty will continue to restrain global economic growth for a prolonged period. We are confident that these headwinds will dissipate in time, but in the meantime interest rates will remain lower than in the past in order to work against those forces. Will some of the post-crisis economic damage be permanent? Still, it is important to acknowledge that global economic growth is simply not heading back to the high rates we saw before the financial crisis. For one thing, those rates were boosted by unsustainable leverage. For another, we have entered the retirement window for the post-war baby boomers, and that means that global economic capacity is moderating as growth in the workforce slows. In Canada, for instance, potential economic growth has drifted down to around 2 per cent and will remain there for the next few years. Globally, potential growth is probably down to around 3 to 3 1/2 per cent. Both figures are lower than before the crisis. But this modest deceleration in global growth potential is a natural consequence of demographics, not the product of the crisis. The more important question is whether any of the problems we see today will become permanent. This question is relevant at the global level, but let me illustrate it with direct reference to our own situation here in Canada.

150 P a g e 150 Historically, a typical recession/recovery cycle has taken a couple of years to complete. During the recession - let's say it originates with a drop in export demand - companies cut back production, lay off workers, and investment and consumption spending fall. Monetary and fiscal policies respond, exports recover, companies rehire their workers and move production back to normal. But this cycle has not been a typical one. The downturn was deep and has proved to be long lasting. Canada's export sector not only cut back on production and laid off workers, many companies restructured, many simply disappeared. Recent Bank of Canada research on exporters sifted through more than 2,000 categories of underperforming, non-energy exports. We found that the value of exports from about a quarter of them has fallen by more than 75 per cent since the year Had the exports of these products instead risen in line with foreign demand, they would have contributed about $30 billion in additional exports last year. By correlating these findings with media reports, we found that many were affected by factory closures or other restructurings. Obviously, not all of this can be blamed on the financial crisis and the ensuing downturn, but for companies that were already struggling with competitiveness, the crisis surely accelerated things. The point is, when companies downsize, relocate or close their doors, the effects on the economy are permanent. Those specific lost exports will not recover - something else is more likely to take their place, but that requires that surviving companies expand, or new exporting companies be created.

151 P a g e 151 And both such processes are bound to be much slower than in the typical recession/recovery scenario. A destructive downturn also creates long-lasting effects in our labour market, since the associated jobs are lost permanently. We have recovered well from the employment losses during the downturn, but our labour market has not yet returned fully to normal. Indeed, labour conditions in Canada point to material slack in the economy. We have been creating jobs at a trend rate of less than 1 per cent, well below what one would expect from an economy that is recovering. Furthermore, much of the recent employment growth has been part time. There are over 900,000 people in Canada who are working part time but would prefer to be in full-time positions, and total hours worked are barely growing at all. And then there are the young people who are out of work, underemployed or trying to improve their job prospects by extending their education. We estimate that there are around 200,000 of these people, and I bet almost everyone in this room knows at least one family with adult children living in the basement. I'm pretty sure these kids have not taken early retirement. The good news is that these destructive effects should be reversible over time. Once we have seen a sustained increase in export demand, uncertainty about the future will diminish and firms will respond.

152 P a g e 152 Our research indicates that many of the export sectors that we expect to lead the expansion still have some excess capacity to meet higher demand. This is one reason why our productivity growth has picked up recently - firms are responding with what they have, and job creation has remained modest. But once those capacity limits are reached, exporting firms will begin to rebuild their production capacity with new investments and job creation will pick up. Those same conditions will be ideal for fostering new firm creation, and as we all know, new companies create a disproportionate share of new jobs. The implication is clear: a sustained expansion in our exports not only will represent new demand, it will ignite the rebuilding phase of our business cycle, which will create new supply. This virtuous cycle continues until the excess capacity in the labour market is reabsorbed. By our estimation, it will take around two years for us to use up our excess capacity, at which point inflation will be sustainably at our target. In the meantime, continued monetary stimulus is needed to keep the process in motion, and if the headwinds discussed earlier persist, continued policy stimulus may still be needed to offset them even after our excess capacity has been absorbed. Are we simply sowing the seeds of the next financial crisis? To summarize to this point, the global headwinds that are preventing a return to natural, self-sustaining growth remain considerable, and some of the damage already experienced in our economy will be long lasting. On the positive side, though, our conservative assessment is that global momentum is building, Canada is beginning to benefit,

153 P a g e 153 and with the assistance of continuing monetary stimulus, we can return to natural growth at full capacity over the next two years. This leads to my third question: Is all of this monetary stimulus simply sowing the seeds of the next financial crisis? The side effects of aggressive and prolonged monetary stimulus are well known - it promotes excessive risk-taking in financial markets and excessive borrowing by individuals. These are the very ingredients that led to the 2008 financial crisis in the first place. Accordingly, this question merits a serious response. To begin, we knew back in 2008 that stimulative monetary policies would encourage people to borrow more to buy more homes and cars. That is why we do it - to buffer the downturn in the economy. This happens in every business cycle, not just this one. What distinguishes this cycle is its duration, which is leading to a buildup of financial stability risks over time. We study these risks in detail in our Financial System Review, which is published twice a year. The next issue will be released on 10 December. Importantly, the world has changed since A key commitment of the G-20 in 2008 was to strengthen the global financial system. That work is very well advanced, and the system is far better capitalized and more resilient today. Furthermore, there have been a variety of macroprudential policy changes that have made the system safer.

154 P a g e 154 Here in Canada, for example, we have strengthened the rules around the mortgage market in several ways. Those changes, combined with very high-quality underwriting even before those changes were made, make the Canadian situation very different from what we saw in the United States just before the crisis. That being said, some critics would still say that we are running the risk of creating the next financial crisis through our actions. I might ask in response: What is it you would have us do, then? As the central bank, we only have one real channel of influence, which is to set short-term interest rates. Right now, we are providing monetary stimulus sufficient to bring inflation sustainably to our target within a reasonable time frame, around two years from now. To argue that we should instead set interest rates in a way that reduces financial stability risks, then, is clearly a call for higher interest rates. Let's walk through a thought experiment together. What would our world look like today if, instead of keeping interest rates low to stimulate the economy, both Canada and the United States had moved their policy rates back up to neutral at the beginning of 2011? We estimate that the neutral rate of interest today is between 3 and 4 per cent for Canada, and use a similar number for the United States, so our thought experiment is to raise rates to about 3 1/2 per cent in both countries. Such a move would of course allow those headwinds we talked about earlier to blow us backwards. We estimate that, under this hypothetical scenario the output gap in Canada would have been around 5 1/2 per cent today, instead of around 1 per cent.

155 P a g e 155 Unemployment would have been around 2 percentage points higher than it is today, and core inflation would be running somewhere between 0 and 1 per cent. Most of the impact would be felt in reduced housing construction and renovation and auto production, as these were the sectors that responded to the policies put in place after the crisis. Moreover, these estimates do not capture the range of confidence effects that would permeate the rest of the economy under such a difficult scenario, so the story could even be worse. From this monetary policy-maker's perspective, that's an unattractive alternative. Our primary job is to pursue our 2 per cent inflation target, with a degree of flexibility around the time horizon of its achievement; that flexibility permits the Bank to give due consideration to financial stability risks, provided they do not threaten macroeconomic performance. Currently, inflation is close to target, but some of its strength is due to temporary factors, such as increases in prices for meat, electricity and telecommunications, and the pass-through of past exchange rate depreciation. Unless the output gap closes as expected over the next two years, inflation will drift back down significantly below 2 per cent as the temporary effects of these factors wear off. Meanwhile, financial stability risks are clearly on our radar. In particular, housing activity is showing renewed momentum and consumer debt levels are high, so household imbalances appear to be edging higher. But it is our judgment that our policy of aiming to close the output gap and ensuring inflation remains on target will be consistent with an eventual easing in those household imbalances.

156 P a g e 156 Accordingly, we judge that the overall risks of attaining our inflation target over a reasonable time frame fall into the zone of balance at this time. Conclusion Let me conclude. I have put a lot of emphasis today on the things we don't know. But it is important to underscore that we have a wide range of tools, some of them very sophisticated and others as simple as having conversations with Canadian companies, to help us reach judgments on those issues. The Bank's approach to policy is evolving in light of these developments. We have made some major advances in our thinking in the past year, and in the transparency with which we present these issues to you. Many of the key variables that are essential to the policy decision - measures of capacity, the neutral rate of interest, our outlook for growth and inflation, and so on - are now conveyed in ranges. These elements of uncertainty are being explicitly incorporated into our decision making. All of this demands that we think of monetary policy as an exercise in risk management. Although we regard the risks around attaining our inflation target over a reasonable time frame to be balanced, as policy-makers, we acknowledge that, in the current situation, the consequences of an upside risk would be more manageable than those associated with a downside risk. If this makes central bankers seem overly preoccupied with downside risks, and seem gloomy to you, then take heart - we are just doing our job.

157 P a g e 157 The global financial cycle and how to tame it Panel remarks by Hervé Hannoun, Deputy General Manager, Bank for International Settlements. International Symposium of the Banque de France Central banking: the way forward? Introduction I would like first to compliment Professor Hélène Rey for her thoughtful analysis of the global financial cycle and how to tame it. I am in agreement with the general thrust of her argument and in particular with her conclusion that floating exchange rates do not sufficiently insulate economies from the global financial cycle. My four comments today will cover national and global financial cycles; the excess elasticity of the international monetary system; monetary policy spillovers; and the limits of macroprudential policy. Financial cycles, national and global My first remark relates to financial cycles, national and global. This year s BIS Annual Report refers to the financial cycle as the self-reinforcing interactions between perceptions of risk, risk-taking and financing constraints. These interactions lead to booms and busts that span ordinary business cycles. Emphasising the frequent synchronisation of national financial cycles, the Annual Report measured them at the national level (Graph 1). Professor Rey analyses the global financial cycle in terms of gross capital flows, credit creation and asset prices. She highlights its relationship with risk aversion as proxied by the VIX and with monetary policy in the centre country.

158 P a g e 158 The two approaches to financial cycles, national and global, are quite complementary. We need to update our understanding of how the international transmission mechanism works.

159 P a g e 159 As Hyun Shin emphasised earlier, the first phase of global liquidity from 2003 to 2008 was mostly bank- driven.

160 P a g e 160 By contrast the second phase of global liquidity since 2010 has been bond market-driven. The current global financial cycle features rapid growth (to more than USD 5 trillion) of the outstanding amount of US dollar and euro-denominated bonds issued by borrowers who reside outside the United States and the euro zone (Graph 2, top panel), as a mix of conventional and unconventional monetary policy has pushed down term premiums (bottom panel). Excessive elasticity of the international monetary system My second remark is related to the international monetary system. Since the end of the dollar s link to gold, the de facto global anchor of the system is just the aggregate of the domestic monetary policies of the major reserve currencies. These policies may serve the domestic needs of each country or currency area. But this does not mean that they add up well for the world economy as a whole. The lack of a strong anchor is a key factor behind the excessive elasticity of the system. This means its inability to prevent the build-up of financial imbalances in the form of unsustainable credit and asset price booms. The global policy interest rate needed for the entire world is very hard to achieve given the near-zero policy rate (negative in real terms) in the G7 countries (Graph 3).

161 P a g e 161 In particular, the IMF s SDR interest rate in October was 3 basis points, with negative contributions from three-month eurepo and Japanese government bills. The nominal global policy rate is currently around 2% (Graph 4). In a world growing in nominal terms by 5 6%, the global policy rate should surely exceed its current 2% level. The influence of the 3 basis-point SDR rate on this 2% global policy rate is one of the world economy s great asymmetries.

162 P a g e 162 I commend the IMF for trying to integrate the global dimension in its spillover reports. But the monetary policy recommendations for reserve currencies in its Article IV or World Economic Outlook reports tend to take a purely national perspective. Indeed, over the past 15 years in my recollection the IMF s recommendations on monetary policy have almost always been in the direction of more easing. This suggests to me that the global perspective of the build-up of financial imbalances has been missing. All this means that the lack of global anchor of the international monetary system, well described by Tommaso Padoa-Schioppa, remains. And so does the system s excessive elasticity and inability to constrain effectively global liquidity. Cross-border monetary policy spillovers My third remark is on cross-border spillovers. Spillovers from unconventional monetary policy in advanced economies are a particular concern for emerging markets. Policymakers in many of these economies have had to cope with large capital inflows in search of yield, alternating with equally large capital outflows such as those triggered by the taper tantrum episode in mid Monetary policy in the major currencies transmits itself to the rest of the world through five channels, three price channels and two quantity channels (Table 1). Looking at the price channels, first, there is followership in policy interest rates: central banks set lower policy rates than they otherwise might to avoid capital inflows and currency appreciation (Graph 5).

163 P a g e 163 Second, major central banks unconventional policies lower yields in globally integrated bond markets, including emerging local currency bond markets. Third, emerging market currencies appreciate as core central banks seek to out- ease each other. When it comes to the quantity channels, the growing $11.5 trillion in offshore dollar and euro credit to non-residents also transmits ease, regardless of where that credit originates. And, last but not least, there is the channel of capital flows to EMEs. Do these spillovers require some form of coordination at the global level among monetary policymakers to take them into account or internalise them? Professor Rey considers this simple idea to be unrealistic as it would conflict with domestic mandates of the major central banks, and Bill Dudley has assented to this view.

164 P a g e 164 That said, the President of the New York Fed has also said that given the role of the US dollar as the global reserve currency, the Fed has a special responsibility to manage policy in a way that helps promote global financial stability. This is, I think, an important statement. Limits of macroprudential policy: no substitute for monetary policy My last point is to highlight the risk of excessive expectations of how much macroprudential policies alone can tame the financial cycle, be it global or national. Professor Rey concludes that short-term policy rates will not be enough to tame the financial cycle. Instead she advocates the use of a diversified macroprudential toolkit. When at the BIS we developed and strongly advocated the macroprudential concept, well before the crisis, we always referred to a macroprudential approach to banking supervision and regulation. Strengthening this macroprudential orientation was intended to lessen procyclicality and mitigate systemic risk. We sought to remedy certain limitations in prudential policy, not to offer a substitute for monetary tightening during financial booms. After six years of near-zero interest rates, normalisation of monetary policy has not started, as the major central banks are still waiting for irrefutable evidence, from a myriad of high-frequency and often revised indicators, that the recovery is firmly established. In this context it might be tempting to assign to macroprudential policy the role of taming the financial cycle and curbing excessive risk-taking, while focusing monetary policy on the normal business cycle.

165 P a g e 165 Thus, macroprudential measures would become the preferred instrument for policy tightening while monetary policy could remain ultra-easy. If the objective is to tame the financial cycle, there is an inevitable tension here. In the end, both policies operate largely by influencing incentives for risk-taking. To be sure, macroprudential measures can be more targeted. But by the same token, they are more limited. Macroprudential policy cannot substitute for monetary policy. It would be a mistake, for instance, to believe that a higher bank leverage ratio (which is, by the way, needed) could allow central banks to keep policy interest rates (the broad price of leverage) near zero. In my view, combining macroprudential tightening and monetary easing is not the right way to go about leaning against a financial boom: the macroprudential tool is most effective when it works with monetary policy, not against it. Monetary and macroprudential policies should pull in the same, not in opposite directions. Using the brake and the accelerator simultaneously is not to be recommended, at least in conventional driving. To conclude, I would say, that, in the aftermath of the global financial crisis, policymakers have been successful in tightening the (macro) prudential policy through the global regulatory reform in an effort to make the next crisis both less likely and less severe. At the same time, they have aggressively and persistently eased monetary policy, thereby amplifying the risk-taking channel of transmission. Arguably, the net effect of prudential tightening and monetary easing on systemic risk is ambiguous.

166 P a g e 166 The Importance of the SEC s Rulemaking Agenda You Are What You Prioritize: Commissioner Daniel M. Gallagher Remarks at the 47th Annual Securities Regulation Seminar of the Los Angeles County Bar Association, Los Angeles, CA Thank you, John [Hartigan], for that kind introduction. I am honored to be a part of this venerable conference, which is one of the longest-running of its kind, spanning 47 of the 80 years that the SEC has been in existence. The Los Angeles County Bar Association has always been a leader in addressing the legal and policy issues that impact our capital markets, and I am pleased to be able to join you today to continue that tradition. I always look forward to my trips to the West Coast, in large part because they give me the opportunity to visit our regional offices here that are so programmatically important to the agency. Earlier this week, I visited with our dedicated staff both here in Los Angeles and up the coast in San Francisco, and I am proud to report that the SEC s California regional offices are firing on all cylinders and performing at the top of their game. * * * I am going to speak to you this afternoon about the Commission s agenda not only the current agenda, but also our agenda over the past several years. After all, what we did or didn t do in the recent past has a tremendous effect on our current and future agenda. Never in the Commission s history has it been so important to be at the top of our game.

167 P a g e 167 In many ways, however, never before have we been so hampered and distracted by external factors. The incredible burden imposed on the Commission by Congress through the Dodd-Frank Act has handcuffed and politicized what is supposed to be indeed, must be an independent agency. The Commission is at a precipice, teetering on the edge of irrelevancy as we devote a wildly disproportionate amount of resources to implementing an agenda that is no less political than other, more widely discussed pieces of single party legislation. The Affordable Care Act may get more attention, but Dodd-Frank is just as radical, passed in a similarly hasty, sloppy process motivated by the desire not to allow a serious crisis to go to waste. Since the passage of Dodd-Frank in July 2010, the agency has lost its way, as well as a significant part of its independence. The never-ending effort to appease the Dodd-Frank coalition of politicians and special interest groups has caused the Commission to veer towards the political whims of the day and away from its core, tri-partite mission of protecting investors, facilitating capital formation, and maintaining fair, orderly, and efficient markets. Meanwhile, other regulators, particularly the prudential regulators, have unleashed a torrent of rules that hugely impact the markets overseen by the SEC. As I noted in a speech last week, the move to impose prudential regulation on our capital markets, in particular by applying a one-size-fits-all approach to capital requirements, is nothing short of an existential threat to those markets and to the SEC itself. Dodd-Frank is no ordinary piece of legislation. It is a 2,319 page Frankenstein s monster, cobbled together out of a hodgepodge of provisions advanced by special interests, very few of which have any nexus with the actual causes of the financial crisis or the SEC s core mission.

168 P a g e 168 It was natural and expected that Congress would respond to the tragic financial crisis of , just as it did in response to the 1929 stock market crash. However, unlike its measured response to the 1929 crash, Congress rushed to judgment in responding to the recent financial crisis, passing Dodd-Frank even before its own commissioned report on the causes of the crisis was finished. Just as Dr. Frankenstein implanted the abnormal brain into his monster, the animating principles of Dodd-Frank are based on abnormal narratives that is, narratives that bear no relation to the actual causes of the financial crisis. And the resulting monster which in honor of Halloween I will call Dodd-Frankenstein has been unleashed for years, wreaking havoc on the country and its financial markets. Policymakers who played a role in the irrational exuberance of the housing markets in the years leading up to the financial crisis understandably were not interested in revisiting and shining a light on their pre-crisis actions when they drafted the legislative response to the crisis. Accordingly, Dodd-Frank was built on a narrative of Wall Street greed and regulatory failures. While these two factors certainly played a role in the crisis, they were not fundamental, underlying causes of the crisis so much as symptoms of a much larger illness failed federal housing policy. Once it was clear that Dodd-Frank would be a single party, runaway train of legislation, it became a convenient vehicle for every orphaned wish list item of policymakers and special interest groups. Take, for example, the sociopolitical conflict minerals and extractive resources mandates the SEC spent the better part of two years implementing between 2010 and 2012.

