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  1. P age |1 InternationalAssociationofRiskandComplianceProfessionals(IARCP) 1200GStreet NWSuite800Washington,DC20005-6705USATel:202-449-9750www.risk-compliance-association.com Top10riskandcompliancemanagementrelatednewsstoriesandworldeventsthat(forbetterorforworse)shapedthe week'sagenda,andwhatisnext DearMember, Whichis thedifferencebetweentriggersandvulnerabilities? DearMrBernanke,can youclarifyplease? Hedid,atthe49thAnnualConferenceonBankStructureandCompetitionsponsoredbytheFederalReserveBankofChicago,Chicago,Illinois He said: “Torespondtothispoint,Iwilldistinguish,asIhaveelsewhere,betweentriggersandvulnerabilities. Thetriggersofanycrisisaretheparticulareventsthat touchoffthecrisis--theproximatecauses,ifyouwill. Forthe2007-09crisis,aprominenttriggerwasthelossessufferedbyholdersofsubprimemortgages. Incontrast,thevulnerabilitiesassociatedwithacrisisarepreexistingfeaturesofthefinancialsystemthatamplifyandpropagatetheinitialshocks. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  2. P age |2 Examplesofvulnerabilitiesincludehighlevelsofleverage,maturity transformation,interconnectedness,andcomplexity,allofwhichhavethepotentialtomagnifyshocks to thefinancialsystem. Absentvulnerabilities,triggersmightproducesizablelossestocertainfirms,investors,orassetclassesbutwouldgenerallynotleadtofull-blownfinancialcrises;thecollapseoftherelativelysmallmarketforsubprimemortgages,forexample,wouldnothavebeennearlyasconsequentialwithoutpreexistingfragilitiesinsecuritizationpracticesandshort-termfundingmarketswhichgreatlyincreaseditsimpact.” Didyouaddressvulnerabilitiesthisweek? MrBernankecontinued: “Moreover,attemptsto addressspecificvulnerabilitiescanbesupplementedbybroadermeasures--suchasrequiringbankstoholdmorecapitalandliquidity--thatmakethesystemmoreresilienttoarangeofshocks.” ReadmoreatNumber1below. Welcome totheTop10list. BestRegards, GeorgeLekatisPresidentoftheIARCP GeneralManager,ComplianceLLC1200GStreetNWSuite800, WashingtonDC20005,USATel:(202)449-9750 Email:lekatis@risk-compliance-association.comWeb:www.risk-compliance-association.com HQ:1220N.MarketStreetSuite804,WilmingtonDE19801,USA Tel:(302)342-8828 InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  3. P age |3 ChairmanBenS.Bernanke Atthe49thAnnualConferenceonBankStructureandCompetitionsponsoredbytheFederalReserveBankofChicago,Chicago,Illinois MonitoringtheFinancialSystem “Wearenowmorethanfouryearsbeyondthemostintensephaseofthefinancialcrisis,butitslegacyremains. Oureconomyhasnotyetfullyregainedthejobslostintherecessionthataccompaniedthefinancialnearcollapse. Andourfinancialsystem--despitesignificanthealingoverthepastfouryears--continues to strugglewiththeeconomic,legal,andreputationalconsequencesoftheeventsof2007to2009.” ErkkiLiikanen Bankingstructureandmonetarypolicy– whathavewe learnedinthelast20years? PresentationbyMrErkkiLiikanen,GovernoroftheBankofFinlandandChairmanoftheHighlevelExpertGrouponthestructureoftheEUbankingsector,attheconference“Twenty yearsoftransition–experiencesandchallenges”,arrangedbytheNationalBankofSlovakia,Bratislava. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  4. P age |4 TheimpactofthecrisisonfinancialintegrationinCentralandEasternEurope SpeechbyMrIgnazioVisco,GovernoroftheBankofItaly,attheconference“Twentyyears oftransition–experiencesandchallenges”,hostedby theNationalBankofSlovakia,Bratislava “ThetransitioncountriesofCentralandEasternEuropewerenoexception:theirquiterapidfinancialintegrationoverthepast twenty-yearsbrought aboutlastingeconomicbenefits,butalsoleft themrelativelyexposedtotheglobalfinancialturmoil,in particularthroughtheirlinks withWesternEuropeanbankswhichholddominantstakesintheregion’smarkets.” Revisedrulesformarketsinfinancialinstruments(MiFID/MiFIR) ProposalforaDirectiveoftheEuropean ParliamentandoftheCouncilonmarketsin financialinstrumentsrepealingDirective2004/39/EC ofthe EuropeanParliamentandoftheCouncil(Recast)(MiFID) ProposalforaRegulationoftheEuropeanParliamentandoftheCouncilonmarketsinfinancialinstrumentsandamendingRegulation[EMIR]onOTCderivatives,centralcounterpartiesandtraderepositories(MiFIR) InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  5. P age |5 APRAreleasessecondconsultationpackageforthe supervisionofconglomerategroups TheAustralianPrudentialRegulationAuthority(APRA)hasreleasedforconsultationproposedriskmanagementandcapitaladequacyrequirementsforthesupervisionofconglomerategroups. Conglomerategroups,referredto asLevel3groups,aregroupscomprisingAPRA-regulatedinstitutionsthatperformmaterialactivitiesacrossmorethanoneAPRA-regulatedindustryand/orinoneormorenon-APRA-regulatedindustry. GovernorElizabethA.Duke AttheHousingPolicyExecutiveCouncil,Washington,D.C. AViewfromtheFederalReserveBoard:TheMortgageMarketandHousingConditions “SincejoiningtheBoardin2008amidacrisiscenteredonmortgagelending,Ihavefocusedmuchofmyattentiononhousingandmortgagemarkets,issuessurroundingforeclosures,andneighborhoodstabilization. In Marchofthisyear,Ilaid outmythoughtsoncurrentconditionsinthehousingandmortgagemarketsin aspeechtotheMortgageBankersAssociation.” InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  6. P age |6 TheNeedforRobustSECOversightofSROs By Commissioner LuisA.Aguilar U.S. SecuritiesandExchangeCommissionWashington,D.C. ProposalforastructuralreformofEUbanks “ThereareconcernsthatlargeEUbankinggroups,aredifficult tomanage,monitor,andsupervise. Furthermore,theymayalsobedifficultto resolve,due to theircomplexity,interconnectedness,geographicscope,andability to expandrapidly. Also,theunrestrictedco-minglingofdepositssubjecttogovernmentguaranteeswithmarketandtradingactivitiesmaysubjectdepositorstoadditionalrisks.” InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  7. P age |7 APRAreleasessecondconsultationpackageonBaselIIIliquidityreforms TheAustralian PrudentialRegulationAuthority(APRA)hastodayreleasedasecondconsultationpackageoutliningitsproposedimplementationoftheBaselIIIliquidityreformsforauthoriseddeposit-takinginstitutions(ADIs)inAustralia. Thepackageincludesadiscussionpaper,areviseddraftPrudentialStandardAPS210Liquidity(APS210)andadraftPrudentialPracticeGuideAPG210Liquidity. OTCderivativesstatisticsatend-December2012 MonetaryandEconomicDepartmentMay2013 “Notionalamountsfor interestratederivatives,thelargestsegmentofthemarket,stoodat$490trillionatend-2012. Whiletheoverallfigurewasmoreorlessunchangedfromend-June2012,breakdownsshowedoffsettingmovements. Forswaps,notionalamountsdroppedinthesecondhalfof2012byabout2%to$370trillion,owinginpart to thecompressionoftradesthroughcentralcounterparties(CCPs).” InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  8. P age |8 ChairmanBenS.Bernanke Atthe49thAnnualConferenceonBankStructureandCompetitionsponsoredbytheFederalReserveBankofChicago,Chicago,Illinois MonitoringtheFinancialSystem Wearenowmorethanfouryearsbeyondthemostintensephaseofthefinancialcrisis,butitslegacyremains. Oureconomyhasnotyetfullyregainedthejobslostintherecessionthataccompaniedthefinancialnearcollapse. Andourfinancialsystem--despitesignificanthealingoverthepastfouryears--continues to strugglewiththeeconomic,legal,andreputationalconsequencesoftheeventsof2007to2009. Thecrisisalsoengenderedmajorshiftsinfinancialregulatorypolicyand practice. NotsincetheGreatDepressionhaveweseensuchextensivechangesinfinancialregulationasthosecodifiedintheDodd-FrankWallStreetReformandConsumerProtectionAct(Dodd-FrankAct)intheUnitedStatesand,internationally,intheBaselIIIAccordandarangeofotherinitiatives. Thisnewregulatoryframeworkisstillunderconstruction,buttheFederalReservehasalreadymadesignificantchangestohowitconceptualizesandcarriesoutbothitsregulatoryandsupervisoryroleanditsresponsibility to fosterfinancialstability. In myremarks todayIwilldiscussthe FederalReserve'seffortsinanareathattypicallygetslessattentionthanthewritingandimplementation ofnewrules--namely,ourongoingmonitoringofthefinancialsystem. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  9. P age |9 Ofcourse,theFedhasalwayspaidcloseattentiontofinancialmarkets,forbothregulatoryandmonetarypolicypurposes. However,inrecentyears,wehavebothgreatlyincreasedtheresourceswedevotetomonitoringandtakenamoresystematicandintensiveapproach,ledbyourOfficeofFinancialStabilityPolicyandResearchand drawingonsubstantialresourcesfromacrosstheFederalReserveSystem. Thismonitoringinformsthepolicy decisionsofboththeFederalReserveBoardandtheFederalOpenMarketCommitteeaswellasourworkwithotheragencies. Thestep-upinourmonitoringismotivatedimportantlybyashiftinfinancialregulationandsupervision towardamoremacroprudential,orsystemic,approach,supplementingourtraditionalmicroprudentialperspectivefocusedprimarilyonthehealthofindividualinstitutionsandmarkets. Inthespiritofthismoresystemicapproachtooversight,theDodd-FrankActcreatedtheFinancialStabilityOversightCouncil(FSOC),whichiscomprisedoftheheadsofanumberoffederalandstateregulatoryagencies. TheFSOChasfosteredgreaterinteractionamongfinancialregulatoryagenciesaswellasasenseofcommonresponsibilityforoverallfinancialstability. Councilmembersregularlydiscussriskstofinancialstabilityand produceanannualreport,whichreviewspotentialrisksandrecommendswaystomitigate them. TheFederalReserve'sbroad-basedmonitoringeffortshavebeenessentialforpromotingacloseandwell-informedcollaborationwithotherFSOCmembers. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  10. P age |10 AFocusonVulnerabilities Ongoingmonitoringofthefinancialsystemisvitalto themacroprudentialapproach to regulation. Systemicrisks can onlybedefusediftheyarefirstidentified. Thatsaid,itisreasonabletoaskwhethersystemicriskscaninfactbereliablyidentifiedinadvance;afterall,neithertheFederalReservenoreconomistsingeneralpredictedthepastcrisis. Torespondtothispoint,Iwilldistinguish,asIhaveelsewhere,betweentriggersandvulnerabilities. Thetriggersofanycrisisaretheparticulareventsthat touchoffthecrisis--theproximatecauses,ifyouwill. Forthe2007-09crisis,aprominenttriggerwasthelossessufferedbyholdersofsubprimemortgages. Incontrast,thevulnerabilitiesassociatedwithacrisisarepreexistingfeaturesofthefinancialsystemthatamplifyandpropagatetheinitialshocks. Examplesofvulnerabilitiesincludehighlevelsofleverage,maturity transformation,interconnectedness,andcomplexity,allofwhichhavethepotentialtomagnifyshocks to thefinancialsystem. Absentvulnerabilities,triggersmightproducesizablelossestocertainfirms,investors,orassetclassesbutwouldgenerallynotleadtofull-blownfinancialcrises;thecollapseoftherelativelysmallmarketforsubprimemortgages,forexample,wouldnothavebeennearlyasconsequentialwithoutpreexistingfragilitiesinsecuritizationpracticesandshort-termfundingmarketswhichgreatlyincreaseditsimpact. Ofcourse,monitoringcananddoesattempt to identifypotentialtriggers--indicationsofanassetbubble,forexample--butshocksofonekindoranotherareinevitable,soidentifyingandaddressing InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  11. P age |11 vulnerabilitiesiskeyto