169 P a g e 169 While the elimination of gang violence in the Congo is a laudable goal, I am one hundred percent sure that a lack of corporate disclosures about humanitarian issues did not bring down Lehman Brothers or AIG. Funny, though, that the words Fannie and Freddie don t feature in Dodd-Frank, yet these two taxpayer-owned Zombie banks continue to be the nerve center of the U.S. housing markets. Not so funny is the fact that these sociopolitical mandates have done far more harm than good to the people they were meant to protect, causing at least a million subsistence miners to lose their jobs. Dozens of SEC staff members spent thousands of hours working on these two rules alone, which our economists estimated would cost issuers an astonishing $4 billion that s right, billion. All too predictably, this colossal waste of the Commission s resources resulted in two severely flawed rules that were challenged and fully or partially vacated by the federal courts, and which continue to drain precious Commission resources. Unfortunately, the portion of the conflict minerals rule that did take effect cost issuers an astonishing $700 million in the first year alone. While I often point to conflict minerals and extractive resources as Exhibits 1 & 2 of the Commission s misguided rulemaking agenda, they are just the tip of the iceberg. Take, for example, the Commission s rush to pass the proxy access rule just weeks after Dodd-Frank was enacted. While the ruins of the financial crisis were still smoldering, a majority of the Commission thought it was a good idea to prioritize a longtime wish list item of unions and other special interests that lacked any connection whatsoever to the turmoil that brought down the financial markets. Consistent with the theme of prioritizing the political over the important, in 2013 a majority of the Commission proposed a rule

170 P a g e 170 requiring public companies to disclose the ratio of CEO compensation to their median employee. And let s not forget about the time and resources the agency wasted on the Volcker Rule, despite the fact that the rule s namesake as well as the then-secretary of the Treasury who presided over the creation of Dodd-Frank both publicly stated that proprietary trading had nothing to do with the financial crisis. The Commission created an entirely new regulatory regime for municipal securities advisors and rushed to push out rules under Title IV of Dodd-Frank to regulate hedge funds and private equity funds, despite the lack of any evidence that any of these entities contributed to the crisis. And, maddeningly, earlier this week a majority of the Commission, together with other federal agencies, passed an utterly impotent Dodd-Frank mandated rule on credit risk retention that codifies the worst features of the failed federal housing policy that led to the crisis. I often tell people that the SEC won the Dodd-Frank booby prize, and we are still paying the price over four years later. The Act was packed with roughly 400 mandated rulemakings and studies for the federal regulatory agencies, with approximately 100 assigned to the SEC far and away the most of any of the agencies involved. Rather than tending our regulatory garden, so to speak, by focusing on policy issues that are core to our mission, the Commission has spent much, if not most, of its time and resources for nearly half a decade shoveling manure, in some cases for no discernable purpose whatsoever. Even after all this effort, of the 100 rulemakings mandated to the SEC by Dodd-Frank, we still have more than half left to finalize. Notwithstanding my outspoken criticism, I recognize that Dodd-Frank is the law of the land and that the Commission must implement it. However, we cannot allow it to get a stranglehold on our

171 P a g e 171 agenda at the expense of the Commission and its staff doing our day jobs. As I stated in a speech last year, it is absolutely critical that we apply a reasoned framework in deciding which of the remaining Commission Dodd-Frank mandates to prioritize. After all, one of the hundred mandates has to be the last one implemented. Sadly, no such framework has been applied during my tenure as a Commissioner. To be fair, there have been some flashes of hope showing that the agency still has a rudder, most notably in the form of non-dodd Frank mandated initiatives. Examples include such projects as Staff Legal Bulletin, issued to provide guidance on the use of proxy advisors; last year s release of FAQs on the supervisory liability of compliance and legal personnel; and the Commission s critically important Consolidated Audit Trail rulemaking. In addition, I m hopeful that notwithstanding recent media speculation of delay and discord, we ll be able to complete a rational Regulation SCI final rule in the near future. At a more macro level, the entire Commission has expressed an interest in a holistic review of equity market structure an idea I have advocated throughout my tenure which I hope will start soon. I am also encouraged by the initiative undertaken by Keith Higgins and the Division of Corporation Finance to comprehensively review corporate disclosure. But what other initiatives ought to be at the top of the SEC s agenda? What issues should the Commission be prioritizing, both now and over the long term?

172 P a g e 172 Let me outline for you a few of the items that I consider mission critical for the agency. * * * Topping the list of issues in need of our immediate attention are the fixed income markets. Over the past six months, since the release of a certain book, the impact of high frequency trading on our equity markets has been the topic du jour. However, as I have stated before, if we are setting our regulatory agenda based on Michael Lewis books, we need to address Liar s Poker before Flash Boys. Twenty-five years after the publication of the former, our fixed income markets are shockingly similar to and include many elements unchanged from those described by Lewis in There are two things about the debt markets that should concern us all. The first is the heavy exposure of retail investors to products and trading practices that are little understood by and all too opaque to the average investor. Including asset backed securities, there is approximately $11.3 trillion of debt outstanding in the corporate bond markets. Approximately 45% of that is held by retail customers, and nearly a quarter of that is held directly. Retail participation is even more pronounced in the municipal debt markets, where nearly 75% of the $3.7 trillion in outstanding debt is held by retail investors. It should be a wakeup call to us all that such a staggering percentage of our fixed income markets rests in the hands of ordinary investors who often do not understand the product they hold or the

173 P a g e 173 accompanying risks, including the devastating effect an inevitable interest rate hike could have on their investment. Which brings me to my second major concern the clear and present danger of a liquidity cliff in the debt markets. Over the past few years, these markets have witnessed historic growth due to a zero percent interest rate environment. While investors have been flocking to bonds at a record pace, dealer inventories have shrunk by nearly 75% since 2008 as financial institutions have been forced to deleverage in the wake of Basel III, the Volcker Rule, and other constraints introduced by prudential regulators ostensibly in response to the crisis. This has set the stage for a potentially dire liquidity crisis. When interest rates rise which the Fed has indicated could happen as early as next summer outflows from high yielding and less liquid debt could drive bond prices down. Which raises the question of the hour where is the necessary liquidity going to come from? As the primary regulator of the non-government fixed income markets, the SEC needs to champion the tough reforms that are needed to modernize the fixed income markets. First and foremost, we need to bring transparency to the markets for retail investors by requiring bond traders to disclose markups to customers of riskless principal trades, most of which are really just agency transactions in sheep s clothing. We also need to ensure that there are no regulatory impediments to the development of electronic fixed income trading platforms, and we should work to reduce the number of bespoke bond offerings in favor of encouraging more standardized offerings if that would result in more liquidity.

174 P a g e 174 I recently came across a statistic that was shocking to me General Electric has over 900 bond issuances, but fewer than 50 of them trade on a regular basis. The SEC needs to take steps to facilitate bond market liquidity, ideally by working with the industry and investors to create workable, market-based solutions. The last thing we need is a Dodd-Frank Title VII-like regime in which an equity market structure is overlaid on a market that operates in a fundamentally different manner. * * * Another critically important area that we need to address is capital formation for small businesses. In early 2012, Congress passed with overwhelming bipartisan support an incredibly impactful piece of legislation the JOBS Act. The JOBS Act was all about capital formation and job growth for Main Street, not Wall Street. Just imagine if Bill Gates had decided to sell his fledgling technology company to a competitor in the late 1970s rather than allowing it to grow and become a public company through the IPO process. Many growing businesses have consciously avoided the IPO markets over the past decade because of the burdensome regulatory baggage that accompanies the offering regime. Instead, they ve taken the far simpler option of selling their business outright to a larger entity, or they simply stayed private and never gained access to the capital they needed to take their business to the next level. If Bill Gates had faced such a mountain of impediments to publicly listing his company, he may very well have sold out early too, and the innovation and jobs spawned by an independent Microsoft never would have happened.

175 P a g e 175 As the primary regulator of the capital markets, the SEC has a duty indeed, a defined mission to facilitate capital formation for small businesses. The JOBS Act reminded us of that duty by streamlining the IPO process for emerging growth companies, eliminating the ban on general solicitation for private offerings, creating a crowdfunding capital formation regime, and mandating that the SEC modernize Regulation A. We have made some progress, finalizing a rule on general solicitation and issuing a proposed rule on crowdfunding. I am committed to finalizing our rulemaking on crowdfunding in a workable fashion. If that isn t possible under the JOBS Act as enacted, then the Commission should be loudly telling Congress that we need a legislative fix, and that we need it now. We took a big step forward by issuing proposed rules to amend Regulation A in December of last year, but we have to finish the job as soon as possible. Regulation A+, as our proposed rules have come to be called, would democratize capital formation, allowing equity in small, pre-ipo companies to be sold to the ordinary investor the woman who lives down the street from the brewery that needs to raise capital to grow. She knows the owner, she knows the beer, she likes the beer, and she should be able to buy equity in the business, but she can t do so under the current regulatory paradigm because she is not an accredited investor and the brewery cannot afford a traditional IPO. With Regulation A+, we are on the cusp of breaking down the barriers of entry into the capital markets for small businesses and ordinary investors. But Regulation A+ is only half of the equation.

176 P a g e 176 We also need to facilitate the development of a secondary market for small businesses on which equities can be traded after an initial offering. To this end, I have been an outspoken advocate for the creation of Venture Exchanges : national equities exchanges with rules tailored for smaller businesses, including those engaging in issuances under Regulation A. Shares traded on these exchanges would be exempt from state blue sky registration, and the exchanges themselves would be exempt from the Commission s national market structure and unlisted trading privileges rules. This new regulatory framework would attract market makers and analysts to these exchanges, fostering the rebirth of a secondary market for small business equity that has been suffocated by layer upon layer of regulatory burdens. * * * These are just a few examples of the vital initiatives the Commission needs to prioritize, but there are certainly others. We need to finish removing references to credit rating agencies from our rule book one of the few Dodd-Frank mandates that was germane to the financial crisis and we need to revise the long-outdated transfer agent rules, which have not been amended in decades. We also should consider revisiting the Securities Investor Protection Act in light of the shortcomings that became evident following the collapse of Lehman Brothers and the Madoff Ponzi scheme, among other failures. And we also need to finalize rules for the Commission s 17(h) broker-dealer risk assessment program. But beyond these discrete items, we must take a step back and realize where we are today as a regulator and where we have been for the past five years.

177 P a g e 177 We need to set a course to once again being a preeminent federal agency and thought leader in the policy debates that have been for too long happening around us. Once again, thank you for this opportunity to share my thoughts with you, and I wish you an enjoyable and productive conference.

178 P a g e 178 Implementing the regulatory reform agenda - the pitfall of myopia Speech by Mr Stefan Ingves, Chairman, Basel Committee on Banking Supervision and Governor, Sveriges Riksbank at the Federal Reserve Bank of Chicago The subject of this conference is indeed very timely - six years after the outbreak of the financial crisis, there has been substantial progress in the post-crisis regulatory reform agenda, with a number of important milestones reached. Therefore, now is a good time to take a step back and ask how the different bits and pieces of the regulatory framework fit together. And, more specifically - have the vulnerabilities revealed in the crisis been adequately addressed? Are additional adjustments still necessary? Or, conversely, have we gone too far and created a regulatory Frankenstein's monster that no-one has full control over and that stifles lending and economic growth? This latter view is one that I sometimes hear when meeting representatives of the banking industry. The feeling seems to be that we are overwhelming the financial system with a regulation tsunami with too many reforms being implemented too soon. This will lead to unacceptable consequences in the form of higher funding costs, reductions in market liquidity with market-makers pulling out of markets, collateral shortages; and many banking activities simply disappearing, or moving to the so called shadow banking sector. And indeed - the financial crisis has led to a comprehensive response from regulators and policymakers across the world. Compared to the pre-crisis era, international banks will face: - substantially higher capital requirements, - higher demands on the quality of capital,

179 P a g e a leverage ratio, - an international liquidity framework, with both short-term and structural liquidity requirements (I am proud to note that the Basel Committee, less than a week ago, published the final standard for the net stable funding ratio, NSFR), and - a regulatory framework for global systemically important banks (G-SIBs). When you add to this ongoing work related to reducing RWA variability and disclosure, you end up with a pretty impressive list - a list that represents an unprecedented leap forward in terms of global banking regulation. So then, how do I see this? Do I claim to know how all these new rules will play out together? Am I confident that there will be no inconsistencies and contradictions? No, definitely not. We have every reason to be humble in this respect. Monitoring and assessing the effects of reforms will therefore be imperative. Will the reforms be costly for banks in the short term? Yes, they will. Will banks have to adjust their activities? Yes, a return to pre-crisis banking behaviour is neither appropriate nor viable. Do I therefore think that regulation has gone too far and that parts should be undone? No, not at all. In this presentation I will try to explain why I think this is so. I will also speak about what is still lacking and the regulatory challenges we face ahead. Why we shouldn't back-track on regulation There are several reasons why I don't think the regulatory agenda has gone too far. First of all, my experience is that important regulatory and structural reforms are all too often hindered by myopia.

180 P a g e 180 People tend to focus on costs and pains in the short run, leaving aside the longer term gains that reforms aim to achieve. The perceived short-term costs are simply much easier to sell politically, compared to the abstract benefits of lowering the risk of crises. This is especially so, since the benefits may accrue only to future generations - a group that has difficulties making its voice heard in today's policy debate. This time has been no exception: for years, people shied away from necessary actions to strengthen the financial system. When the crisis hit, perceptions changed, providing a window of opportunity for regulatory reforms that were long overdue. However, we must not begin to close this window and lose sight of why we are undertaking these reforms. Let me start with a reminder of the regulatory framework before the crisis. Both Basel I and II included a risk-weighted capital adequacy framework. However, for the last 20 years banks' balance sheets ballooned, while their equity failed to take off. For example, from 1993 to 2008 the total assets of a sample of what we call global systemically important banks saw a twelve-fold increase (increasing from $2.6 trillion to just over $30 trillion). But the capital funding these assets only increased seven-fold, (from $125 billion to $890 billion). Put differently, the average risk weight declined from 70% to below 40%. The problem was that this reduction did not represent a genuine reduction in risk in the banking system. To take an even more concrete example from my own country: during the past twenty years or so, the risk weights for retail mortgages in the major Swedish banks have decreased from 50% to 35% with the adoption of Basel II (from Basel I) and further, to about 6% when banks themselves were allowed to model risk weights.

181 P a g e 181 In equity terms, this means that instead of SEK 17,000 of their own equity to fund a mortgage of 1 million, banks' models implied that SEK 1,200 was enough. In retrospect, it is clear that the decrease in risk weights did not reflect actual risks and banks therefore needed more capital. Furthermore, although it is a historical fact that banks' problems often start in the form of liquidity constraints, there were no global liquidity regulations for banks prior to the crisis. This meant that banks could rely heavily on very short-term market funding to finance highly illiquid and long-term assets. This worked fine during the Great Moderation, but unfortunately with the collapse of Lehman Brothers another old truism suddenly came to life: "markets function the worst when you need them the most". Against this background, it is quite embarrassing that so few could see the crisis coming. From a regulatory point of view, all the ingredients were there, or rather they were lacking. And this is the first point I want to make - the regulatory framework was unsatisfactory and becoming more so the more complex the financial system became. Then, turning to my second point, which is: The costs of financial crises are huge. This is true in general, but especially so for the recent one. For example, according to a recent study by IMF economists, in a sample of countries representing just over 50% of world GDP, the total amount of government recapitalisation, asset purchases and guarantees during the period amounted to nearly $5 trillion. This is equivalent to 16% of the GDP of these economies, or nearly $5,000 per citizen. But, this is only a lower bound of the cost of the crisis.

182 P a g e 182 If we also include the impact on GDP and the loss of production relative to its pre-crisis trend, the costs rise. This has been showed by several studies, including the one just mentioned by IMF economists, which estimates that banking crises that occurred between 1970 and 2000 are resulting in output losses of more than 20% on average if we look at all countries, and more than 30% of GDP in advanced economies. These results are in line with the BIS finding that the median discounted cumulative loss of output over the course of a crisis in the same period was about 19% of pre-crisis GDP. Now, the question of exactly how much regulation leads to the optimal outcome in terms of long-term growth is, of course, debatable. But let me underline that ambitious attempts have been made by the BIS, but also the OECD and others, to assess the net effect of recent regulatory reform measures, and the results generally point in one direction: that the net effect of reforms is positive. In addition, let me also underline that the Basel Committee has not been blind and deaf to the worries expressed by the industry about excessive regulation. Many adjustments have been made, not least when it comes to the new liquidity regulation. It is also standard procedure that new regulations are subject to industry consultation and in many cases additional discussions also take place with the industry itself, as well as with investors, to avoid unintended consequences. In this context, however, let me remind us all that the reactions we get from the banking industry are sometimes slightly biased, if I dare say so. A telling example is the lobbying effort during the design of the Basel II framework. As part of that work, in 2003 the Committee consulted on a new securitisation framework, which, with the benefit of hindsight, turned out to be very weak.

183 P a g e 183 Yet the comments from the industry on the proposed securitisation framework were in general quite alarming. Allow me to quote just a couple of the replies to the consultation proposal that the Committee received (all of which are publicly available): One bank wrote: "The prescribed risk weightings for securitisation exposure(s)-result in excessive risk weights compared to the economic risks of securitisation tranches, particularly for retail and mortgage portfolios." This particular bank happened to incur $24.7 billion in losses from CDOs during the crisis. Another bank wrote: "If adopted, the current proposal for securitisation will materially impair the ability of banks to distribute risk from their own balance sheets into the capital markets." - This bank incurred USD 13 billion losses in Q and USD19 billion in writedowns on real estate and related structured credit positions.6 Let me emphasise that there is nothing special with these two examples. I can assure you that there are many more similar examples to quote - the message being that the proposed reforms were overly restrictive, would damage the market and reduce activity. This illustrates that we need perspective when assessing the feasibility of reforms. To sum up so far: yes, there has been a strong regulatory reaction to the crisis, but as I see it, this is appropriate, given - the pre-crisis regulatory framework, - the costs crises give rise to, and - the efforts that the Basel Committee has made to mitigate risks of unintended consequences, The problem is that myopic observers tend to forget these aspects. Are we there yet? What are the remaining challenges? I would now like to change perspective slightly and ask, are we there yet?

184 P a g e 184 Have our efforts done the trick, or are there still challenges to be tackled? Well, from a Basel Committee perspective I am pleased to be able to say that the Basel III framework is now agreed - in principle. This is a major achievement that all participating parties should be proud of. If I widen the scope, beyond the Basel III framework, and look at other parts of the reform agenda, it is obvious that the work on ending the "too big to fail" problem has been difficult, and that some work still remains to be done. However, the reason we have not yet reached our goal is not lack of effort, but simply that the resolution of very large, cross-border banks is not easy. The main remaining issue here concerns how to ensure that global systemically important banks have sufficient capacity to absorb losses in resolution, without having to ask tax-payers to foot the bill. This work goes under the name of T-LAC, or total loss absorbing capacity. I find it reasonable to believe that there will be an agreement on a consultative document to be published in the context of the G20 summit in Brisbane. So, viewed against the broad regulatory reform agenda put in place as a reaction to the crisis, it is fair to say that we are indeed seeing some light at the end of the tunnel. The main pieces are starting to come in place. Unfortunately, concluding the post crisis reform agenda does not mean that we can lie down, relax and declare "mission accomplished". We need to look closely at the regulatory framework, remind ourselves of the reasons we put these measures in place, and ask whether they are delivering the right outcomes. And here I would like to focus on the interlinked issues of implementation and calibration. Let me start with some reflections on implementation.

185 P a g e 185 For some time now, the Basel Committee has engaged in the process of monitoring and assessing how members implement what has been agreed by the Committee. The assessment work is carried out on a jurisdictional as well as on a thematic basis. In the jurisdictional assessment we look at how Committee members have implemented the Basel standard - determining whether or not it is a fair reflection of the Basel III requirements. After an assessment has been thoroughly debated in the Committee, the final assessment becomes public. The assessments, and the publication of the results, have proved to be a powerful tool. To date, more than 200 adjustments have been made by member jurisdictions in response to findings raised by the assessment teams. In addition, the process has also generated a positive feedback loop, meaning that the lessons learnt from assessments are used to improve and clarify the standards. So far, the assessments have concentrated on the capital framework, but from 2015 onwards the scope of this work will widen further to include the implementation of the liquidity coverage ratio and the SIB-requirements. However, for the new, stricter requirements to bring the benefits we are aiming for, it is important that they be properly reflected, not only in national legislation, but also at the level of individual banks. To use an analogy of car safety, if we are now providing banks with air bags, in the form of higher capital requirements, it is important that those airbags are actually activated in case of an accident. For this to happen, the sensors need to be functioning and well-calibrated. For banks, this means that risk weights need to signal appropriately the risks that individual banks actually face. This aspect is captured in the Committee's thematic assessments.

186 P a g e 186 To put it simply, in these assessments we examined whether the banks' risk-weighted assets could be trusted. The results showed that banks' risk-weighted assets differ to an extent that goes well beyond what can be explained by business models and historical experiences. If we just take the banking-book results, two banks with exactly the same assets could report capital ratios that differ by as much as 4 percentage points. The potential for differences this wide, particularly as they are derived from only a part of a bank's business, weakens confidence in the measurement of bank capital. Of course, this was not a total surprise. It was a reflection of what I mentioned earlier: that internally-modelled risk weights lead to capital not keeping pace with asset expansion. This has undermined the confidence in banks and the credibility of the concept of banks' internally-modelled risk weights. Ensuring consistency in the implementation of risk-based capital standards will therefore be a key factor in restoring confidence in banks. The Committee is thus assessing bank capital ratios with a view to ensuring that they appropriately reflect the risks that banks face. There should be "truth in advertising" for the regulatory ratios that banks present. To achieve this, the regulatory framework needs to deliver readily comprehensible and comparable outcomes. In my view, these assessments, both the jurisdictional and the thematic that compares risk-weighted assets, are absolutely vital for achieving our goals. This will be an important focus for the Committee in the coming years. I would now like to take a step further and focus on the link between implementation and how the system should be calibrated.