ensuringthatthefinancialsystemoverallisrobust. Moreover,attemptstoaddressspecificvulnerabilitiescanbesupplementedbybroadermeasures--suchasrequiringbankstoholdmorecapitalandliquidity--thatmakethesystemmoreresilienttoarangeofshocks. Two otherrelatedpointsmotivateourincreasedmonitoring. Thefirstisthatthefinancialsystemisdynamicandevolving notonlybecauseofinnovationandthechangingneedsoftheeconomy,butalsobecausefinancialactivities tend tomigratefrommore-regulatedto less-regulatedsectors. AninnovativefeatureoftheDodd-FrankActisthatitincludesmechanisms topermittheregulatorysystem,atleastinsomecircumstances,toadapttosuchchanges. Forexample,the actgivestheFSOCpowerstodesignatesystemicallyimportantinstitutions,marketutilities,andactivitiesforadditionaloversight. Suchdesignationisessentiallyadeterminationthataninstitutionoractivitycreatesorexacerbatesavulnerabilityofthefinancialsystem,adeterminationthatcanonlybemadewithcomprehensivemonitoringandanalysis. Thesecondmotivationformoreintensivemonitoringistheapparent tendencyforfinancialmarketparticipants totakegreaterrisks whenmacroconditionsarerelativelystable. Indeed,itmaybethatprolongedeconomicstabilityisadouble-edgedsword. Tobesure,afavorable overallenvironmentreducescreditrisk andstrengthensbalancesheets,allelsebeingequal,butitcouldalsoreduce InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  12. P age |12 theincentivesformarketparticipants totakereasonableprecautions,whichmaylead inturntoabuildupoffinancialvulnerabilities. Probablyourbestdefenseagainstcomplacencyduringextendedperiodsofcalmiscarefulmonitoringforsignsofemergingvulnerabilitiesand,whereappropriate,thedevelopmentofmacroprudentialand otherpolicytoolsthatcanbeused to addressthem. TheFederalReserve'sFinancialStabilityMonitoringProgramSo,whatspecificallydoes theFederalReservemonitor? In theremainderofmyremarks,I'llhighlightanddiscussfourcomponentsofthefinancialsystemthatareamongthosewefollow mostclosely:systemicallyimportantfinancialinstitutions(SIFIs),shadowbanking,assetmarkets,andthenonfinancialsector. SystemicallyImportantFinancialInstitutions SIFIs arefinancialfirmswhosedistressorfailurehasthepotentialtocreatebroaderfinancialinstabilitysufficienttoinflictmeaningfuldamageontherealeconomy. SIFIstendtobelarge,butsizeisnottheonlyfactorused todeterminewhetherafirmissystemicallyimportant;otherfactorsincludethefirm'sinterconnectednesswiththerestofthefinancialsystem,thecomplexityandopacityofitsoperations,thenatureandextentofitsrisk-taking,itsuseofleverage,itsrelianceonshort-termwholesalefunding,andtheextentofitscross-borderoperations. UndertheDodd-FrankAct,thelargestbankholdingcompaniesaretreatedasSIFIs; in addition,asImentioned,theactgivestheFSOCthepowertodesignateindividualnonbankfinancialcompaniesassystemicallyimportant. Thisdesignationprocessisunderway. Dodd-FrankalsoestablishesaframeworkforsubjectingSIFIs tocomprehensivesupervisoryoversightandenhancedprudentialstandards. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  13. P age |13 Forallsuchcompanies,theFederalReservewillhaveaccesstoconfidentialsupervisoryinformationandwillmonitorstandardindicatorssuchasregulatorycapital,leverage,andfundingmix. However,someofthesemeasures,suchasregulatorycapitalratios,tendtobebackwardlookingandthusmaybeslow to flagunexpected,rapidchangesintheconditionofafirm. Accordingly,wesupplementthemorestandardmeasureswith othertypesof information. Onevaluablesourceofsupplementaryinformationisstresstesting. Regular,comprehensivestresstestsareanincreasinglyimportantcomponentoftheFederalReserve'ssupervisorytoolkit,havingbeenusedinourassessmentoflargebankholdingcompaniessince2009. Toadministerastresstest,supervisorsfirstconstructahypotheticalscenariothatassumesasetofhighlyadverseeconomicandfinancial developments--forexample,adeeprecessioncombinedwithsharp