187 P a g e 187 Because my view is that there are a number of trade-offs at play here, which need to be taken into account. For instance, if we don't implement the necessary changes and succeed in properly restoring the credibility of risk-weighted capital ratios, a more important role will have to be played by other parts of the regulatory system, such as the leverage ratio. For now, our working hypothesis is a regulatory minimum leverage ratio of 3%, but to me this is more of a place-holder. What the final outcome should be will depend on the calibration of the whole regulatory framework, in which the risk weights and leverage ratio are important pieces. An important element in this calibration will be transparency - the more transparent banksare with methods and models to calculate risk weights, the better it will be for the credibility of the system as such. If we widen the perspective further, I think there is also an interesting issue of calibration linked to the concept of going-concern capital requirements on the one hand, and gone-concern capital requirements on the other. When we discuss appropriate levels of TLAC we should keep in mind that the less we strengthen the credibility of the system for going concern capital requirements, the higher banks' gone-concern capacity to absorb losses will have to be. Concluding remarks So, to wrap up: I see no reason to pull the brake on regulatory reforms. We must not lose sight of the long-term benefits of limiting the costs to society that financial crises cause. And, although a lot has been achieved, challenges still remain - especially when it comes to implementation, implementation monitoring and calibration of the whole framework. As I said earlier, I do not know with full certainty how all the different parts of the reforms will play out together. This further underlines the necessity to constantly monitor what is happening, very much in line with what the organisers of this conference are doing.

188 P a g e 188 And as financial systems have an amazing ability to reinvent themselves, regulatory reform is a never-ending task. Therefore, we need forums such as this conference to evaluate where we are, and where we should be going - hopefully, then, we won't have to make regulatory leaps quite as far as we were forced to this time.

189 P a g e 189 ECB - Guide to banking supervision Foreword This guide is fundamental to the implementation of the Single Supervisory Mechanism (SSM), the new system of financial supervision comprising, as at November 2014, the European Central Bank (ECB) and the national competent authorities (NCAs) of euro area countries. It explains how the SSM functions and gives guidance on the SSM s supervisory practices The SSM, which officially entered into operation in November 2014, is itself a step towards greater European harmonisation. It promotes the single rulebook approach to the prudential supervision of credit institutions in order to enhance the robustness of the euro area banking system. Established as a response to the lessons learnt in the financial crisis, the SSM is based on commonly agreed principles and standards. Supervision is performed by the ECB together with the national supervisory authorities of participating Member States. The SSM will not reinvent the wheel, but aims to build on the best supervisory practices that are already in place. It works in cooperation with the European Banking Authority (EBA), the European Parliament, the Eurogroup, the European Commission, and the European Systemic Risk Board (ESRB), within their respective mandates, and is mindful of cooperation with all stakeholders and other international bodies and standard-setters. The SSM is composed of the ECB and the NCAs of participating Member States and therefore combines the strengths, experience and expertise of all of these institutions. The ECB is responsible for the effective and consistent functioning of the SSM and exercises oversight over the functioning of the system, based on

190 P a g e 190 the distribution of responsibilities between the ECB and NCAs, as set out in the SSM Regulation. To ensure efficient supervision, credit institutions are categorised as significant or less significant : the ECB directly supervises significant banks, whereas the NCAs are in charge of supervising less significant banks. This guide explains the criteria used to assess whether a credit institution falls within the significant or less significant institution category. This guide is issued in accordance with the Interinstitutional Agreement between the European Parliament and the ECB. The procedures described in the guide may have to be adapted to the circumstances of the case at hand or the necessity to set priorities. The guide is a practical tool that will be updated regularly to reflect new experiences that are gained in practice. This guide is not, however, a legally binding document and cannot in any way substitute for the legal requirements laid down in the relevant applicable EU law. In case of divergences between these rules and the guide, the former prevail. 1 Introduction 1 The Single Supervisory Mechanism (SSM) comprises the ECB and the national competent authorities (NCAs) of participating Member States. The SSM is responsible for the prudential supervision of all credit institutions in the participating Member States. It ensures that the EU s policy on the prudential supervision of credit institutions is implemented in a coherent and effective manner and that credit institutions are subject to supervision of the highest quality. The SSM s three main objectives are to: ensure the safety and soundness of the European banking system; increase financial integration and stability;

191 P a g e 191 ensure consistent supervision. 2 On the basis of the SSM Regulation, the ECB, with its extensive expertise in macroeconomic policy and financial stability analysis, carries out clearly defined supervisory tasks to protect the stability of the European financial system, together with the NCAs. The SSM Regulation and the SSM Framework Regulation provide the legal basis for the operational arrangements related to the prudential tasks of the SSM. 3 The ECB acts with full regard and duty of care for the unity and integrity of the Single Market based on the equal treatment of credit institutions with a view to preventing regulatory arbitrage. Against this background, it should also reduce the supervisory burden for cross-border credit institutions. The ECB considers the different types, business models and sizes of credit institutions as well as the systemic benefits of diversity in the banking industry. 4 In carrying out its prudential tasks, as defined in the SSM Regulation, the ECB applies all relevant EU laws and, where applicable, the national legislation transposing them into Member State law. Where the relevant law grants options for Member States, the ECB also applies the national legislation exercising those options. The ECB is subject to technical standards developed by the European Banking Authority (EBA) and adopted by the European Commission, and also to the EBA s European Supervisory Handbook. Moreover, in areas not covered by this set of rules, or if a need for further harmonisation emerges in the conduct of the day-to-day supervision, the ECB will issue its own standards and methodologies, while considering Member States national options and discretions under EU legislation. 5 This guide sets out: the supervisory principles of the SSM; the functioning of the SSM, including:

192 P a g e 192 the distribution of tasks between the ECB and the NCAs of the participating Member States; the decision-making process within the SSM; operating structure of the SSM; the supervisory cycle of the SSM; the conduct of supervision in the SSM, including: authorisations, acquisitions of qualifying holdings, withdrawal of authorisation; supervision of significant institutions; supervision of less significant institutions; overall quality and planning control. 2 Supervisory principles 6 In the pursuit of its mission, the SSM constantly strives to maintain the highest standards and to ensure consistency in supervision. The SSM benchmarks itself against international norms and best practices. The revised Basel Committee s Core Principles for Effective Banking Supervision as well as the EBA rules form a sound foundation for the regulation, supervision, governance and risk management of the banking sector. 7 The SSM approach is based on the following principles, which inspire any action at the ECB or centralised level and at the national level, and which are essential for an effective functioning of the system. These principles underlie the SSM s work and guide the ECB and the NCAs in performing their tasks. Principle 1 Use of best practices The SSM aspires to be a best practice framework, in terms of objectives, instruments, and powers used.

193 P a g e 193 The SSM s evolving supervisory model builds on state-of-the-art supervisory practices and processes throughout Europe and incorporates the experiences of various Member States supervisory authorities to ensure the safety and soundness of the banking sector. The methodologies are subject to a continuous review process, against both internationally accepted benchmarks and internal scrutiny of practical operational experience, in order to identify areas for improvements. Principle 2 Integrity and decentralisation All participants in the SSM cooperate to achieve high-quality supervisory outcomes. The SSM draws on the expertise and resources of NCAs in performing its supervisory tasks, while also benefiting from centralised processes and procedures, thereby ensuring consistent supervisory results. In- depth qualitative information and consolidated knowledge of credit institutions is essential, as is reliable quantitative information. Decentralised procedures and a continuous exchange of information between the ECB and the NCAs, while preserving the unity of the supervisory system and avoiding duplication, enable the SSM to benefit from the national supervisors closer proximity to the supervised credit institutions, while also ensuring the necessary continuity and consistency of supervision across participating Member States. Principle 3 Homogeneity within the SSM Supervisory principles and procedures are applied to credit institutions across all participating Member States in an appropriately harmonised way to ensure consistency of supervisory actions in order to avoid distortions in treatment and fragmentation. This principle supports the SSM as a single system of supervision. The principle of proportionality (see Principle 7) is applied. Principle 4 Consistency with the Single Market The SSM complies with the single rulebook.

194 P a g e 194 The SSM integrates supervision across a large number of jurisdictions and supports and contributes to the further development of the single rulebook by the EBA, while helping to better address systemic risks in Europe. The SSM is fully open to all EU Member States whose currency is not the euro and who have decided to enter into close cooperation. Given its central role in the SSM, the ECB contributes to further strengthening the convergence process in the Single Market with respect to the supervisory tasks conferred on it by the SSM Regulation. Principle 5 Independence and accountability The supervisory tasks are exercised in an independent manner. Supervision is also subject to high standards of democratic accountability to ensure confidence in the conduct of this public function in the participating Member States. In line with the SSM Regulation, there will be democratic accountability at both the European and national levels. Principle 6 Risk-based approach The SSM approach to supervision is risk-based. It takes into account both the degree of damage which the failure of an institution could cause to financial stability and the possibility of such a failure occurring. Where the SSM judges that there are increased risks to a credit institution or group of credit institutions, those credit institutions will be supervised more intensively until the relevant risks decrease to an acceptable level. The SSM approach to supervision is based on qualitative and quantitative approaches and involves judgement and forward-looking critical assessment. Such a risk-based approach ensures that supervisory resources are always focused on the areas where they are likely to be most effective in enhancing financial stability. Principle 7 Proportionality The supervisory practices of the SSM are commensurate with the systemic importance and risk profile of the credit institutions under supervision.

195 P a g e 195 The implementation of this principle facilitates an efficient allocation of finite supervisory resources. Accordingly, the intensity of the SSM s supervision varies across credit institutions, with a stronger focus on the largest and more complex systemic groups and on the more relevant subsidiaries within a significant banking group. This is consistent with the SSM s risk-based and consolidated supervisory approach. Principle 8 Adequate levels of supervisory activity for all credit institutions The SSM adopts minimum levels of supervisory activity for all credit institutions and ensures that there is an adequate level of engagement with all significant institutions, irrespective of the perceived risk of failure. It categorises credit institutions according to the impact of their failure on financial stability and sets a minimum level of engagement for each category. Principle 9 Effective and timely corrective measures The SSM works to ensure the safety and soundness of individual credit institutions as well as the stability of the European financial system and the financial systems of the participating Member States. It pro-actively supervises credit institutions in participating Member States to reduce the likelihood of failure and the potential damage, with a particular focus on the reduction of the risk of a disorderly failure of significant institutions. There is a strong link between assessment and corrective action. The SSM s supervisory approach fosters timely supervisory action and a thorough monitoring of a credit institution s response. It intervenes as early as possible, thus reducing the potential losses for the credit institution s creditors (including depositors). However, that does not mean that individual credit institutions cannot be allowed to enter resolution procedures.

196 P a g e 196 The SSM works with other relevant authorities to make full use of the resolution mechanisms available under national and EU law. In the event of a failure, resolution procedures as provided by the Bank Recovery and Resolution Directive are applied to avoid, in particular, significant adverse effects on the financial system and to protect public funds by minimising reliance on extraordinary public financial support. 3 The functioning of the SSM 8 The SSM combines the strengths of the ECB and the NCAs. It builds on the ECB s macroeconomic and financial stability expertise and on the NCAs important and long-established knowledge and expertise in the supervision of credit institutions within their jurisdictions, taking into account their economic, organisational and cultural specificities. In addition, both components of the SSM have a body of dedicated and highly qualified staff. The ECB and the NCAs perform their tasks in intensive cooperation. This part of the guide describes the distribution of supervisory tasks, the organisational set-up at the ECB, and the decision-making process within the SSM. 3.1 The distribution of tasks between the ECB and NCAs The SSM is responsible for the supervision of around 4,700 supervised entities within participating Member States. To ensure efficient supervision, the respective supervisory roles and responsibilities of the ECB and the NCAs are allocated on the basis of the significance of the supervised entities. The SSM Regulation and the SSM Framework Regulation contain several criteria according to which credit institutions are classified as either significant or less significant (see Box 1). Box 1 Classification of institutions as significant or less significant To determine whether or not a credit institution is significant, the SSM conducts a regular review: all credit institutions authorised within the

197 P a g e 197 participating Member States are assessed to determine whether they fulfil the criteria for significance. A credit institution will be considered significant if any one of the following conditions is met: the total value of its assets exceeds 30 billion or unless the total value of its assets is below 5 billion exceeds 20% of national GDP; it is one of the three most significant credit institutions established in a Member State; it is a recipient of direct assistance from the European Stability Mechanism; the total value of its assets exceeds 5 billion and the ratio of its cross-border assets/liabilities in more than one other participating Member State to its total assets/liabilities is above 20%. Notwithstanding the fulfilment of these criteria, the SSM may declare an institution significant to ensure the consistent application of high-quality supervisory standards. The ECB or the NCAs may ask for certain information to be submitted (or resubmitted) to help facilitate the decision. Through normal business activity or due to exceptional occurrences (e.g. a merger or acquisition), the status of credit institutions may change. If a group or a credit institution that is considered less significant meets any of the relevant criteria for the first time, it is declared significant and the NCA hands over responsibility for its direct supervision to the ECB. Conversely, a credit institution may no longer be significant, in which case the supervisory responsibility for it returns to the relevant NCA(s). In both cases, the ECB and the NCA(s) involved carefully review and discuss the issue and, unless particular circumstances exist, plan and implement the transfer of supervisory responsibilities so as to allow for a continued and effective supervision. To avoid rapid or repeated alternations of supervisory responsibilities between NCAs and the ECB (e.g. if a credit institution s assets fluctuate at

198 P a g e 198 around 30 billion), the classification has a moderation mechanism: whereas the shift in status from less significant to significant is triggered if just one criterion is met in any one year, a significant group or credit institution will only qualify for a reclassification as less significant if the relevant criteria have not been met over three consecutive calendar years. Institutions are notified immediately of the SSM s decision to transfer supervisory responsibilities from the NCA to the ECB, or vice versa: prior to the adoption of the decision, the ECB gives the institution the opportunity to provide written comments. During the transition, institutions receive regular updates as needed and are introduced to their new team of supervisors. Once the transition is complete, a formal handover meeting is organised for representatives from the supervised institution and the outgoing and incoming supervisors. 10 The ECB directly supervises all institutions that are classified as significant (see Figure 1), around 120 groups representing approximately 1,200 supervised entities, with the assistance of the NCAs. The day-to-day supervision will be conducted by Joint Supervisory Teams (JSTs), which comprise staff from both NCAs and the ECB (see Box 3). The NCAs continue to conduct the direct supervision of less significant institutions, around 3,500 entities, subject to the oversight of the ECB. The ECB can also take on the direct supervision of less significant institutions if this is necessary to ensure the consistent application of high supervisory standards. 11 The ECB is also involved in the supervision of cross-border institutions and groups, either as a home supervisor or a host supervisor in Colleges of Supervisors (see Box 2). Moreover, the ECB participates in the supplementary supervision of financial conglomerates in relation to the credit institutions included in a conglomerate and assumes the responsibilities of the coordinator referred to in the Financial Conglomerates Directive.

199 P a g e 199 Box 2 Colleges of Supervisors Established in accordance with the Capital Requirements Directive (CRD IV), Colleges of Supervisors are vehicles for cooperation and coordination among the national supervisory authorities responsible for, and involved in, the supervision of the different components of cross-border banking groups. Colleges provide a framework for the supervisors and competent authorities to carry out the tasks referred to in CRD IV, for example reaching joint decisions on the adequacy of own funds and their required level and on liquidity and model approvals. Within the SSM, the ECB may have the following roles in supervisory colleges for significant banking groups: home supervisor for colleges that include supervisors from nonparticipating Member States (European colleges) or from countries outside the EU (international colleges); host supervisor for colleges in which the home supervisor is from a non-participating Member State (or a country outside the EU). Where the ECB is the consolidating or home supervisor, it acts as chair of the college, both in European and international colleges. The NCAs of the countries in which the banking group has an entity participate in the college as observers. This means that the NCAs continue their regular participation in, and contribution to, the college s tasks and activities and receive all information, but do not take part in decisions or voting procedures. When the ECB acts as a host supervisor, the NCAs of the countries in which the banking group has an entity generally participate in the college as observers, unless the group has less significant entities in their respective countries, i.e. entities that are not under the ECB s direct supervision, in which case the NCAs continue to participate as members. The EBA and the Basel Committee have issued guidelines/principles for the operational functioning of the colleges.

200 P a g e Against this background, the ECB is responsible for the direct supervision of around 120 groups, which together account for almost 85% of total banking assets in the euro area. Supervised credit institutions that are considered less significant are supervised directly by the relevant NCAs under the overall oversight of the ECB. This structure for banking supervision adequately reflects the SSM Regulation. All credit institutions under the SSM s supervision are subject to the same supervisory approach.

201 P a g e Decision-making within the SSM The Supervisory Board plans and carries out the SSM s supervisory tasks and proposes draft decisions for adoption by the ECB s Governing Council. The Supervisory Board is composed of the Chair and Vice-Chair, four representatives of the ECB, and one representative of the NCAs in each participating Member State, usually the top executive of the relevant NCA responsible for banking supervision. The Supervisory Board s draft decisions are proposed on the basis of thorough, objective, and transparent information, bearing in mind the interest of the EU as a whole. The Supervisory Board operates in a way that ensures its independence. 14 The decision-making process is based on a non-objection procedure (see Figure 2). If the Governing Council does not object to a draft decision proposed by the Supervisory Board within a defined period of time that may not exceed ten working days, the decision is deemed adopted. The Governing Council may adopt or object to draft decisions but cannot change them. The ECB has created a Mediation Panel to resolve differences of views expressed by the NCAs concerned regarding an objection by the Governing Council to a draft decision of the Supervisory Board. 15 The ECB has also established an Administrative Board of Review to carry out internal administrative reviews of decisions taken by the ECB in the exercise of its supervisory powers. Any natural person or supervised entity may request a review of an ECB decision, which is addressed to them, or is of direct and individual concern. The Administrative Board of Review may also propose to the Governing Council that it suspend the application of the contested decision for the duration of the review procedure. The Board is composed of five independent members who are not staff of the ECB or an NCA.

202 P a g e 202 A request for a review of an ECB decision by the Administrative Board of Review does not affect the right to bring proceedings before the Court of Justice of the EU. 3.3 Operating structure of the SSM 16 The ECB has established four dedicated Directorates General (DGs) to perform the supervisory tasks conferred on the ECB in cooperation with NCAs (see Figure 3):

203 P a g e 203 DGs Micro-Prudential Supervision I and II are responsible for the direct day- to-day supervision of significant institutions; DG Micro-Prudential Supervision III is responsible for the oversight of the supervision of less significant institutions performed by NCAs; DG Micro-Prudential Supervision IV performs horizontal and specialised tasks in respect of all credit institutions under the SSM s supervision and provides specialised expertise on specific aspects of supervision, for example internal models and on-site inspections.

204 P a g e 204 Additionally, a dedicated Secretariat supports the activities of the Supervisory Board by assisting in meeting preparations and related legal issues.

205 P a g e DG Micro-Prudential Supervision I is responsible for the supervision of the most significant groups (around 30); DG Micro-Prudential Supervision II is in charge of the remaining significant groups. The day-to-day supervision of significant groups is conducted by Joint Supervisory Teams (JSTs), supported by the horizontal and specialised expertise divisions of DG Micro-Prudential Supervision IV (see Box 3). 18 Ten horizontal and specialised divisions of DG Micro-Prudential Supervision IV support JSTs and NCAs in the conduct of supervision of both significant and less significant credit institutions. These ten divisions are: Risk Analysis, Supervisory Policies, Planning and Coordination of Supervisory Examination Programmes, Centralised On-site Inspections, Internal Models, Enforcement and Sanctions,

206 P a g e 206 Authorisations, Crisis Management, Supervisory Quality Assurance, and Methodology and Standards Development. The horizontal divisions interact closely with the JSTs in, for example, defining and implementing common methodologies and standards, offering support on methodological issues and helping them to refine their approach. The aim is to ensure consistency across the JSTs supervisory approaches. 19 The SSM actively fosters a common supervisory culture by bringing staff from various NCAs together in the JSTs, in the context of the supervision of less significant institutions, and in the horizontal and specialised divisions. In that respect, the ECB also plays a role in organising staff exchanges between NCAs as an important tool for achieving a sense of commonality of purpose. This shared culture is the foundation of consistent supervisory practices and approaches throughout the participating Member States. 20 The supervisory tasks are supported by the ECB s shared services, including services for human resources, information systems, communications, budget and organisation, premises and internal audit, and legal and statistical services. The SSM is thus able to exploit operational synergies while keeping the required separation between monetary policy and banking supervision The supervisory cycle The process for the supervision of credit institutions can be envisaged as a cycle (see Figure 5): regulation and supervisory policies provide the foundation for supervisory activities and for the development of supervisory methodologies and standards. 22 The methodologies and standards underpin the day-to-day supervision that is carried out to the same high standards across all credit institutions. Through various channels, including the SSM s participation in international and European fora, the lessons learnt in the course of

207 P a g e 207 supervision and the performance of quality assurance checks feed back into the definition of methodologies, standards, supervisory policies and regulation. 23 Experience gained from the practical implementation of the methodologies and standards feeds through to the planning of supervisory activities for the forthcoming cycle. This planning also incorporates the analysis of key risks and vulnerabilities and strategic supervisory priorities. The supervisory cycle is set out in more detail below.

208 P a g e Supervisory policies The European banking regulatory framework follows the Basel Accords and is harmonised through the single rulebook, which is applicable to all financial institutions in the Single Market. The ECB s Supervisory Policies Division assists in developing statutory prudential requirements for significant and less significant banks on, for example, risk management practices, capital requirements and remuneration policies and practices. The Supervisory Policies Division coordinates the SSM s international cooperation and participates actively in various global and European fora, such as the EBA, the European Systemic Risk Board (see Box 4), the Basel Committee on Banking Supervision and the Financial Stability Board. The Supervisory Policies Division supports the JSTs work in the Colleges of Supervisors by setting up and updating cooperation agreements. Additionally, the Division will establish and coordinate cooperation with non-participating Member States and with countries outside the EU, for example by concluding Memoranda of Understanding. The Supervisory Policies Division launches and coordinates these activities in close cooperation with all stakeholders, such as other ECB business areas, other banking supervision DGs and the NCAs. Box 4 bodies Cooperation with other European institutions and To create a safer and sounder financial sector, new rules have been implemented and new institutions and bodies have been established since 2007, within both the EU and the euro area. As a key element of this new institutional framework, the SSM cooperates closely with other European institutions and bodies as explained below. European Systemic Risk Board The European Systemic Risk Board (ESRB) is tasked with overseeing risks in the financial system within the EU as a whole (macro-prudential oversight).

209 P a g e 209 If the ECB uses the macro-prudential instruments defined in the CRD IV or the Capital Requirements Regulation (CRR), either at the request of the national authorities or by deciding to adopt stricter measures than the ones adopted at the national level, it needs to take the ESRB s recommendations into account. A close cooperation between the ECB and the ESRB and the development of information flows is mutually beneficial: it improves the ESRB s ability to effectively identify, analyse and monitor EU-wide systemic risks, while the SSM may take advantage of the ESRB s expertise, which goes beyond the banking sector and covers the entire financial system, including other financial institutions, markets and products. European Banking Authority The ECB closely cooperates with the European Supervisory Authorities, especially the European Banking Authority (EBA). As banking supervisor, the SSM should carry out its tasks subject to, and in compliance with, the EBA s rules. The SSM is involved in the EBA s work and contributes significantly to supervisory convergence by integrating supervision across jurisdictions. Single Resolution Mechanism The Single Resolution Mechanism (SRM) is one of the components of the banking union, alongside the SSM and a common deposit guarantee scheme. It is set to centralise key competences and resources for managing the failure of any credit institution in the participating Member States. The SRM complements the SSM; it will ensure that if a bank subject to the SSM faces serious difficulties, its resolution can be managed efficiently with minimal costs to taxpayers and the real economy. The interaction and cooperation among resolution and supervisory authorities is the key element of the SRM. Thus, the resolution authorities, the ECB and NCAs will inform each other without undue delay on the situation of the credit institution in crisis and discuss how to effectively address any related issues.

210 P a g e 210 The SSM will assist the SRM in reviewing the resolution plans, with a view to avoiding a duplication of tasks. European Stability Mechanism With the establishment of the SRM, the European Stability Mechanism (ESM) will be able to recapitalise institutions directly (the credit institution would have to be or be likely to be in the near future unable to meet the capital requirements established by the ECB in its capacity as supervisor, and the institution must pose a serious threat to the financial stability of the euro area as a whole or of its Member States). The functioning of the recapitalisation tool necessitates effective cooperation and the development of robust information flows between the SSM, the ESM and the national resolution authorities. If an ailing credit institution that is directly supervised by the ECB needs to be recapitalised, the ECB will be responsible for compiling the necessary information. For institutions that it does not directly supervise, the ECB, on notification of the petition for direct ESM support, must immediately start preparations to assume direct supervision of the respective credit institution. The ECB will also actively participate in the negotiations with the ESM and the management of the ailing credit institution regarding the terms and conditions of the recapitalisation agreement Methodology and standards development Supervisory methodologies and standards of the highest quality are essential to achieve consistent and efficient supervisory outcomes. The ECB has established a dedicated Methodology and Standards Development Division, which regularly reviews and develops supervisory methodology. Supervisory methodologies and standards may also evolve from work by international standard-setting bodies on harmonising financial sector regulations or from work by EU authorities on developing a single rulebook. The ECB may issue its own regulations, guidelines and instructions on supervisory methodologies and common standards, taking into account the

211 P a g e 211 developments in international and European regulations and the role of the EBA in establishing the single rulebook to ensure harmonised supervisory practices and consistency of supervisory outcomes within the SSM over time. The common set of methodologies and standards covers topics such as the details of the Supervisory Review and Evaluation Process (SREP) and the notification and application procedures for supervised entities The Supervisory Review and Evaluation Process For the purpose of performing the Supervisory Review and Evaluation Process (SREP), the SSM has developed a common methodology for the ongoing assessment of credit institutions risks, their governance arrangements and their capital and liquidity situation. The methodology benefits from the NCAs previous experience and best practices and will be further promoted and developed by the JSTs and the ECB horizontal divisions. The SSM SREP is applied proportionately to both significant and less significant institutions, ensuring that the highest and most consistent supervisory standards are upheld. 31 As defined in CRD IV, the SREP requires that the supervisors (for significant institutions, the JSTs; for less significant institutions, the NCAs under the overall oversight of the ECB) review the arrangements, strategies, processes and mechanisms implemented by the credit institutions and evaluate the following: risks to which the institutions are or might be exposed; risks that an institution poses to the financial system in general; risks revealed by stress testing, taking into account the nature, scale and complexity of an institution s activities. 32 The SSM SREP (see Figure 6) encompasses three main elements: a risk assessment system (RAS), which evaluates credit institutions risk levels and controls;

212 P a g e 212 a comprehensive review of the institutions Internal Capital Adequacy Assessment Process (ICAAP) and Internal Liquidity Adequacy Assessment Process (ILAAP); a capital and liquidity quantification methodology, which evaluates credit institutions capital and liquidity needs given the results of the risk assessment. 33 Both the RAS and capital and liquidity quantification follow a multi-step approach. They aim to produce supervisory assessments rooted in quantitative and qualitative analysis. They rely on a wide range of backward and forward- looking information (e.g. probability of default, loss given default, stress tests).

213 P a g e 213 They are built on a constrained judgement approach, so as to ensure consistency across the SSM, while allowing for expert judgement to consider the complexity and variety of situations within a clear and transparent framework. 34 The risks to which credit institutions are exposed are assessed by risk levels and by the corresponding risk controls/risk mitigation measures. Institutions business risk and profitability, as well as their internal governance and overall risk management, are assessed from a more holistic perspective. All assessments are then integrated into an overall assessment. 35 The SSM follows a risk-based approach while focusing on compliance with regulatory requirements. It also respects the principle of proportionality, taking into account an institution s potential impact on the financial system, its intrinsic riskiness and whether it is a parent entity, subsidiary or solo institution. This results in a differentiated frequency and intensity for the institution s risk profile assessment within the year. The risk profile assessment in turn may result in a wide range of supervisory actions and measures, including short-term ones that are taken immediately by the relevant JST and more long-term ones that are covered by the SREP report and annual supervisory planning. There is a direct link between an institution s overall risk profile assessment and the level of supervisory engagement. 36 Traceability and accountability are key features of the entire supervisory assessment process. The capital requirements defined under Pillar 1 of the Basel Accords are minimum requirements that credit institutions must fulfil at all times. Therefore, the SSM constantly monitors the institutions compliance with the requirements and also considers Pillar 1 capital requirements as a floor. Internal models, which institutions subject to supervisory approval are allowed to use to calculate capital requirements for Pillar 1 risks, are regularly reviewed by the SSM.

214 P a g e Furthermore, credit institutions may be required to hold additional capital and liquidity buffers for risks that are not, or not fully, covered by Pillar 1. To this end, credit institutions must use their internal assessment and calculation methods, specifically their Internal Capital Adequacy Assessment Process (ICAAP) and Internal Liquidity Adequacy Assessment Process (ILAAP). Credit institutions are required to carefully document these processes and calculations. They are also required to create adequate governance structures to ensure that their ICAAP/ILAAP outcomes are reliable. Therefore, a comprehensive review of the ICAAP/ILAAP is performed as part of the SREP. 38 As recommended by the EBA Guidelines, the SSM strives to take adequate SREP decisions using a wide range of information coming from several building blocks. These include the credit institutions regular reports, ICAAP/ILAAP, the institutions risk appetite, supervisory quantifications used to verify and challenge the credit institutions estimates, risk assessment outcomes (including risk level and control assessments), the outcome of stress tests, and the supervisor s overall risk priorities. 39 Supervisory quantifications calculated for assessing institutions capital and liquidity needs, as well as ICAAP and ILAAP, play a key role in anchoring the process. 40 The SSM uses both top-down and bottom-up supervisory stress tests as part of the capital and liquidity adequacy assessments. Stress tests are a key forward-looking tool for assessing institutions exposure and resilience to adverse but plausible future events. They can also be used to test the adequacy of credit institutions risk management procedures, their strategic and capital planning and the robustness of their business models.

215 P a g e Based on all the information reviewed and evaluated during the SREP, the SSM makes the overall assessment of the capital and liquidity adequacy of the credit institution and prepares SREP decisions (see Figure 6). At the end of the process, it takes an overall view on the adequate level of capital and liquidity for an institution. SREP decisions may also include qualitative measures, for instance to deal with shortcomings in institutions risk management. The outcome of this analysis and any necessary corrective actions are presented to the credit institution and the credit institution is given the opportunity to comment in writing to the ECB on the facts, objections and legal grounds relevant to the ECB s supervisory decision. Where appropriate, specific meetings can be organised with the credit institution to discuss the outcomes and corrective actions to be taken. 42 The outcome of the SREP for significant credit institutions is submitted to the Supervisory Board. For institutions with subsidiaries in non-ssm EU countries, the SREP decision will be taken jointly by all of the relevant competent authorities. 43 The result of the SREP is also a key input for the SSM s strategic and operational planning. In particular, it has a direct impact on the range and depth of off-site and on-site activities that are carried out for a given institution. This planning is defined annually and revised on a semi-annual basis Risk analysis As a natural complement to the JST s day-to-day analysis of a credit institution s risks, risks are also analysed horizontally by a dedicated Risk Analysis Division, which provides benchmarking and contextual information to line supervisors. 45 The assessment of the risks facing credit institutions requires an understanding of the external context in which they operate.

216 P a g e 216 The Risk Analysis Division hence also considers system-wide risks, such as those arising from international imbalances or excessive risk concentration potentially leading to sectorial bubbles (e.g. residential or commercial real estate). Its risk analysis also draws on analyses performed by other ECB business areas, particularly macro- prudential analysis. Sectoral analysis also facilitates the understanding of key market developments. 46 Risk analyses performed by JSTs and by the dedicated Risk Analysis Division complement each other. The Risk Analysis Division monitors the overall risk environment of the SSM and delivers timely and in-depth risk analyses across institutions. JSTs are an important source of institution-specific information for the Risk Analysis Division. 47 Adequate, reliable and up-to-date supervision and risk analysis is based on accurate supervisory data. The ECB therefore maintains close cooperation with the NCAs and their reporting units, which are the first receivers of supervisory reporting data. The ECB s reporting and statistics units performs its own quality checks before the data are used for supervisory and risk analysis purposes and for decision-making. The SSM reporting schedule defines the reporting timelines and formats, taking into account the harmonised requirements applicable across the EU. 4 The conduct of supervision in the SSM 48 The SSM Regulation speaks about creating a truly integrated supervisory mechanism. In practice, this implies, first of all, that key processes are generally the same for all credit institutions regardless of whether they are significant or less significant and involve both the ECB and the NCAs. It also implies a single supervisory approach.

217 P a g e 217 Each credit institution that is covered by the SSM is supervised according to the same methodology and with due respect to the principle of proportionality. The common procedures applying to both significant and less significant institutions, and the approaches to the supervision of both categories, are set out below. 4.1 Authorisations, acquisitions of qualifying holdings, withdrawal of authorisations 49 The ECB has the power to grant and withdraw the authorisation of any credit institution and to assess the acquisition of holdings in credit institutions in the euro area. This is done jointly with the NCAs. The ECB also must ensure compliance with EU banking rules and the EBA regulation and applies the single rulebook. Where appropriate, it may also consider imposing additional prudential requirements on credit institutions in order to safeguard financial stability. The ECB s Authorisation Division is responsible for these tasks. 50 The SSM Regulation has established a number of procedures, known as the common procedures, which ultimately are decided on by the ECB, regardless of the significance of the credit institution concerned. These are the procedures for authorisations to take up the business of a credit institution, withdrawals of such authorisations and the assessment of acquisitions of qualifying holdings. The SSM Framework Regulation sets out how the ECB and the NCAs are involved in these common procedures (see Figure 7).

218 P a g e Granting of authorisations and acquisitions of qualifying holdings 51 The SSM common procedures are governed by the following key principles: Applications for authorisations and notifications of an acquisition of a qualifying holding are always sent by the applicant entity to the relevant NCA: for the granting of new banking licences, this is the NCA of the Member State where the new credit institution is to be established; for intended acquisitions of qualifying holdings, the relevant NCA is the NCA of the Member State where the institution being acquired is established.

219 P a g e 219 The NCA notifies the ECB of receipt of an application for authorisation within 15 working days. As regards notification of an intention to acquire a qualifying holding, the NCA notifies the ECB of such notification no later than five working days following its acknowledgement of receipt to the applicant. A common procedure cannot be finalised until the required information has been submitted. Applicants should therefore ensure that their applications are complete and well structured. If the first review of an application reveals omissions or inconsistencies, the receiving NCA immediately asks the applicant to make the necessary amendments. Once applications have been submitted and their completeness verified, they are subject to a complementary assessment by the receiving NCA, the ECB and any other NCAs concerned. The assessment seeks to ensure that all relevant parties gain a thorough understanding of the business model and its viability. To this end, the assessment covers all the criteria set out in relevant national and EU laws. 52 If the NCA is satisfied that the application complies with national conditions for authorisations, it proposes to the ECB a draft decision containing its assessment and recommendations. As regards qualifying holdings, the NCA proposes a draft decision to the ECB to oppose or not to oppose the acquisition. The final decision on the approval or rejection rests thereafter with the ECB following the usual decision-making procedure. If an application is to be rejected or additional conditions need to be imposed, it will become the subject of a hearing procedure. Once a final decision has been reached, the applicant is notified by either the NCA processing the application (in the case of licensing applications) or the ECB (in the case of intended acquisitions of qualifying holdings).

220 P a g e Withdrawal of authorisations Both the ECB and the NCAs of participating Member States where an institution is established have the right to propose the withdrawal of a banking licence. NCAs can propose a withdrawal upon the request of the credit institution concerned or, in other cases, on its own initiative in accordance with national legislation. The ECB can initiate a withdrawal in cases set out in the relevant EU laws. The ECB and the relevant NCAs consult on any proposals for the withdrawal of a licence. These consultations are intended to ensure that, before a decision is taken, the relevant bodies (i.e. NCAs, national resolution authorities and the ECB) have sufficient time to analyse and comment on the proposal, raise potential objections and take the necessary steps and decisions to preserve the going concern or resolve the institution, if deemed appropriate. 54 Following the consultation, the proposing body composes a draft decision explaining the rationale behind the proposed withdrawal of the licence and reflecting the results of the consultation. Thereafter, the final decision rests with the ECB. 55 Before a draft decision proposal is submitted to the ECB, the supervised institution in question is prompted to provide its own views on the matter and is given the right to be heard by the ECB. Once taken, the ECB s final decision is notified to the respective credit institution, the NCA, and the national resolution authority. 4.2 Supervision of significant institutions Supervisory planning The planning of supervisory activities is decided through a two-step process: strategic planning and operational planning. Strategic planning is coordinated by the ECB s Planning and Coordination of Supervisory Examination Programmes Division.

221 P a g e 221 It encompasses the definition of the strategic priorities and the focus of supervisory work for the following 12 to 18 months. More specifically, it takes into account factors such as the assessment of risks and vulnerabilities in the financial sector, as well as guidance and recommendations issued by other European authorities, in particular the ESRB and the EBA, findings of the JSTs through the SREP and priorities highlighted by the relevant NCAs. The strategic plan frames the nature, depth and frequency of activities to be included in the individual Supervisory Examination Programmes (SEPs), which are defined for each significant institution. 57 Operational planning is conducted by the JSTs under the coordination of the ECB s Planning and Coordination of SEPs Division. JSTs produce individual SEPs, which set out the main tasks and activities for the following 12 months, their rough schedules and objectives, the need for on-site inspections, and internal model investigations. The Planning and Coordination of SEPs Division, along with the relevant horizontal functions and NCAs, coordinates the allocation of SSM resources and expertise to ensure that each JST has the capacity to carry out the annual supervisory tasks and activities. Although the main items of individual SEPs are discussed with the credit institution beforehand, JSTs are always able to perform ad hoc tasks and activities that are not part of the supervisory plan, especially to address rapidly changing risks at individual institutions or at the broader system level. 58 There are several tools for conducting the basic supervisory activities. In their day-to-day supervision, the JSTs analyse the supervisory reporting, financial statements and internal documentation of supervised institutions; hold regular and ad hoc meetings with the supervised credit institutions at various levels of staff seniority; conduct ongoing risk analyses and ongoing analysis of approved risk models; and analyse and assess credit institutions recovery plans. Box 5 explains the regulations regarding the language the institution can use in its communication with the ECB.

222 P a g e General process requests, notifications and applications The general process regarding requests, notifications and applications (i.e permission requests ) for significant credit institutions is described in Figure 8. The procedure starts when a credit institution files a permission request. The JST where applicable, in close cooperation with the relevant horizontal division checks if the permission request includes all relevant information and documents. If necessary, it can request additional information from the credit institution. The JST and the relevant horizontal division check that the request meets the supervisory requirements set out in the respective legislation, i.e. EU laws or its national transposition.

223 P a g e 223 Once the analysis has been completed and a decision taken, the ECB notifies the applicant of the outcome. For other processes such as passporting, the approval of internal models and the appointment of new managers different procedures have to be followed. These are described in more detail below Right of establishment of credit institutions within the SSM If a significant13 institution in a participating Member State wishes to establish a branch within the territory of another participating Member

224 P a g e 224 State via passporting procedures14, it has to notify the NCA of the participating Member State where it has its head office and provide the necessary documentation. On receipt of this notification, the NCA immediately informs the ECB s Authorisation Division, which then assesses the adequacy of the administrative structure in light of the activities envisaged. Where no decision to the contrary is taken by the ECB within two months of receipt of the credit institution s notification, the significant institution may establish the branch and commence its activities. A credit institution in a participating Member State wishing to establish a branch or exercise the freedom to provide services within the territory of a non- participating Member State informs the relevant NCA of its intention. On receipt of such notification from a significant institution, the relevant NCA immediately informs the ECB, which then carries out the required assessment Internal models CRD IV establishes two different types of supervisory activities related to internal models used for calculating minimal capital requirements: those concerned with the approval of such models (or material changes / extensions thereof) and those concerned with ongoing model supervision. 63 The general procedure for the approval of internal models for the calculation of minimum capital requirements under the CRR for significant and less significant banks encompasses different steps, involving the JST as the contact point for the significant institutions, supported by the ECB s Internal Models Division. For less significant institutions, NCAs are the contact point. Where appropriate, discussions are held with the credit institution to address critical points and to establish the operational schedule of the approval process. 64 The JST, supported by the ECB s Internal Models Division, checks if the credit institution complies with the legal requirements and the relevant EBA Guidelines.

225 P a g e 225 At this stage, credit institutions need to be prepared for intensive interaction and collaboration to make the process smooth and efficient for all parties. This process comprises a range of tools, including off-site and on-site evaluations. These activities are carried out by a dedicated project team responsible for the entire model assessment process. Project teams can consist of members of the JSTs, experts from the ECB s horizontal divisions and dedicated model experts from the NCAs, and are led by project managers who report to the JST coordinator. 65 On the basis of the project team s report, the JST, supported by the ECB s Internal Models Division, prepares a proposal for a draft decision for approval by the Supervisory Board and the Governing Council. The proposal comprises the JST s views on the authorisation (or refusal) of the use of internal models to calculate the capital requirements. Conditions, such as additional reporting requirements as well as additional supervisory measures, may be attached to the authorisation. 66 Furthermore, the objective of ongoing model supervision is to keep a close watch on a credit institution s permanent compliance with applicable requirements. It comprises the analysis of risk, capital or other reports on model aspects, the analysis of credit institutions model validations and the assessment of (immaterial) model changes. In addition, a full review of internal models with a special focus on appropriateness in the light of best practice and changes to business strategies takes place regularly, at least every three years. The reviews are conducted by the JST, where necessary with the support of the Internal Models Division. The annual benchmarking required by Article 78 of the CRD is performed by the EBA and the SSM as competent authority Assessment of the suitability of members of management bodies

226 P a g e 226 The fit and proper assessment of the members of the management body of significant and less significant institutions is a key part of supervisory activities. The members need to be of sufficiently good repute and to possess sufficient knowledge, skills and experience to perform their duties. In the case of an initial authorisation (licensing) of a credit institution, the fit and proper assessment is performed as part of the authorisation procedure. 68 Changes to the composition of the management body of a significant institution are declared to the relevant NCA, which then informs the relevant JST and the ECB s Authorisation Division, which, together with the staff of the NCA, collects the necessary documentation (which may include an interview with the nominated candidate). With the assistance of the NCA, the JST and the Authorisation Division jointly carry out the assessment and then present a detailed proposal to the Supervisory Board and Governing Council for a decision On-site inspections The SSM carries out on-site inspections, i.e. in-depth investigations of risks, risk controls and governance with a pre-defined scope and time frame at the premises of a credit institution. These inspections are risk-based and proportionate. 70 The ECB has established a Centralised On-site Inspections Division, which is among other things responsible for planning the on-site inspections on a yearly basis. 71 The need for an on-site inspection is determined by the JST in the context of the SEP and scheduled in close cooperation with the ECB s Planning and Coordination of SEPs Division. The scope and frequency of on-site inspections are proposed by the JST, taking into account the overall supervisory strategy, the SEP and the characteristics of the credit institution (i.e. size, nature of activities, risk culture, weaknesses identified). In addition to these planned inspections, ad hoc inspections may be conducted in response to an event or incident

227 P a g e 227 which has emerged at a credit institution and which warrants immediate supervisory action. If deemed necessary, follow-up inspections may be carried out to assess a credit institution s progress in implementing remedial actions or corrective measures identified in a previous planned or ad hoc inspection. 72 In general, the purpose of on-site inspections is to: examine and assess the level, nature and features of the inherent risks, taking into account the risk culture; examine and assess the appropriateness and quality of the credit institution s corporate governance and internal control framework in view of the nature of its business and risks; assess the control systems and risk management processes, focusing on detecting weaknesses or vulnerabilities that may have an impact on the capital and liquidity adequacy of the institution; examine the quality of balance sheet items and the financial situation of the credit institution; assess compliance with banking regulations; conduct reviews of topics such as key risks, controls, governance. 73 Different types of inspections can be carried out by the ECB. Whereas full-scope inspections cover a broad spectrum of risk and activities of the credit institution concerned in order to provide a holistic view of the credit institution, targeted inspections focus on a particular part of the credit institution s business, or on a specific issue or risk. Thematic inspections focus on one issue (e.g. business area, types of transactions) across a group of peer credit institutions. For example, JSTs may request a thematic review of a particular risk control or the governance process across institutions. Thematic reviews may also be triggered on the basis of macro-prudential and sectoral analyses that identify threats to financial stability on account

228 P a g e 228 of weakening economic sectors or the spread of risky practices across the banking sector. 74 The composition of the team in terms of size, skills, expertise and seniority will be tailored to each individual inspection. The staffing of inspection teams is looked after by the ECB in close cooperation with the NCAs. The head of the inspection team (head of mission) and inspectors are appointed by the ECB in consultation with the NCAs. Members of the JST may participate in inspections as inspectors, but not as heads of mission, to ensure that on-site inspections are conducted in an independent manner. Where necessary and appropriate, the ECB can call on external experts. The outcome of on-site inspections is reflected in a written report on the inspected areas and findings. The report is signed by the head of mission and sent to the JST and the NCAs concerned. Based on the report, the JST is responsible for preparing recommendations. The JST then sends the report and recommendations to the credit institution and, in general, calls for a closing meeting with the institution. 75 Under the SSM Regulation, the ECB may at any time make use of its investigatory powers vis-à-vis less significant banks. These powers include the possibility to conduct on-site inspections Crisis management With the transposition of the Bank Recovery and Resolution Directive (BRRD) into national law, the ECB as a banking supervisor will be enabled to react in a timely manner if a credit institution does not meet, or is likely to breach, the requirements of CRD IV and will ensure that credit institutions establish reliable recovery plans.

229 P a g e The ECB has established a Crisis Management Division, tasked with supporting the JSTs in times of crisis. The ECB s Crisis Management Division is also reviews the significant supervised credit institutions recovery plans and conducts further analysis, which allows for benchmarking, quality control, consistency checks and expert support to the JSTs. With regard to resolution planning, the SSM has a consultative role under the BRRD and the SRM Regulation. The Crisis Management Division is a key player in this consultative process. Moreover, the ECB s Crisis Management Division and the JSTs will participate in Crisis Management Groups set up for specific banks (see Box 6).

230 P a g e Use of supervisory measures and powers The ECB is empowered to require significant credit institutions in participating Member States to take steps at an early stage to address problems regarding compliance with prudential requirements, the soundness of management, and sufficiency of the coverage of risks in order to ensure the viability of the credit institution. Before making use of its supervisory powers with regard to significant credit institutions, the ECB may consider first addressing the problems informally, for example by holding a meeting with the management of the credit institution or sending a letter of intervention.

231 P a g e 231 The type of action taken depends on the seriousness of the deficiencies, the required time frame, the degree of awareness at the credit institution, the capability and reliability of corporate bodies, and the availability of human, technical and capital resources within the credit institution. If the action is based on the national law of a participating Member State, the respective NCA might be asked for support to ensure that all the legal prerequisites are covered. Supervisory powers consist of measures characterised by increasing intensity in terms of content and form and may imply: the accurate listing of goals and the time frame for their achievement, while entrusting the credit institution, on its own responsibility, with the task of identifying the most effective measures without enforcing limits or rules other than the ones laid down in the legal framework; the adoption of specific measures for prudential purposes, such as requiring the credit institution to take specific actions concerning regulatory matters (organisation of risk management and internal controls, capital adequacy, permissible holdings, limitation of risk, disclosure) or operational limits or prohibitions; the use of other legal powers of intervention intended to correct or resolve irregularities, inaction or specific negligence; the obligation for a credit institution to present a plan for restoring compliance with supervisory requirements. 81 The use of supervisory powers is monitored by means of a timely assessment by the ECB of the credit institution s compliance with the recommendations, supervisory measures or other supervisory decisions imposed on it. The follow- up is based on ongoing supervisory activities and on-site inspections; the ECB will respond if non-compliance is identified. The monitoring procedures ensure that the ECB adequately addresses any irregularities or insufficiencies detected in a credit institution in implementing the supervisory measures, thereby mitigating the risk of failure of the credit institution.

232 P a g e Enforcement and sanctions If regulatory requirements have been breached, the supervisor may impose sanctions on credit institutions and/or their management. The ECB may impose administrative pecuniary penalties on credit institutions of up to twice the amount of the profits gained or losses avoided because of the breach where those can be determined, or up to 10% of the total annual turnover in the preceding business year. In addition, in the case of a breach of a supervisory decision or regulation of the ECB, the ECB may impose a periodic penalty payment with a view to compelling the persons concerned to comply with the prior supervisory decision or regulation of the ECB. The periodic penalty payment will be calculated on a daily basis until the persons concerned comply with the supervisory decision or regulation of the ECB, provided that the periodic penalty is imposed for a period of no longer than six months. 83 The ECB s Enforcement and Sanctions Division investigates in the spirit of transparent investigation and decision-making alleged breaches by credit institutions of directly applicable EU law, national law transposing EU directives or ECB regulations and decisions, observed by a JST during the day-to-day supervision. In this case, the JST will establish the facts and refer the case to the Enforcement and Sanctions Division for follow-up. The Enforcement and Sanctions Division acts independently from the Supervisory Board to ensure the impartiality of the Supervisory Board members when they adopt a sanctioning decision. The Enforcement and Sanctions Division is also responsible for processing reports of breaches of relevant EU law by credit institutions or competent authorities (including the ECB) in the participating Member States. The ECB has established a reporting mechanism in order to encourage and enable persons with knowledge of potential breaches of relevant EU law by supervised entities and competent authorities to report such breaches to the ECB.

233 P a g e 233 Such reports on violations are an effective tool for bringing incidents of business misconduct to light Supervision of less significant institutions The SSM aims to ensure that the EU s policy relating to the prudential supervision of credit institutions is implemented in a coherent and effective manner, that the single rulebook for financial services is applied in the same manner to credit institutions in all Member States concerned, and that credit institutions are subject to supervision of the highest quality, unfettered by non- prudential considerations. Moreover, the experience of the financial crisis has shown that smaller credit institutions can also pose a threat to financial stability; the ECB should therefore be able to exercise supervisory tasks in relation to all credit institutions and branches, which are established in participating Member States of credit institutions established in non-participating Member States. These objectives can only be achieved through: collaboration in good faith between NCAs and the ECB; an effective exchange of information within the SSM; a harmonisation of both processes and consistency of supervisory outcomes. 86 NCAs are responsible for the direct supervision of less significant institutions (with the exception of common procedures, which are a joint responsibility of the ECB and the NCAs). They plan and carry out their ongoing supervisory activities according to the common framework and methodologies created for the SSM. In doing so, NCAs act in line with the SSM s overall supervisory strategy, using their own resources and decision-making procedures. Ongoing activities include organising meetings with the senior management of less significant institutions, conducting regular risk analyses within the country concerned, and planning and carrying out on-site inspections.

234 P a g e 234 NCAs will also continue to perform supervision in areas that are not covered by the SSM Regulation. 87 Even though NCAs have primary responsibility for organising and conducting the supervision of less significant institutions, ECB staff may also participate in certain activities, for example on-site inspections. As well as providing expertise and support to NCAs, this promotes and facilitates the exchange of staff among NCAs (and between NCAs and the ECB) and helps to foster a common supervisory culture within the SSM. 88 At the same time, the ECB is responsible for the effective and consistent functioning of the SSM and is entrusted with an oversight responsibility to ensure that the supervisory activities carried out by the NCAs are of the highest quality and that supervisory requirements on all credit institutions covered by the SSM are consistent. This task is performed by DG Micro-Prudential Supervision III. 89 DG Micro-Prudential Supervision III achieves these objectives by applying the supervisory approaches developed by DG Micro-Prudential Supervision IV for significant credit institutions in a proportional manner. DG Micro-Prudential Supervision III comprises three divisions: The Supervisory Oversight and NCA Relations Division is responsible for cooperation with NCAs and oversees their supervisory approaches vis-à-vis less significant institutions, with the objective of ensuring high standards of supervision and supporting the consistent application of supervisory processes and procedures by NCAs, thereby serving as the primary contact point for NCAs towards the ECB as banking supervisor. The Division also takes care of the quality assurance regarding the supervisory processes in NCAs in liaison with DG Micro-Prudential Supervision IV (horizontal and specialised divisions). The Institutional and Sectoral Oversight Division in cooperation with DG Micro-Prudential Supervision IV monitors specific banking sub-sectors (e.g. savings banks, cooperative banks) and individual institutions among the less significant institutions according to their priority ranking (i.e. risk and impact assessment) and organises thematic reviews.

235 P a g e 235 It also evaluates whether the ECB should take over direct supervision of a specific institution and participates in cooperation with DG Micro-Prudential Supervision IV in on-site examinations of less significant institutions. Furthermore, it is responsible for crisis management activities related to less significant institutions. The Analysis and Methodological Support Division develops and maintains the methodology based on the supervisory approach developed by DG Micro-Prudential Supervision IV for the classification of less significant institutions and the application of the RAS and the SREP to them. It is also responsible for the regular supervisory reporting on less significant institutions and for overseeing the risks and vulnerabilities of banking sub- sectors. 90 The following sections provide an overview of the processes and procedures carried out by the ECB in relation to the supervision of less significant institutions Information gathering Credit institutions in Europe are interconnected through their mutual short and long-term lending and their trading activities. It is important, therefore, that a wider sector-level analysis is performed, for example to capture possible contagion effects and to assess the kind of supervisory policy measures the ECB and the NCAs should take with respect to less significant institutions. 92 To be able to exercise its oversight function and to ensure financial stability in the euro area, the ECB regularly receives quantitative and qualitative information on the less significant institutions. This information is provided using defined reporting procedures between the ECB and NCAs. The information received enables the ECB to identify particular risks in individual institutions and to perform a sector-wide analysis, which in turn supports the ECB s overall supervisory objectives.

236 P a g e 236 Based on the analysis, the ECB can also identify areas where ECB regulations, guidelines or general instructions are needed to ensure consistency in supervision and the application of high supervisory standards. 93 In addition to the regular information received from NCAs (including supervisory reporting to competent authorities) and taking account of the principle of proportionality, the ECB may also request additional information on less significant institutions, generally from NCAs, as necessary to exercise its oversight task Oversight activities The ECB is responsible for conducting the general oversight of the NCAs supervisory activities to ensure the adequate and harmonised conduct of supervision of the less significant institutions. Oversight activities can be conducted, for example, through reviews of specific topics (e.g. risk areas) across all or a sample of NCAs. They provide a targeted insight into the NCAs supervision at the level of individual institutions or classes of similar institutions. 95 Furthermore, NCAs provide material draft supervisory decisions and procedures to the ECB. The scope of these decisions and procedures is defined in the SSM Framework Regulation. They consist of procedures that have a significant impact on the less significant institutions and the removal of members of the management boards of less significant institutions and the appointment of special managers. A balance is pursued between providing the ECB with information on NCA activities crucial to the integrity of the SSM, but avoiding an overflow of notifications to the ECB. NCAs must also inform the ECB if the financial situation of a less significant institution deteriorates rapidly and significantly. 96 NCAs report regularly to the ECB on the less significant institutions in a format defined by the ECB. In addition, some ex post

237 P a g e 237 reporting procedures have been established under which NCAs report regularly on the measures that they have taken and the performance of their tasks with regard to the less significant institutions. The ECB also reviews how NCAs apply SSM supervisory standards, processes and procedures, such as the SREP, with regard to the less significant institutions. The oversight of processes includes assessing whether standards are applied in a harmonised way and checking whether comparable situations lead to comparable outcomes across the SSM. The ECB can also recommend changes to areas where further harmonisation is needed and, where appropriate, may also develop standards as regards supervisory practices. The ECB s oversight activities are a collaborative assessment of whether and how SSM standards and processes can be improved to reach the common goal of harmonised and effective supervision across the SSM Intervention powers of the ECB The ECB, in cooperation with the NCAs, determines regularly whether an institution changes its status from less significant to significant by fulfilling any of the criteria established in the SSM Regulation (see Box 1) or vice versa, and decides to take over supervisory responsibilities for individual less significant institutions from one or more NCAs accordingly or to end direct supervision. 99 The ECB may also at any time on its own initiative, after consulting with the NCAs, decide to directly exercise supervision on less significant institutions, when necessary, to ensure consistent application of high supervisory standards, for example if the ECB s instructions have not been followed by the NCA and thus the consistent application of high supervisory standards is compromised. It should be noted that the deterioration of a less significant institution s financial condition or the initiation of crisis management proceedings are not necessarily reasons for the ECB to take over supervision from the responsible NCAs.

238 P a g e Overall quality and planning control The supervision of both significant and less significant institutions requires overall mechanisms to ensure that the SSM approach to supervision remains consistent and of the highest quality across all supervised entities. This implies avoiding distortions between the two sets of credit institutions while applying supervisory approaches and the principle of proportionality in a structured way Quality assurance The aim of quality assurance is to assess the consistent application of the common methodological framework and to ensure that it is complied with. Furthermore, quality assurance monitors the quality of supervisory practices. The horizontal quality control of the JSTs is performed by a dedicated division within DG Micro-Prudential Supervision IV, whereas the quality assurance of the NCAs supervision of the less significant institutions is carried out by the ECB s Supervisory Oversight and NCA Relations Division within DG Micro-Prudential Supervision III. This is all the more important as the SSM operates across participating Member States and involves both national supervisors and the ECB. The main goal of quality assurance is to identify improvement potential for methodologies, standards and supervisory policies Planning control As regards significant institutions, the ECB s Planning and Coordination of SEPs Division checks regularly to see whether the tasks specified in the SEPs have been fulfilled by the JSTs and requests corrective actions if needed. For the less significant institutions, supervisory planning is carried out by NCAs and, when necessary, overseen by DG Micro-Prudential Supervision III. Furthermore, SEPs are designed and updated based on the findings made in previous periods.

239 P a g e 239 Findings are discussed with the parties involved with a view to improving and further harmonising future activities. 5 Abbreviations BRRD Bank Recovery and Resolution Directive CBSG Cross-Border Stability Group CMG Crisis Management Group CRD IV Capital Requirements Directive CRR Capital Requirements Regulation EBA European Banking Authority ECB European Central Bank ESAs European Supervisory Authorities ESFS European System of Financial Supervision ESM European Stability Mechanism ESRB European Systemic Risk Board EU European Union FSB Financial Stability Board G-SIFIs ICAAP ILAAP Global Systemically Important Financial Institutions Internal Capital Adequacy Assessment Process Internal Liquidity Adequacy Assessment Process JST Joint Supervisory Team MoU Memorandum of Understanding NCA national competent authority RAS risk assessment system

240 P a g e 240 SEP Supervisory Examination Programme SREP Supervisory Review and Evaluation Process SSM Single Supervisory Mechanism

241 P a g e 241 Monetary Policy Accommodation, Risk-Taking, and Spillovers Governor Jerome H. Powell Global Research Forum on International Macroeconomics and Finance, Washington, D.C. Our panel's topic--"monetary Policy Spillovers and Cooperation in a Global Economy"--is surely a timely one. I will offer brief introductory thoughts and then discuss some recent research by Federal Reserve Board economists that has bearing on these matters. The Federal Reserve's monetary policy is motivated by the dual mandate, which calls upon us to achieve stable prices and maximum sustainable employment. While these objectives are stated as domestic concerns, as a practical matter, economic and financial developments around the world can have significant effects on our own economy and vice versa. Thus, the pursuit of our mandate requires that we understand and incorporate into our policy decision-making the anticipated effects of these interconnections. And the dollar's role as the world's primary reserve, transaction, and funding currency requires us to consider global developments to help ensure our own financial stability. Since the financial crisis, the Federal Reserve has pursued a highly accommodative monetary policy, which has had important effects on asset prices and global investment flows. With unconventional tools, the scale and scope of these effects were difficult to predict ex ante. Nor is it possible to predict with confidence how markets will react day to day as policy returns to normal. The Federal Open Market Committee (FOMC) has gone to great lengths to provide transparency about its policy intentions.

242 P a g e 242 Yet, since Chairman Bernanke first discussed the end of the asset purchase program in mid-2013, volatility has surprised both on the upside (the "taper tantrum") and on the downside (the actual taper and the low volatility throughout most of 2014). In my view, while market volatility will continue to ebb and flow, these fluctuations are not likely to have important implications for policy. The path of policy will depend on the progress of the economy toward fulfilment of the dual mandate. Overall, accommodative monetary policy seems to have provided significant support for U.S. growth. And, of course, a strong U.S. economy contributes to strong growth around the globe, particularly in the emerging market economies (EMEs). But what of the so-called spillovers in the form of flows into, and out of, EMEs, whose financial sectors are small compared with global investment flows? Such spillovers could merely reflect investor responses to changing differentials between rates of return abroad and in the United States. But these spillovers could also reflect shifts in investor preferences for risk. By design, accommodative monetary policy--whether conventional or unconventional--supports economic activity in part by creating incentives for investors to take more risk. Such risk-taking can show up in domestic financial markets, in the international investments of U.S. investors, and even, ultimately, in general risk attitudes toward foreign financial markets. Distinguishing between appropriate and excessive risk-taking is difficult, however. I now turn to some recent research on whether there has been an increase in the riskiness of our investments abroad and whether such increases might be traced to the current low-interest rate environment. Many studies of the pre-crisis period document the pro-cyclical nature of bank lending and leverage, and the buildup of risk-taking and leverage by banks.

243 P a g e 243 It is much harder to find evidence that low interest rates have led to increased post-crisis risk-taking by U.S. banks. Growth in overall lending by U.S. banks has been modest at best. However, some pockets of increased risk-taking by banks and other investors are observable in domestic markets, such as leveraged loans. And on the international front, there has been a notable increase in syndicated loan originations. Recent research by Board staff, using a database of loans primarily to U.S. borrowers but also to some foreign borrowers, suggests that lenders have indeed originated an increased number of risky syndicated loans post-crisis, based on the assessed probability of default as reported to bank supervisors (figure 1). Regression results confirm that the average probability of default is significantly inversely related to U.S. long-term interest rates. This increase in riskiness of syndicated loans post-crisis has been accompanied by a shift in the composition of loan holders: An increasing share is now held not by banks but by hedge, pension, and other investment funds (figure 2).

244 P a g e 244 These nonbank investors also tend to hold loans with higher average credit risk (figure 3).

245 P a g e 245 These data suggest that a tougher regulatory environment may have made U.S.-based bank originators unable or unwilling to hold risky loans on their balance sheets. Related work by the same researchers, using a database with more-extensive coverage of loans to foreign borrowers, shows a similar pattern of increased risky loan underwriting by international lenders, an increase that is also significantly inversely related to U.S. interest rates. Together, these results suggest a potential spillover from accommodative U.S. monetary policy through increased risk-taking in syndicated loans globally, although preliminary results also indicate that investors still require extra return for this extra risk. Another area in which to look for links between low interest rates and risk-taking is in cross-border securities purchases. The role of low interest rates in advanced economies in encouraging capital flows to EMEs where returns are higher has been a familiar theme. And recent studies have found that asset prices in EMEs do respond systematically to U.S. monetary policy shocks.

246 P a g e 246 For evidence of increased risk-taking in cross-border investment, let's look at the composition of U.S. investors' foreign bond portfolios. Although emerging market bonds remain a relatively small proportion of the aggregate U.S. cross-border bond portfolio (figure 4), within foreign government bonds, U.S. investors have modestly shifted their portfolio shares toward higher-yielding bonds of emerging market sovereigns (figure 5). Ex post, these portfolio reallocations delivered a higher return to U.S. investors on this part of their portfolio relative to what they would have received if they had left portfolio compositions unchanged at the average shares in 2008 and 2009, but at a cost to the portfolio's credit quality (figure 6).

247 P a g e 247 Regression results confirm that in choosing among foreign government bonds, U.S. investors have put more weight on returns since the crisis. But search for higher returns has not been the only motivation for international investors post-crisis: Demand for liquid high-grade "safe" or money-like assets has also increased from foreign official investors for investment of foreign exchange reserves, from pension funds and other institutions who face portfolio allocation constraints or regulatory requirements, and from investment strategies requiring cash-like assets for margining and other collateral purposes.

248 P a g e 248 Some shift to safe assets is also seen in U.S. portfolios: U.S. investors actively rebalanced their holdings of foreign financial sector bonds toward those with higher credit ratings, but at some cost in returns (figure 7; figure 8).

249 P a g e 249 Taken together, developments in U.S. bond portfolios do not indicate a worrisome pickup in risk-taking in external investments. But it is important to recognize that portfolio reallocations that seem relatively small for U.S. investors can loom large from the perspective of the foreign recipients of these flows. At roughly $400 billion at the end of 2012, emerging market bonds accounted for a tiny fraction of the roughly $25 trillion in bonds held by U.S. investors. But to the recipient countries, these holdings can account for a large fraction of their bond markets. Even relatively small changes in these U.S. holdings can generate large asset price responses, as was certainly the case in the summer of Likewise, a reassessment of risk-return tradeoffs could disrupt financing for projects that are dependent on the willingness of investors to participate in global syndicated loan markets. We take the consequences of such spillovers seriously, and the Federal Reserve is intent on communicating its policy intentions as clearly as possible in order to reduce the likelihood of future disruptions to markets. We will continue to monitor investor behavior closely, both domestically and internationally

250 P a g e 250 Shadow banking - what kind of regulation for the (European) shadow banking system? Notes by Mr Pentti Hakkarainen, Deputy Governor of the Bank of Finland, for the panel discussion at the SAFE Summer Academy 2014 "Shadow Banking: Evolution, Background, Perspectives", Brussels A viable and well-functioning shadow banking system is beneficial for the real economy Before going to the actual topic of today's panel and presenting some thoughts on regulation of the (European) shadow banking system, let me start with a few words on how I see the shadow banking system. I will not go too much into the details of the definition and coverage of the shadow banking system as it has been a topic of another discussion earlier today. Let me just say that it is very important to have a clear understanding of what we are talking about and hence what we potentially try to regulate and supervise. I would like to highlight that I see many benefits in a viable and well-functioning shadow banking system. Shadow banking is a modern, sophisticated, and complementary way to share risks efficiently. It is also an alternative way to allocate resources in the economy outside the regular banking sector, upon which we here in Europe are particularly dependent. We may even be too dependent on banks according for example to the Advisory Scientific Committee of the European Systemic Risk Board. Thus it is important to revitalise and strengthen alternative funding channels which can further support sustainable growth in the real economy. Competition with reputation rather than heavy regulation

251 P a g e 251 My short answer to the question expressed in the topic of this panel (What kind of regulation for the European shadow banking system) is that calls for regulation are justified. However, the shadow banking system should not be regulated in the same way as the regular banking sector. Let me elaborate on this view. First, we must ensure that regular banking activities and shadow banking activities should not be mixed or confused with each other. It should be crystal clear for investors in for example money market funds that they do not enjoy any coverage comparable to a deposit insurance system. Similarly, it should be clear to entities in the shadow banking system that they will not be supported by the government (the same applies to banks as failing banks will not be supported or bailed-out as the new recovery and resolution framework has been fully implemented) nor that they have access to the liquidity support of the central bank. If shadow banking entities were under similar regulation and supervision as regular banks, this might give a misleading signal to the market that they implicitly also enjoy a similar safety net. Formal surveillance by authorities can also reduce the incentives of outsiders to monitor shadow banking entities. Shadow banking entities have to earn the trust of investors and counterparties on their own merits. They have to be able to compete independently by prudently managing the business and maintaining sufficient buffers. Appropriate disclosure of information and sufficient transparency of operations enable efficient monitoring and are instrumental in building trust. Secondly, in spite of our best efforts, supervisors tend to follow a step or two behind the actions of those we supervise. This is the case also with regular banks, which operate in and adjust to a continuously changing environment. Still I would argue that the banking business is more stable.

252 P a g e 252 Moreover, there are more similarities across regular banks than there are across the heterogeneous group of shadow banking entities, making regular banks easier to supervise. Thus regulating and supervising the shadow banking system might be particularly challenging, if not even impossible. A better option might be to make sure they have the right incentives to do their job well. Regulating systemically important shadow banking entities and the importance of separation between the regular banking and shadow banking system However, there are some exceptions to the ideal situation I have tried to picture, making more comprehensive and stricter regulation warranted. First of all if a shadow banking entity becomes systemically important its failure may have devastating effects on the rest of the financial system and eventually on the real economy. As some risks are likely to shift to the shadow banking system due to the tighter regulation in the regular banking sector, risk concentrations may very well be built up in the shadow banking system. There is an externality that calls for regulation. Here the US has taken the lead and already allows the authorities to ensure that the perimeter of prudential regulation can be extended as appropriate to cover systemically important (and significant) shadow banking institutions. This avenue is one option to be considered in Europe. Secondly, the systemic risk building up in the shadow banking system and the failure of a shadow banking entity should not cause contagion to the regular banking sector. Thus there is a need to regulate and supervise the link between the regular banking sector and the shadow banking system. Much has already been done to this end.

253 P a g e 253 For example the Risk Retention Rule guarantees that an originator has a skin-in-the-game as it must keep a certain part of the risks at its own balance sheet and thus the bank will measure the risk of the link to the shadow banking system appropriately. Similarly the due diligence requirement reduces the information asymmetry in securitisation structures and makes them more transparent. This facilitates the understanding of risks taken by regular banks in the shadow banking system. The objective of the proposed Regulation of Money Market Funds is to ensure that the risk of MMFs is properly accounted for by the investors among which regular banks are frequently found. The distinction between insured deposits and this important source of funding for shadow banking entities is clarified. To further strengthen the securitisation process the EU Credit Rating Agency (CRA) regulations improves the transparency and accountability of rating agencies. Finally, the capital requirements related to securitisations have been reformed to ensure that the parties involved in the process are sufficiently protected against potential shortcomings and failures. Also, there is an ongoing discussion on reforming the structure of banks in the European Union based on the work of the High-level Expert Group chaired by governor Liikanen, the member of which our panel chairman, prof. Jan Pieter Krahnen also was. Based on the final report of the Group, the Commission proposed Regulation on structural measures to improve the resilience of EU credit institutions. One element of this proposal is to curb the link between banks and the shadow banking system, by imposing a ban not only on proprietary trading, but also on exposures to shadow banking entities engaging in proprietary trading and exposures to hedge funds and entities sponsoring hedge funds. Similar rules are already implemented in the US through the Volcker-rule. In January 2014, the Commission also published a proposal on Regulating shadow banking system transparency.

254 P a g e 254 The aim is to improve the reporting and increase the efficiency of supervision on securities financing transactions so that the links to the banking sector are properly understood. Moreover, the proposed rules on how client assets can be reused as collateral clarify the complex chains of rehypothecation. The transparency of the collateral chains, in which both regular banks and shadow banking entities are involved, is also improved. During the financial crisis we learned that opacity and uncertainty about the extent of rehypothecation and the risks involved can severely undermine confidence in counterparties. The ABS market in Europe Continuing on the development of a particular shadow banking activity, I would say that a step towards the right direction has been taken as the new regulation supports the ABS market (or securitisation market in generally) and endeavors to ensure growth, while for example the proposed regulation on structural reform in EU aims to better separate shadow banking from the traditional one. Furthermore, it enhances the market discipline, which in turn, provides a decent and solid ground for well-functioning shadow banking system. As the ECB Governing Council decided in June 2014 to "intensify preparatory work related to outright purchases in the ABS market (to enhance the functioning of the monetary policy transmission mechanism)", I would also like to say a few words about the ABS market in Europe and its potential. The current ABS market in Europe is small and impaired: public issuance of asset backed securities is minimal and the market is shrinking. It is unfortunate as the ABS-market has a good potential to contribute to unlocking the Europe's credit market, by offering a viable complementary funding source for the real economy, in particular for the SME sector. Considering the weakness of the securitisation market, it is obvious that the market is still suffering from the stigma it received when the global financial crisis erupted and the failures of the securitisation market were uncovered.

255 P a g e 255 The market suffers from a reputation as a capital arbitrage tool of banks that turned out to be disastrous for financial stability. The stigma is persistent and mutual, even though the European ABS market performed relatively well during the crisis compared with the respective American one. Another reason behind the small and weak European securitisation market may be the heterogeneity of the European securitisation market, namely the differences in for example lending criteria, banking institutions, rating standards and default laws among the European countries. Diminishing these differences would enable a better-functioning European securitisation market. Harmonising some standards and enhancing relevant data availability could dispel the risk that banks would off-load bad parts of their balance sheets with securitisation activities. Moreover, common rules and standards would support the development of the currently very fragmented market to a pan-european one in a single market spirit. Finally, considering the potential role of the ABS market in the monetary policy transmission mechanism, a central bank should avoid a situation in which it could become the only buyer in the ABS market. It is thus utterly important to enhance the development of the private market in ABS. So far the ABS market has probably played a minor role in private sector debt financing; its main driver may have been the collateral needs of banks. From the view point of regulation these facts should not be forgotten. It is desirable to make regulation such that it restricts neither the supply nor the demand side of the ABS market. Concluding remarks To conclude, I would like to highlight the following points.

256 P a g e 256 In principle, shadow banking system is beneficial, and one must be careful with its regulation. As professor Bengt Holmström has reminded: "Of special concern is the tendency to demonize or ban innovations that backfired, not because they were fundamentally wrong, but because the particular implementation was flawed. The originate-and-distribute model and MBSs [or securitisation in generally] will certainly have an important place in the future." Thus, we should learn from the fundamental analyses of what went wrong last time, and keep restoring the confidence to the securitisation market. Finally, one thing that should be kept in mind is a possible post-crisis reinvention of the financial system that Andy Haldane, Chief Economist of Bank of England, talks about in his recent publication. As a consequence of the crisis, some part of financial activities will migrate outside the banking system, inducing the shape and form of risk itself to change. This could have further implications for stability of the financial system and the broader economy. Haldane continues that as risk changes its composition, not its quantum, the financial system may exhibit a new strain of systemic risk that is even more related to shadow banking entities. Therefore, regulators must follow intensively the development of the post crisis financial system that might result in new type of systemic risks, and be ready to adjust regulation accordingly in a proactive manner.

257 P a g e 257 Big Bang banking union - what can we expect? Speech by Dr Andreas Dombret, Member of the Executive Board of the Deutsche Bundesbank, at the Euro Finance Week, Frankfurt am Main 1. Introduction Ladies and gentlemen Thank you for the invitation and the opportunity to speak again at the Euro Finance Week. It is a pleasure to be here today. Let us briefly discuss physics before we turn to a topic that is more related to the Euro Finance Week. The British astronomer Martin Rees once said: "We can trace things back to the earlier stages of the Big Bang, but we still don't know what banged and why it banged. That's a challenge for 21st century science." Well, the euro area had its own "Big Bang" two weeks ago, and in this case we know pretty well what banged - and why. On 4 November, the ECB became the direct supervisor for the 120 largest banks in the euro area which, in terms of assets, represent more than 80% of the euro area's banking system. Thus, with a big bang, the ECB became one of the largest banking supervisors in the world. Taking banking supervision from the national to the European level has been the biggest step of financial integration in Europe since the introduction of the euro in This big bang created a new universe for the banks and the financial markets. But what exactly can we expect from the new European banking supervision?

258 P a g e 258 And probably even more importantly: what is it that we cannot expect from it? In the following I would like to discuss both questions. 2. The Single Supervisory Mechanism - just the first step Taking banking supervision from the national level to the European level addresses three problems that became apparent during the recent crisis. First, European banking supervision will allow banks in the entire euro area to be supervised according to the same high standards. These standards will emerge from sharing experience across borders and taking the best parts from every national approach towards banking supervision. Germany, for instance, could benefit from a more quantitative-oriented approach towards banking supervision which other countries already follow. Second, European banking supervision will make it possible to effectively identify and manage cross-border problems. This is essential because today, large banks are usually active in more than one country. The failure of the Franco-Belgian bank Dexia in 2011 is a classic example in which banking supervision with a cross-border focus could have improved crisis management. Another example is the case of German Hypo Real Estate, which failed in Third, taking banking supervision from the national to the European level will add a degree of separation between supervisors and the banks they supervise. This will prevent supervisors from treating their banks with kid-gloves out of national interest. Nevertheless, we can expect European banking supervision to draw upon the experience and resources of national supervisors.

259 P a g e 259 Supervision itself will take place in so-called joint supervisory teams. These teams are headed by ECB staff but are composed of national supervisors. To sum up: there is a lot we can expect from European banking supervision, and now it has to deliver. In this regard, we should remember one thing: European banking supervision is an immensely complex operation that has been put together in a very short time. Thus, it would probably be unrealistic to expect everything to run smoothly from day one. It will certainly take some time before every detail is sorted out deep down in the engine room of actual banking supervision. Nevertheless, I am confident that we will get there and that our expectations will be fulfilled. 3. The Single Resolution Mechanism - the necessary second step But we should not let unrealistic expectations become the roots of complacency and, consequently, disappointment. European banking supervision is not the holy grail of financial stability. It certainly contributes to making banks more stable, but it is no panacea. Thus, we have to supplement it with other measures. Let me elaborate on one point in that regard. Banking supervision cannot prevent individual banks from failing - not at the national level and not at the European level. Is this a problem? Not at all: the possibility of failure is an essential element of a market economy. Nevertheless, banks are special in that respect.

260 P a g e 260 Just remember the 15th of September 2008, when the failure of a single investment bank pushed the financial system to the brink of collapse. The lesson is that the failure of very large or interconnected banks can lead to a systemic crisis. Thus, these banks are perceived as being "too big to fail": when push comes to shove, the government might be compelled to step in to prevent disaster. Consequently, "too big to fail" banks operate with an implicit and cost-free insurance. Apart from the costs this insurance imposes on taxpayers, it most definitely sets the wrong incentives for the risk-conscious behaviour of banks. Thus, solving the "too big to fail" problem is paramount for making the financial system more stable and saving taxpayers' money. Can European banking supervision solve that problem? Well, it can certainly contribute by putting "too big to fail" banks under close observation. And yet it has to be supplemented with other measures. And here, we recently made some progress - at the global level and at the European level. At the global level, the G20 Heads of Governments and States have just this Sunday decided on international criteria that global systemically important banks will have to fulfil in future regarding their capital structure. In particular, these banks will need a minimum amount of Total Loss Absorbing Capacity - in short TLAC. This approach combines the existing minimum capital requirements with new requirements to ensure that large banks have sufficient capacity to absorb losses, both before and during resolution. TLAC therefore, in my view, represents a watershed in ending "too big to fail". It will allow for the orderly resolution of those banks without disrupting the financial system and while protecting taxpayers from having to foot the bill.

261 P a g e 261 For the TLAC-concept, I wish to signal my strong support. To achieve these worthy goals, I suggest agreeing upon a figure at the upper end of the range of 16% - 20% proposed by the FSB. However, reaching an agreement on TLAC is not the finish line of the regulatory agenda. The next months need to be used for in-depth public consultation as well as an impact study of the new rules. I hope that this study will lend support to a figure at the upper end of the proposed range. Finally, after both the impact study and the public consultation, implementation is the next step, and this should not be underestimated. Another major step towards solving the "too big to fail" problem has been taken with regard to cross-border resolution. In October, 18 global banks and the International Swaps and Derivatives Association agreed to implement new rules on derivatives trading. Whenever a large bank fails, these rules will allow authorities to temporarily suspend the right of other banks to terminate derivatives contracts. This will buy precious time to organise an orderly resolution of the failed bank. However, it is paramount that we not only have the necessary procedures in place to wind down a failed bank, but the political will to go through with it. This political will exists in Germany and is a universal pre-condition for ending "too big to fail". We have also made progress at the European level. The Bank Recovery and Resolution Directive spells out clear rules on who has to bear the costs when a bank fails. In a nutshell: bail-out is out and bail-in is in.

262 P a g e 262 In future, shareholders and creditors will be first in line when it comes to bearing losses; taxpayers will be last in line. This directive will be implemented in Germany in early 2015; the latest possible date for implementation in other countries is Also from 2016 onwards, European banking supervision will be supplemented with a European resolution mechanism for banks. From then on, the banking union will rest on two pillars and provide a stable framework for European financial markets. 4. What about the banks? What does all that mean for the banks? In essence, regulators and supervisors are working towards strengthening the principles of a market economy. Naturally, this puts more weight on the shoulders of market participants, that is, the banks. In future, there will be no public lifeguard standing by to bail banks out when things go wrong. Failure has become a real possibility and banks have to acknowledge that. They should have an interest in safeguarding their stability and strengthening their profitability. Regarding the stability of banks, the comprehensive assessment provided a deep insight into the state of the European system. So let us take a closer look at the German banks that were subjected to that assessment. All in all, German banks did rather well. Of the 25 German banks that were examined, there was only one "technical" failure, since the bank in question has already remedied its capital shortfall. Over all, it could be concluded that German banks are stable enough from a capital point of view to cope with severe economic stress.

263 P a g e 263 But again, no bank should give in to complacency. And neither should supervisors. We should, for instance, be aware that the comprehensive assessment focused on risk-weighted capital ratios. Markets and supervisors, however, also cast an eye on unweighted capital ratios. And with regard to these leverage ratios, German banks are below average compared to other euro-area countries. Thus, there is ample room to catch-up and improve stability even further. Nevertheless, while stability is necessary for a bank, it is not sufficient. Banks have to be profitable as well. And in this regard, too, German banks need to catch up. Their return on assets and their return on equity are also relatively low compared to other euro-area countries. A recent study even comes to the conclusion that only 6% of German banks earned their cost of capital last year. What can explain these weak earnings? Well, the main culprit in Germany seems to be a business model that is relatively dependent on interest income. Such a business model poses a major challenge in the current environment of low interest rates. Consequently, in the first six months of this year, the operative results of the large German banks were about 8% below their 2013 levels - a result which was largely driven by a contracting interest margin. Nonetheless, banks are also faced with a structural problem in this context: the interest margin has been declining constantly since the mid980s. The banks should therefore reconsider their business models and gear them towards sustainable profitability.

264 P a g e 264 To be sure, the need to adapt business models is not only relevant for German banks. However, in its recent Financial Stability Report, the IMF finds that German banks are again below average in terms of reforming their business models. Again, there is room to catch up with international peers. An obvious strategy for the German banks would be to diversify their sources of income away from interest income. Looking at the cost-side, German banks fare rather well compared to other countries. That is the good news. But there are still options to reduce costs. In this regard, mergers may well be a potential strategy. The German banking market still offers scope for further consolidation - the focus here should, of course, always remain on arriving at a sustainable business model. As a side note: in future, European banking supervision will also keep a close watch on the business models of banks. However, we should not expect supervisors to be the better bankers. At the end of the day, management decisions have to be taken by those who bear the risks and reap the rewards. What the supervisors could do is impose additional capital or liquidity requirements whenever they have doubts about the sustainability of a bank's business model. 5. Conclusion Ladies and gentlemen There is no doubt: European banking supervision is an important step forward in ensuring financial stability in the euro area. Nevertheless, as I said earlier, unrealistic expectations are the roots of complacency and, consequently, of disappointment.

265 P a g e 265 European banking supervision is just the first pillar of the envisaged banking union. It has to be supplemented with the European resolution mechanism for banks. This second pillar of the banking union will be erected in Eventually, the banking union will provide a stable framework for the banking system and strengthen market forces. This, in turn, puts more responsibility into the hands of banks. It is up to each individual bank to ensure its own stability and profitability. This requires the banks to rethink their business models and to rethink their culture. Regulatory measures like TLAC that will abolish implicit guarantees for banks will also necessitate changes in banks' behaviour for the better. The original role of banks is to service the real economy. Putting this idea back into the heads of bankers would contribute greatly to making the financial system more stable. We have to do away with a culture in which everything is allowed that is not explicitly forbidden. We need a culture which encourages bankers to look beyond the horizon of short-term returns. If banks succeed in creating such a culture, they will eventually regain the trust of the people that got lost in the crisis. Regulation and supervision can play a supporting role, but the burden ultimately lies with the banks. Thank you.

266 P a g e 266 Introductory remarks at the EP s Economic and Monetary Affairs Committee Speech by Mario Draghi, President of the ECB Mr Chairman, Honourable Members of the Economic and Monetary Affairs Committee, Ladies and Gentlemen, It is a pleasure for me to be back again in this committee for the last hearing of This year has once again been a year of profound change for the euro area and for the Union as a whole. It was a year of legislative and institutional progress on many fronts, as 2014 saw the birth of banking union with the agreement of the Single Resolution Mechanism, the start of the Single Supervisory Mechanism and the successful conclusion of the comprehensive assessment of banks balance sheets. And it was indeed a challenging year for monetary policy, which saw the ECB take a wide range of measures to respond to the risks emanating from an increasingly sobering economic outlook. You have chosen two topics for today s hearing, the relationship of financial fragmentation and monetary policy as well as the Eurosystem s collateral framework. I will touch on both these issues, but let me first run you through our current assessment of the economic outlook. Economic and monetary developments The euro area growth momentum has weakened over the summer months and most recent forecasts have been revised downwards. At the same time, our expectation for a moderate recovery in 2015 and 2016 remains in place.

267 P a g e 267 Demand should be supported by a number of factors. Among them are our monetary policy measures and progress made in fiscal consolidation and structural reforms in some countries. At the same time, high unemployment, sizeable unutilised capacity, and the still ongoing and necessary balance sheet adjustments are likely to dampen the recovery. Risks to the economic outlook continue to be on the downside. In particular, the weakening in the euro area s growth momentum, alongside heightened geopolitical risks, could dampen confidence and, in particular, private investment. In addition, insufficient progress in structural reforms in euro area countries constitutes a key downward risk to the economic outlook. Inflation in the euro area remains very low. In October, it stood at 0.4%. We expect it to remain at around current low levels over the coming months, before increasing gradually during 2015 and Looking forward, we closely monitor risks to price developments. The latest monetary data point to subdued underlying growth in broad money. Its annual growth rate has increased moderately over recent months. It appears that the turning point in credit growth is now behind us, and credit growth rates, while remaining negative, are gradually improving. Monetary policy and financial fragmentation Let me turn to financial fragmentation, the first topic you suggested for today s hearing. Fragmentation in various segments of the financial market has been a major obstacle to the smooth conduct and transmission of monetary policy, and ultimately to our ability to deliver on our mandate.

268 P a g e 268 Also owing to determined actions the ECB has taken, fragmentation has receded significantly since the height of the financial crisis. Unsecured money market rates are trading again at reasonable spreads over their secured counterparts. Sovereign bond spreads in the euro area decreased significantly from their peaks in Together, these developments reflect the gradual return of confidence among investors in the euro area. Yet, we still face a situation where our very accommodative monetary policy stance does not sufficiently reach some final borrowers in the euro area. This is because credit markets in some parts of the euro area are still impaired and show only timid signs of recovery. As a result, credit growth continues to contract and credit conditions - while having eased recently - remain overall tight from a historical perspective. Importantly, costs of bank funding have improved, but are still relatively high in some Member States. Where they are lower, they are not passed on in full to the real economy. The monetary policy measures decided in June and September this year, the Targeted Longer-term Refinancing Operations and the purchase programmes for asset-backed securities and covered bonds, are designed to overcome these obstacles. They will enhance the transmission of monetary policy, support the provision of credit to the euro area economy and, as a result, provide further monetary policy accommodation. We see early indications that our credit easing package is delivering tangible benefits. Since the beginning of June, forward money market rates have shown steep declines across the maturity spectrum. Now, the forward curve consistently lies below zero over a two-year horizon.

269 P a g e 269 EONIA is not expected to exceed 25bps before well into The 3-month EURIBOR rate, which is an important conduit of monetary policy impulses to lending rates, dropped to all-time lows and now stands close to zero. And the policy decisions, in particular those announced in September, triggered a compression of spreads across other asset classes, including ABS, covered bonds and sovereign bonds. But more time is needed for the full materialisation of the positive effects of the most recent set of measures. In this context, let me emphasise that we are committed to scale the total magnitude of our measures lending operations as well as outright purchases up to a size that can deliver the intended support to inflation and the recovery of the euro area economy. All these measures will have a sizeable impact on our balance sheet, which we expect to move towards its early 2012 dimension. This will ensure that our accommodative monetary policy stance will contribute to a gradual recovery and a return of inflation rates in the medium term to levels closer to our aim of below but close to 2%. Nonetheless, we need to remain alert to possible downside risks to our outlook for inflation, in particular against the background of a weakening growth momentum and continued subdued monetary and credit dynamics. We therefore need to closely monitor and continuously assess the appropriateness of our monetary policy stance. If necessary to further address risks of too prolonged a period of low inflation, the Governing Council is unanimous in its commitment to using additional unconventional instruments within its mandate. In this context, we have also tasked relevant ECB staff and Eurosystem committees with the timely preparation of further measures to be implemented, if needed. Such measures could include further changes to the size and composition of the Eurosystem balance sheet, if warranted to achieve price stability over the medium term.

270 P a g e 270 Monetary policy alone however cannot overcome financial fragmentation in the euro area. Fragmentation across national borders also reflects underlying national imbalances and institutional deficiencies. Overcoming these require determined structural reforms on the side of national governments to improve the business environment and setting incentives to invest, with the aim to boost productivity, create new jobs and raise the growth potential of the economy. Reducing financial fragmentation also requires tackling remaining shortcomings in economic and financial integration. As already mentioned, substantial progress has been made this year. Banking union should now be completed following the finalisation of the Comprehensive Assessment and the SSM taking on supervisory responsibility. This means in particular completing the SRM, enhancing the borrowing capacity of the Single Resolution Fund and thereby delivering on the commitment to establish a credible backstop. Moreover, looking forward, a greater integration of financial markets also referred to as a Capital Markets Union (CMU) would be warranted to further reduce fragmentation of financial markets, improve funding to SMEs, enhance the transmission of the ECB s monetary policy, and overall benefit economic growth. We look forward to the detailed elements that the Commission will announce in the course of 2015 and I have no doubt that the European Parliament as co-legislator will again play a decisive role in this regard. The collateral framework of the Eurosystem Let me now say a few words on the second topic you have chosen, our collateral framework. Since the very beginning, the Eurosystem collateral framework had been designed to achieve two goals at the same time: First to protect the Eurosystem from incurring losses, as it is explicitly required by the Statute of the ECB/ESCB; second to ensure that Eurosystem credit operations can be carried out smoothly by making sufficient collateral available.

271 P a g e 271 The past and recent experience has shown that such a dual set-up of the Eurosystem collateral framework has been indeed very effective. So far, the Eurosystem has never had to recognise a loss stemming from the Eurosystem credit operations. In the few cases where counterparties have defaulted, for instance in the case of a subsidiary of Lehman Brothers, the Eurosystem was able to fully cover its exposure by seizing the posted collateral. At the same time, the collateral framework ensured that banks were able to obtain sufficient amounts of central bank liquidity throughout the crisis. This became most visible in the context of the two Very Long Term Refinancing Operations that the ECB conducted in 2011 and In these operations banks obtained collateralised central bank liquidity in the order of EUR 524 billion within only 10 weeks. This basic set-up of the collateral framework has remained the same since the beginning of monetary union; the three constituent parts of the Eurosystem collateral framework, i.e. (i) the counterparty framework, (ii) the basic eligibility criteria for underlying assets and (iii) the risk control measures, have remained largely unchanged. The Eurosystem maintains a broad counterparty framework and its eligibility criteria are still based on the same principles as at the beginning. This shows that the design of the Eurosystem collateral framework is in general very robust. However, some changes were necessary to guarantee a smooth implementation of monetary policy at times of financial market stress that led to a general reduction in access to market funding. A collateral framework must never act in a pro-cyclical manner: Restricting banks access to liquidity in a crisis for instance, by introducing more restrictive criteria for collateral might pose a risk not to only to the most vulnerable banks, but to the whole financial system.

272 P a g e 272 Ultimately, this would increase the risk for the central bank s balance sheet rather than protecting it. Hence, in order to enable that a wide range of the counterparties could continue participating in the refinancing operations, the Eurosystem temporarily relaxed some of the eligibility criteria for underlying assets. This was done on several occasions. For instance, from 2008 to 2011 and again as of 2012, we accepted foreign denominated marketable assets. In 2012 we created the Additional Credit Claims framework. Credit standards have been changed by accepting lower rated assets compared to those accepted at the beginning, notably for ABS that fulfill certain criteria. However, these accommodative measures were coupled with a stronger-scrutinised counterparty framework and with more stringent risk control measures. As a result, the total amount of eligible collateral increased. Thus, an enhanced participation of counterparties in the refinancing operations was enabled, while at the same time the risks for the Eurosystem expanded only moderately. The Eurosystem collateral framework has been quite complex from the very beginning, not the least because of the variety of national frameworks preceding it. With the onset of the monetary union, the goal was to provide access to Eurosystem credit operations to a broad range of counterparties, in contrast to some other central banks which rely on a few counterparties. Therefore, the collateral framework had to take into account the various national banking systems and financial markets. Some national central banks, for example, accepted credit claims as collateral, while others did not.

273 P a g e 273 Some countries had developed covered bond markets, while others only started to set up a respective covered bonds law later, and the same could be said for ABS. For a collateral framework, a common standard had to be found which embraces these national characteristics, while at the same time ensuring that sufficient collateral is available. Several of the measures taken in the crisis have added to this complexity. Therefore a challenge going forward is to make the collateral framework simpler and more transparent, without impacting the ability of counterparties to access our refinancing operations. I am confident that we will achieve this. Conclusion Ladies and gentlemen, 2014 has been a year of profound change. But what has been achieved so far is not enough needs to be the year when all actors in the euro area, governments and European institutions alike, will deploy a consistent common strategy to bring our economies back on track. Monetary policy alone will not be able to achieve this. This is why there is an urgent need to agree on concrete short-term commitments for structural reforms in the Member States, on a consequent application of the Stability and Growth Pact, on the aggregate fiscal stance for the euro area, on a strategy for investment, and to launch work on a long-term vision to further share sovereignty ensuring the sustainable and smooth functioning of EMU. On that note, I am looking forward to our discussion.

274 P a g e 274 Capital markets union - the "why" and the "how" Dinner speech by Mr Yves Mersch, Member of the Executive Board of the European Central Bank, at the joint EIB-IMF high-level workshop, Brussels Dear Mr Tănăsescu (Mihai Tănăsescu, Board Member of the EIB), Ladies and Gentlemen, In four days' time, the European Central Bank (ECB) will disclose the results of its comprehensive assessment of banks' balance sheets - what we have called a financial health check. This will mark the end of a tremendous effort by both banks and supervisors. Around 6,000 experts have been working full-time over the past twelve months to review the balance sheets of 130 banks in the euro area and Lithuania. Together, these banks represent roughly 85% of total bank assets in the euro area. One reason you are here tonight may be not only the dinner but also that you would like me to let you in on the secret of the numbers we will publish at noon on Sunday. I am afraid I have to keep you on the edge of your seats for four more days. Before we can disclose the outcome, we have to give banks the opportunity to review their results and prepare for publication. That review period will start tomorrow. What we already know is that the banks that will fall under our direct supervision have strengthened their balance sheets by almost 203bn since the summer of 2013.

275 P a g e 275 This includes 59.8bn of gross equity issuance, 31.6bn issuance of contingent convertible bonds (CoCos), 26bn of retained earnings, 18.3bn of asset sales, 17.6bn of one-off items and additional provisioning and about 50bn of other measures. These numbers show that even before the results are announced, the comprehensive assessment is delivering on its objective of repairing and strengthening banks' balance sheets as the ECB takes on its new supervisory responsibilities. But tonight, I would like to look beyond Sunday to the bigger picture surrounding the comprehensive assessment. What some perceive as a burdensome exercise, analysing very technical aspects of bank balance sheets, is in reality a display of the ambition to create a more integrated financial market in Europe. The comprehensive assessment is an important prerequisite and foundation for the Single Supervisory Mechanism (SSM), which will start operating on 4 November. Together, they constitute a sea change in Europe's banking markets. For the first time, common legislation and rules will be applied by a single authority, strongly increasing transparency and banks' comparability across countries. But we must recognise that we have not reached the end of the journey. A single supervisor can more easily ensure comparability where there are single rules. Remember the discussion about the different national definitions of non-performing loans in the context of the asset quality review. This is a telling example that the singleness of Europe's financial market is still challenged by piecemeal national rules and standards.

276 P a g e 276 In addition to banking supervision, there is a second area where fragmentation of Europe's financial market remains a stumbling block. Seven years after the first shock waves of the financial crisis and two years after the sovereign debt crisis in the euro area, economic recovery is still some way off: euro area real GDP remained unchanged between the first and second quarters of this year. Unemployment is still at 11.5%. Prices in September rose by only 0.3% - and measures of inflation expectations have gone down. To restart growth, we must open financing channels, especially for small and medium-sized enterprises (SMEs). And this can best happen when financial markets are fully integrated. In the light of these various concerns, the aspiration to complete the single financial market has returned to the top of the agenda - and quite rightly so. The latest focus for this discussion is the creation of a European capital markets union. Why a capital markets union? Expectations for the project of a capital markets union are high. But to date, there is no common understanding of what it means or what it should look like. For the financial industry, it means new business opportunities; for financial stability experts, it means better control of shadow banking; and for entrepreneurs, it means better access to funding sources. As central banker, I would stress another major advantage of more integrated financial markets in the euro area: it would greatly facilitate the implementation of the ECB's monetary policy. We are clearly at the beginning of the discussion of a capital markets union.

277 P a g e 277 But l believe that a broad public discussion is exactly what we need to generate ideas and start the opinion-forming process. I therefore welcome the fact that Lord Hill has announced his intention to consult a broad range of stakeholders and conduct analyses before presenting more concrete proposals. I too do not have a ready-made blueprint in my bottom drawer. It is time to spell out more clearly what we want and what we do not need, what we can achieve and what we should not attempt. This way we can prevent the capital markets union from becoming a 'Jack of all trades, master of none'. In my view, the various motivations for a capital markets union can be summarised under two main objectives: On the one hand, we need to find ways to generate growth. In a way, the euro area economy is like a plane flying on only one engine: bank financing. To increase the speed and stability of the plane, it would be good to add a second engine: capital market financing. Hence, we must seek to deepen capital markets so that they can play a more important role in supporting the real economy. And we must name areas where removing frictions between national markets can bring new business. On the other hand, we need to ensure financial stability in the longer term. An impressive amount of regulation has been introduced since the crisis began, tackling several fundamental problems in our regulatory set-up.

278 P a g e 278 Indeed, the crisis showed that our initial rules were in some areas too lax and too heterogeneous across countries to ensure the stability and singleness of Europe's financial market. At the same time, we should avoid excesses: more regulation does not always mean more stability. In many instances, the two objectives of growth and financial stability complement each other. I believe that greater integration of markets can be key to both. Fifteen years after the financial services action plan, it is time for another big step forward for Europe's single financial market. How to implement a capital markets union? So what measures do we need to take to achieve these objectives? To my mind, a comprehensive capital markets union requires thinking along three dimensions. The first is the opening of the market itself: in this regard, we have already achieved a great deal within the EU. The second is the introduction of common regulatory standards. And the third consists of the institutional structures that enforce these regulatory standards. I will elaborate on the second dimension and also make some remarks on the third dimension. Regulatory dimension Let me first address the regulatory dimension. Financial markets are complex systems with many different players, products, infrastructures and currencies.

279 P a g e 279 As a consequence, financial markets are at the intersection of many different fields of legal rules, including contract law, corporate governance, capital requirements, insolvency, taxation and consumer protection. To ensure that a single financial market delivers growth and stability, all of these fields need to be taken into account. Let me illustrate this for the financial market segment that is the focus of this high-level workshop. To revive the securitisation market and to ensure its stability, there are three regulatory fields where I believe that action is necessary: ABS regulation; insolvency law; and payment and settlement systems. Let me discuss each in turn. ABS regulation The first key challenge for the securitisation market is the lack of standardisation at the European level and the heavy capital charges for an asset class that have been set internationally. Take the ABS market, which we have been looking closely at for some time. We believe that it could be an important channel for increased lending to SMEs. Because of their size, SMEs generally cannot issue bonds. In addition, the risk of non-payment and the low liquidity of loans to SMEs in difficult times are major hurdles for SMEs to get financing, even through the banking channel. In this regard, securitisation can help to connect SME financing needs with the funds of bank and non-bank investors. It can do so by assisting banks' ability to fund and distribute risk.

280 P a g e 280 Here we believe that having a consistent approach to securitisation underpinning various pieces of legislation is key to attracting a broader investor base and to de-stigmatising European securitisations. Let me say clearly: no one wants to have the complex, opaque products of the pre-crisis years. Repackaging the umpteenth tranche of a financial derivative should be a thing of the past. But the regulatory framework should be appropriate for the actual risk. And in this respect there are significant differences between current and previous securitisations and between the US and European experiences. Since the start of the crisis, the default rates of European ABS were on average between 0.6% and 1.5%. In the US over the same period, they were on average 9.3% to 18.4%. European SME ABS are even further below these default rates, at about 0.1%. It makes little sense to calibrate the international rules solely on the basis of US experiences. It would be like calibrating the price of flood insurance for Madrid on the experience of New Orleans. The current rules lump all ABS together and are much too conservative. They effectively question their existence. Under the current regulatory conditions, simple, transparent ABS built on real assets face almost as many constraints as much more complex financial products. The ECB has therefore, in cooperation with the Bank of England, made a number of proposals for a better functioning European securitisation market.

281 P a g e 281 We have received positive responses from the Commission and the Member States. The proposals are derived in part from the quality and transparency requirements that central banks place on ABS, which can be deposited as collateral in monetary policy operations. And as a central bank, our demands have always been very high. Let me add, that in this regard, the ABS market is a good example of how a capital markets union can also benefit our monetary policy, besides generating growth and promoting financial stability. Insolvency law The second regulatory obstacle for a single market for securitised products is the heterogeneity of insolvency rules across the EU. This applies to both financial and non-financial companies. The Council Regulation on cross-border insolvency proceedings establishes a common framework of basic rules regarding the competent courts, the applicable law and the recognition of court decisions. But within this framework, national laws differ substantially in how far they protect the different stakeholders in insolvency. For example, the rights of preferential creditors differ substantially in some cases. Different prescriptions on the filing and verification of claims can also cause frictions. Heterogeneity becomes all the more important in dealing with the insolvency of multi-national enterprise groups. All in all, the heterogeneity of insolvency rules complicates the creation of homogenous asset pools and therefore the securitisation process.

282 P a g e 282 The Commission proposal to review the Regulation on cross-border insolvency makes suggestions how to improve this situation in the right direction. Payment and settlement systems The third regulatory challenge for the securitisation market is the field of payment systems and securities settlement. Despite much progress over the past decade, securities settlement in the euro area remains fragmented, inefficient and not very customer-friendly. This is not just a problem for smaller businesses, for which adapting to different conditions in the Member States often entails high costs, but also for the integration and functioning of the single market as a whole. A striking comparison is often made with the US, an economic area of comparable size: settling a cross-border securities transaction in Europe has been estimated to cost at least ten times as much as in the US! This issue can be solved by establishing European market infrastructures for the processing of securities transactions, as well as a coordinated and more harmonised monitoring of critical market infrastructures. In all these areas, in which the Eurosystem is competent, relevant initiatives were launched several years ago and have already made significant progress. For example, Target2Securities is the Eurosystem's response to the high fragmentation that characterises the infrastructure supporting capital markets in Europe. T2S will be a new IT platform performing the real-time settlement of securities transactions against central bank money across European borders.

283 P a g e 283 T2S will settle all securities, both debt securities and equities. The T2S platform is now fully developed. This year is reserved for testing and it is set to go live in June This will be a major event with a strong impact on the financial services industry in Europe. All of this applies fully to ABS markets. Their settlement infrastructure will become more integrated and overcome obstacles that have so far hindered cross-border trade. The standardisation of ABS, further harmonisation of insolvency laws and the integration of settlement systems are three illustrations from the securitisation market showing how the regulatory dimension of a capital markets union can achieve progress by accelerating existing initiatives and launching additional ones. More generally, the regulatory dimension implies both a deepening and broadening of the single rulebook. Deepening means that prudential rules should converge further where undue carve outs remain. Broadening means that the single rulebook should be expanded to other areas that affect the single financial market. Institutional dimension Beyond the regulatory dimension of a capital markets union, there are a number of institutional questions related to consistency across market segments, multi-level governance, actors and geographical scope. As regards consistency, we need to ask ourselves: how much integration do we need beyond the banking system?

284 P a g e 284 If banking supervision is becoming European, can payment systems continue to be monitored nationally? What about new technologies? Do we wait until they are established in the old national frameworks before we try to negotiate mutual acceptance, or harmonisation, or should we foster creativity and efficiency by offering from the outset a Europe-wide single framework? As regards multi-level governance, we must identify the areas in which the EU can take the initiative and those in which the Member States can be active. Can we rely on directives with national leeway in their implementation or do we need to make use of Regulations that are directly applicable? As regards actors, there is the question of where we should rely on decentralised application of common rules and where we need institutions at EU level to implement common rules? What functions could be performed, for example, by the European supervisory authorities, whose activities and tasks are currently being reviewed in Brussels? As regards geographical scope, it is important that we strive to make the capital markets union a project of the EU28 to reinforce the single financial market as a whole. Nevertheless, it is clear that the euro area has a particular interest in increased financial integration to pave the road towards a genuine monetary and economic union. Conclusions Let me conclude. Some may argue that the capital markets union is old wine in new bottles.

285 P a g e 285 I disagree. What is old are the problems that we need to overcome. But for that we need new measures that we have not previously been able to implement - either because of a lack of political will or because of an insufficiently clear plan on how to implement them. Art. 114 of the TFEU gives a clear mandate for this purpose. The capital markets union is not so much about a couple of high-profile actions but more about a larger series of less visible initiatives. And that is why we need the capital markets union as connector and label. To operate with this term will help to raise awareness, to define overall objectives, to prioritise resources and to ensure consistency of the individual measures. Ladies and gentlemen, The overall situation of the European economy makes it abundantly clear that we cannot wait for a miracle to end a period of low growth. We are not out of the danger zone. The patient is still fragile and unfortunately relapses cannot be ruled out. As I have explained, a capital markets union can provide very important impulses for both economic recovery and financial stability. I am aware that some of the proposals are ambitious and cannot be implemented overnight. But the fact that the incoming President of the European Commission has already taken up the idea makes me optimistic.

286 P a g e 286 The challenge in the coming months will be to create greater political awareness of the enormous importance of this highly technical area for Europe's economy. At the same time, I want to point out that a capital markets union cannot be our only area of action. Financial policy, fiscal policy and economic policy are all equally important to keep the recovery on track. Governance of the euro area can be thought of like the gearbox of a car. The cogs do not all need to be of equal size but they all need to be moving in the same direction. If only one cog starts going the wrong way, the whole car grinds to a halt. Non-respect of agreed rules by some is clearly establishing moral hazard risks for the actions of others. Many things in the euro area need to come together to create an environment in which businesses and entrepreneurs can generate added value. Ernest Solvay, after whom the library in which the workshop will take place tomorrow is named, provides us with a good example. In the early 1860s, he had a brilliant idea for the industrial production of sodium carbonate. But it took the perseverance of several financiers and ten years before the process was ready to be used on an industrial scale. And Solvay relied on a patent to protect the intellectual property that ultimately formed the basis of his corporate success. Over 150 years later, a capital markets union can help the Ernest Solvays of today.

287 P a g e 287 It can enable all Europe's entrepreneurs to obtain the financing they need to turn their innovative ideas into successful businesses that will create jobs and promote sustained prosperity. Thank you for your attention.

288 P a g e 288 Shadow banking and the roots of international cooperation Speech by Dr Andreas Dombret, Member of the Executive Board of the Deutsche Bundesbank, at a reception to bid farewell to Mr Winfried Liedtke, financial attaché, and to welcome his successor, Mr Thomas Notheis, Beijing Ladies and gentlemen Welcome to our reception here in Beijing. I am happy to have the opportunity to officially thank the Bundesbank's departing representative, Winfried Liedtke, and to welcome his successor, Thomas Notheis. Allow me to say a few words on the roots of international cooperation. Not too long ago the saying was that when the United States sneezes, the world catches a cold. This is certainly still true, and the turbulence following the Federal Reserve's announcement of tapering was a case in point. However, the world economy of today is no longer a unipolar system. Take China as an example. China is now the second largest economy in the world, and the IMF estimates that, measured in purchasing power parities, China might have overtaken the United States in 2014 to become the world's largest economy. Thus, China is an important player on the global stage. According to IMF data, China accounted for more than one third of global economic growth in At the same time, it promotes growth in other parts of the world through trade linkages or direct investment.

289 P a g e 289 Over the past six years, Chinese imports grew by an average of 12% per annum while China's foreign direct investment reached a new record in 2013 with a total of more than US$ 100 billion. However, no one can deny that a global player can also be a global risk: when China sneezes, the world might catch a cold, too. Consequently, the IMF has recently warned that a hard landing in China might pose a risk to the world economy. Nevertheless, globalisation has not just taken us from a world economy that was dominated by one country to a world economy that is dominated by two countries. The world in which we live has become very small over the past decades. And in a small world, every policymaker in every country must be aware that his or her decisions can influence other countries as well. The world is interconnected by a close-knit network of trade relations and through a globalised financial system. Financial markets in particular have become integrated to such a degree that a small distortion at one end of the world can quickly spread and affect the entire system. In 2008, the failure of a single investment bank in the United States sparked a global financial crisis and a worldwide recession. Having acknowledged that financial crises today are global in scope, the G20 embarked on an ambitious agenda to reform global financial regulation. And they have made significant progress. The new Basel III rules will ensure that banks hold more and better capital.

290 P a g e 290 At the same time, new liquidity standards will ensure that banks have sound funding structures. These and other measures will make the global banking system more stable. However, there is always the other side of the coin: tougher rules for banks might lead to regulatory arbitrage where risky activities are shifted toward unregulated areas of the financial system. One current example is the growth of the shadow banking sector, where financial enterprises conduct business which creates bank-like risks but is either regulated insufficiently or not at all. The Financial Stability Board estimates that the assets of non-bank financial intermediaries grew by US$ 5 trillion in 2012 and now stand at US$ 71 trillion. Non-bank financial intermediaries represent about half of banking system assets and 117% of global GDP. And China is no exception here. According to the IMF, the size of the Chinese shadow banking sector has more than tripled since 2008 and reached 35% of GDP in March The IMF estimates that China has the fifth largest shadow banking sector in dollar terms among those jurisdictions which are members of the Financial Stability Board. A growing shadow banking sector is something regulators have to watch closely - not just in China but in other countries, too. Shadow banking participants undertake maturity and liquidity transformation, they engage in the transfer of credit risk, and they operate with leverage. This means they carry out a range of bank-like functions which are associated with bank-like risks.

291 P a g e 291 At the same time, however, there are two key differences compared to the regular banking system. First, shadow banking participants and activities are not subject to banking regulation. Second, shadow banking participants generally have no access to central bank liquidity, nor do they benefit from public backstops such as deposit insurance schemes. The consequence of this structure is a latent risk of runs on shadow banking participants. A run may lead to liquidity bottlenecks which can only be cleared by rapid deleveraging. That in turn may contribute to a collapse in prices on the financial markets, and thus exacerbate the problems in a procyclical fashion. In addition, the structure of many of the transactions conducted in the shadow banking system means that the participants are closely interconnected. Thus, contagion effects within the system are highly likely. These systemic risks within the shadow banking system may then spill over into the regular banking system, which is often directly or indirectly linked to the shadow banking system. Thus, the shadow banking system may well be a source of systemic risk. Accordingly, it is very high up on the G20 reform agenda. In this context, let me make one thing absolutely clear: the purpose of regulation is not to proscribe shadow banking activities or to drive participants out of the market when such activities and participants engender no systemic risk. The sole aim of regulation is to put a brake on systemic risk. We have certainly made some progress on this issue but we still have further to go.

292 P a g e 292 Because the growth of the shadow banking sector is a global issue, further cooperation is needed to make the financial system a safer place. And international cooperation always starts at the personal level, with personal relations forming the root of successful cooperation. This is where our representatives here in Beijing come into play. Their task is to build networks, to share information and ideas, to explain the Bundesbank's positions and to facilitate cooperation. For the past three years, Winfried Liedtke has served as the Bundesbank's representative in Beijing. And judging from the distinguished crowd gathered here today, he has done an excellent job. I would therefore like to thank him personally and in the name of the Bundesbank for his service. I would also like to take the opportunity to welcome our new representative, Thomas Notheis. For the past four years, Thomas Notheis has served as the Bundesbank's representative in Mumbai, meaning that he is not new to either the world of economic diplomacy or to Asia. Some of you have already met him, and I am certain that he will be a worthy successor to Winfried Liedtke. Having a representative here in Beijing shows that the Deutsche Bundesbank acknowledges the global importance of the Chinese economy and its role in global financial markets. I strongly believe that our presence here in Beijing will deepen friendship and cooperation, not only between Thomas Notheis and his peers but also between the Deutsche Bundesbank and the Central Bank of China, and eventually between Germany and China. Thank you!

293 P a g e 293 Sukuk development and financial stability Speech by Dr Zeti Akhtar Aziz, Governor of the Central Bank of Malaysia (Bank Negara Malaysia), at 10th World Islamic Economic Forum (WIEF) "Sukuk Development and Financial Stability", Dubai, 28 October Oct 2014 It is my great pleasure to be here in Dubai at this World Islamic Economic Forum 2014 to speak at this dialogue session on the potential of the sukuk market and its role in the economic development process and in contributing towards financial stability. This recent decade has witnessed the accelerated development of the global sukuk market. The global sukuk market which has now reached USD$270 billion outstanding is evolving to become a distinct platform for fostering greater international economic and financial linkages. The success of the sukuk market reflects its ability to meet the changing and differentiated demands of the modern economy, to develop innovative and cutting edge structures and products, and to achieve such issuances at competitive pricing. The sukuk market has drawn increasing interest from sovereigns, multilateral institutions, multinational and national corporations both from developed and emerging economies to finance investments in a wide range of economic activities and development projects. The geographical reach of the sukuk market has also become more extensive, with the global sukuk outstanding now being domiciled in more than 20 countries, while the investor base that spans from Asia, the Middle East and Europe. In addition to issuances in international reserve currencies that includes the US Dollar, the British Pound and Euro, more recently in Malaysia has been the issuance of sukuk in Renminbi.

294 P a g e 294 For the investors, the sukuk offers the diversification into multiple asset classes and different techniques used to structure medium to long term instruments. Given that the sukuk is based on underlying assets, it discourages over-exposure of the financing beyond the value of the underlying assets. Issuers are thus discouraged from leveraging in excess of the asset value. The prospect of over-indebtedness and its consequences on financial stability are thus reduced. There is also potential for direct participation of investors in the project, thereby granting investors beneficial ownership in the underlying assets, with the rights to receive a share of profits or rental income from the underlying asset of the sukuk while taking the associated risk of such ownership. The sovereign sukuk is generally the first inroad into Shariah compliant funding in the capital market, enabling the creation of reference prices over time, to which private sector entities can benchmark their fund raising activities. Governments have for the most part, remained the most active issuers in the history of the global sukuk market with sovereign issuances accounting for more than 80 percent of the global sukuk issuances. This recent few years has also seen a number of jurisdictions in developed economies strengthening their legal, regulatory and governance framework to facilitate such sukuk issuances. Going forward, the financing requirements for economic development are envisaged to be massive, particularly for emerging and developing economies in the Asian and Middle Eastern regions that are seeking huge amounts of capital to fund new infrastructure and to support economic development.

295 P a g e 295 Given the sheer size of these projects, equity and government budgets cannot be the only source of financing for this next phase of economic growth and industrialisation in our regions. The sukuk market has become a potentially important new source of funding for such long term projects. In the recent decade, a total of US$95 billion of infrastructure sukuk has been issued by more than 10 different countries. In Asia, it is estimated that a funding of US$8.3 trillion is required until 2020 for infrastructure projects, while the funding requirements in the Middle East are estimated to be US$2 trillion over the same period. Developing economies in Africa have also already begun its entry into the sukuk market for such infrastructure financing with some having put in place the legal groundwork for such sukuk issuances. However, low sovereign ratings have limited the ability of certain high-growth developing countries to source such funding, despite being rich in natural resources. Countries that are rich in natural resources may however, pledge these resources for such issuance. Funding may thus be secured arising from the securitisation of such assets. Given the recourse to the asset by investors, it provides the incentive for disciplined and appropriate governance of the management of the project. Additionally, multilateral development banks may also facilitate this process by providing credit guarantees to these countries to reduce the financing cost and improve the quality of the sukuk issuances. On this front, multilateral development banks such as The Islamic Development Bank (IDB) Group and The Asian Development Bank (ADB) commenced initiatives to support member countries to

296 P a g e 296 leverage on Islamic finance for sourcing of funds, through the provision of advisory services, capacity development and technical assistance. Allow me to now share Malaysia's experience in the development of the sukuk market in our Islamic finance marketplace. The Islamic capital market in Malaysia has been systematically developed to ensure accessibility whilst ensuring the protection of investors and efficiency in the intermediation process. The initiatives to develop the market are also strongly backed by the legal and Shariah framework which is further supported by a robust financial infrastructure, including the settlement and bond information system that enables Malaysia to provide a complete sukuk issuance and trading platform. Since the first sukuk issuance in 1990 by a multinational corporation in Malaysia, the sukuk outstanding in the Malaysian marketplace is now US$158 billion. In 2002, the Malaysian government issued its inaugural global sovereign sukuk, raising US$600 million, which became an international benchmark for the issuance of global sovereign sukuk. The marketplace has now been liberalised to allow for multilateral financial institutions, multinational and national corporations from other jurisdictions to issue both ringgit and non-ringgit denominated sukuk in our sukuk market with increasing foreign investor participation in such issuances The sukuk market in Malaysia has seen wide ranging innovative structures and a greater diversity in the type and maturity of the sukuk. A landmark issuance is the US$750 million exchangeable sukuk Musyarakah in 2006 by Khazanah, the government's investment corporation for the purpose of selling a stake in Telekom Malaysia.

297 P a g e 297 It marked the first issuance of its kind, incorporating full convertibility features common to conventional equity-linked transactions. A further notable issuance was the pioneering retail exchange-traded sukuk to raise funds for a transportation project that allowed retail investors the opportunity to have direct access to the sukuk and thus a stake in a massive infrastructure development in the country, therefore broadening the range of low-risk investment products available to such investors. In terms of maturity, the ringgit sukuk market has seen issuances of maturities to 30 years which were well received by the financial market. Regular sukuk issuances with different maturities by the Malaysian government has also created a benchmark yield curve for market reference, of which is complimented by the establishment of a number of indices for non-ringgit and ringgit denominated sukuk that serve as benchmarks to track the performance of sukuk. These initiatives have progressively contributed towards creating a vibrant secondary sukuk market in Malaysia, with increased depth and liquidity. In complementing the sukuk market as a source for fund raising, also being explored are other funding channels to assist small and medium enterprises, new growth industries and entrepreneurs that have limited access to the sukuk market. A multi-bank investment platform is now being developed for the effective matching of funds from potential investors with targeted industries and ventures in the real sector. Foreign Islamic financial institutions and investors also stand to benefit from this platform, with the offering of multi-currency financing options for foreign projects. The platform facilitates Islamic banks to perform investment intermediation functions.

298 P a g e 298 It enhances further the intermediation role of the Islamic banking institutions to also function as an investment intermediary. In an increasingly internationalised global financial marketplace that has generated significant cross-border flows, one of the requirements as we advance forward is the need for more tradeable cross-border Islamic financial instruments that can cater to the different profiling of investors' risk appetites. The issuance of the short-term sukuk by the International Islamic Liquidity Management Corporation (IILM) is a breakthrough in innovation towards increasing cross-border liquidity flows that could potentially enhance financial stability and the efficient functioning of the Islamic financial markets. Let me conclude my remarks. There is clear indication of the growing relevance and importance of the sukuk market, with the growing interest from both emerging and developed jurisdictions and the strategic approaches taken to diversify the funding sources through the sukuk market. The overall direction and potential of the global sukuk market are certainly well recognised, particularly in its role in contributing towards greater economic development. There is significant potential for the sukuk, in particular to fund infrastructure projects. This is particularly relevant for the GCC, African and Asian regions given the infrastructure needs going forward. This would contribute towards building deeper and more liquid, efficient and effective global sukuk market. The dynamism of the sukuk market also contributes towards strengthening financial stability and in facilitating the expansion of inter-regional investment flows.

299 P a g e 299 As we move towards increasing this internationalisation of Islamic finance, and thus towards greater global financial integration, it will contribute towards a global growth process and financial stability that will be mutually reinforcing.

300 P a g e 300 Opening statement before the Senate Standing Committee on Banking, Trade and Commerce Speech by Mr Stephen S Poloz, Governor of the Bank of Canada, to the Senate Standing Committee on Banking, Trade and Commerce, Ottawa, Ontario Good afternoon, Mr. Chairman and committee members. I am pleased to introduce you to Carolyn Wilkins, who assumed the post of Senior Deputy Governor of the Bank of Canada on 2 May of this year. Before we take your questions, let me give you some of the highlights of the economic outlook. I'll draw mainly on the October Monetary Policy Report (MPR), which the Bank published last week, but I'll also reflect back a bit further since it has been some time since we last met. I'll touch on some new advances in our thinking, and talk about how the environment is driving an evolution in the way central bankers conduct monetary policy. Our outlook for the global economy continues to show stronger momentum in 2015 and 2016, but the forecast profile has been downgraded since July. The good news for Canada is that the U.S. economy is gaining traction, particularly in sectors that are beneficial to Canada's exports. And our exports do appear to be responding, with some additional help from a lower Canadian dollar. Our conversations with exporters indicate that they are seeing a better export outlook from the ground. However, it is clear that our export sector is less robust than in previous cycles.

301 P a g e 301 Last spring, as you may recall, we identified which non-energy subsectors could be expected to lead the recovery in exports, and which would not. We have since investigated in more detail the subsectors that have been underperforming. After sifting through more than 2,000 product categories, we have found that the value of exports from about a quarter of them has fallen by more than 75 per cent since the year Had the exports of these products instead risen in line with foreign demand, they would have contributed about $30 billion in additional exports last year. By correlating these findings with media reports, we could see that many were affected by factory closures or other restructurings. In other words, capacity in these subsectors has simply disappeared. This analysis helps us understand a significant portion of the gap in export performance. Our research also tells us that most of the sectors expected to lead the recovery in non-energy exports still have some excess capacity. Our Business Outlook Survey interviews indicate that while companies plan to invest in new machinery and equipment, few are planning to expand their capacity, at least so far. This helps explain why business investment might be delayed relative to what would be expected in a normal cycle. This research has important implications for Canada's employment picture. We know that when companies restructure or close their doors, the associated job losses are usually permanent.

302 P a g e 302 If companies can meet increased export demand with existing capacity, the associated employment gains can be fairly modest, with most of the increase in output coming in the form of higher productivity. The bigger employment gains will come when we enter the rebuilding phase of the cycle - when companies are sufficiently confident about future export demand that they begin to invest in new capacity and create new jobs. These considerations enter into our estimation of the output gap - the difference between GDP and potential GDP - which is the key macroeconomic determinant of the outlook for underlying inflation. When the economy moves into a position of excess supply, inflation declines, and when it moves into a position of excess demand, inflation rises. There is no single preferred measure of capacity in the economy. Traditionally, we have put the most weight on measures based on output, or GDP. Each October, we do a full analysis of the determinants of potential output, and its future trend. We have done so in this MPR, but in future we will update this analysis in every MPR. This time, we also offer a special technical box that considers the dynamics of excess capacity in longer business cycles like this one. The reason this is important is that in such longer business cycles, the restructuring or closure of firms reduces potential output while creating permanent job losses. This means that the output gap can appear smaller than the labour market gap, which is our current situation.

303 P a g e 303 This difference persists until after the rebuilding phase of the recovery I discussed earlier, when the excess capacity measures eventually converge. Our judgment is that we have considerable excess capacity and that continued monetary stimulus is needed to close the gap and bring inflation sustainably to target. But we take account of our uncertainty around the degree of slack by considering a range of possible slack estimates in our deliberations. Another important building block of our policy framework is the neutral rate of interest. The neutral rate is the rate of interest that should emerge once all the dust has settled - inflation is on target, the economy is operating at its full capacity, and all shocks have been worked out. Carolyn discussed this in an important speech last month; there is also a discussion paper about it on our website and a box in this MPR. The neutral rate, too, is uncertain. We estimate that it now lies between 3 and 4 per cent, which is well below pre-crisis levels. But since the difference between current rates and the neutral rate is our best estimate of monetary stimulus, understanding the risks around this is also important. After weighing these considerations, it is our judgment at this time that the risks around achieving our inflation objective over a reasonable time frame are roughly balanced. Accordingly, we believe that the current level of monetary stimulus remains appropriate. Just as our analysis of the economic forces has been evolving with events as they transpire, so is the way we conduct monetary policy adapting in real time to the changing environment.

304 P a g e 304 There is now particular emphasis on the incorporation of uncertainty into policy decision making. We published a discussion paper on the subject earlier this month. We have begun putting our growth and inflation forecasts in the form of ranges rather than points, and have given even more prominence to uncertainty and risks in the MPR. We've refined our analysis of financial stability risks and raised the profile of our Financial System Review. And, we have begun to offer a more fulsome description of how those risks are entering our policy deliberations, particularly in the opening statement that precedes our press conferences. These changes have brought more transparency to our decision making, and our policy narrative has shifted from one traditionally seen almost as "mechanical engineering" to one now characterized as "risk management." One powerful risk management tool that policy-makers have in their tool kit is forward guidance - the ability to provide to markets more certainty about the future path of interest rates. This effectively takes uncertainty out of the market and places it firmly on the shoulders of the central bank. There are costs as well as benefits to using this tool, and so we have decided that forward guidance will be reserved for times when we believe the benefits to its use are clear - periods of market stress, periods when traditional monetary policy tools are constrained, and so on. Otherwise, we will let markets do their job, which is to deal with the daily flow of new information and grind out new pricing, without specific interest rate guidance from the Bank, but supported by the increased transparency around our outlook for inflation and the risks we are managing. And with that, Carolyn and I would be pleased to answer your questions.

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