declinesinthepricesofhousesand otherassets. Thetestedfirmsandtheirsupervisorsthenindependentlyestimatefirms'projectedlosses,revenues,and capitalunderthehypotheticalscenario,andtheresultsarepubliclydisclosed. Firmsareevaluatedbothontheirpost-stress capitallevelsandontheirability to analyzetheirexposuresand capitalneeds. Stress testingprovidesanumberofadvantagesovermore-standardapproachestoassessingcapitaladequacy. First,measuresofcapitalbasedonstresstestsarebothmoreforwardlookingandmorerobustto"tailrisk"--thatis,toextremelyadversedevelopmentsofthesortmostlikelytofosterbroad-basedfinancialinstability. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  14. P age |14 Second,becausetheFederalReserveconductsstresstestssimultaneouslyonthemajorinstitutionsitsupervises,theresults canbeusedbothforcomparativeanalysesacrossfirmsandtojudgethecollectivesusceptibilityofmajorfinancialinstitutionstocertaintypesofshocks. Indeed,comparativereviewsoflargefinancialinstitutionshavebecomeanincreasinglyimportantpartoftheFederalReserve'ssupervisorytoolkitmoregenerally. Third,thedisclosureofstress-testresults,whichincreasedinvestorconfidenceduringthecrisis, canalsostrengthenmarketdisciplineinnormaltimes. Thestressteststhusprovidecriticalinformationaboutkeyfinancialinstitutionswhilealsoforcingthefirmstoimprovetheirability tomeasureandmanagetheirriskexposures. Stress-testingtechniques canalsobeusedinmore-focusedassessmentsofthebankingsector'svulnerabilitytospecificrisksnotcapturedinthemainscenario,suchasliquidityriskor interestraterisk. Likecomprehensivestresstests,suchfocusedexercisesareanimportantelementofoursupervisionofSIFIs. Forexample,supervisorsarecollectingdetaileddataonliquiditythathelpthemcomparefirms'susceptibilitiesto varioustypesoffundingstressesandtoevaluatefirms'strategiesformanagingtheirliquidity. Supervisorsalsoareworkingwithfirmstoassesshowprofitabilityandcapital wouldfareundervariousstressfulinterestratescenarios. FederalReservestaffmemberssupplementsupervisoryandstress-testinformationwithothermeasures. Forexample,thoughsupervisorshavelongappreciatedthevalueofmarket-basedindicatorsinevaluatingtheconditionsofsystemicallyimportantfirms(or,indeed,anypubliclytradedfirm),ourmonitoring InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  15. P age |15 programusesmarketinformationtoamuchgreaterdegreethaninthepast. Thus,inadditiontostandardindicators--suchasstockpricesandthepricesofcreditdefaultswaps,which capturemarketviewsaboutindividualfirms--weusemarket-basedmeasuresofsystemicstabilityderivedfromrecentresearch. Thesemeasuresusecorrelationsofassetpricestocapturethemarket'sperceptionofagivenfirm'spotentialtodestabilizethefinancialsystematatimewhenthebroaderfinancialmarketsarestressed;othermeasuresestimatethevulnerabilityofagivenfirmto disturbancesemanatingfromelsewhereinthesystem. Thefurtherdevelopmentofmarket-basedmeasuresofsystemicvulnerabilitiesandsystemicrisk isalivelyareaofresearch. Networkanalysis,yetanotherpromisingtoolunderactivedevelopment,hasthepotentialtohelpusbettermonitortheinterconnectednessoffinancialinstitutionsandmarkets. Interconnectednesscanarisefromcommonholdingsofassetsorthroughtheexposuresoffirmstotheircounterparties. Networkmeasuresrelyonconceptsusedin engineering,communications,andneurosciencetomaplinkages amongfinancialfirmsandmarketactivities. Thegoalsaretoidentifykeynodesorclustersthatcoulddestabilizethesystemandtosimulatehowashock,suchasthesuddendistressofafirm,couldbetransmittedandamplifiedthroughthenetwork. Thesetoolscanalsobeusedtoanalyzethesystemicstabilityeffectsofachangeinthestructureofanetwork. Forexample,marginrulesaffectthesensitivityoffirmstotheconditionsoftheircounterparties;thus,marginrulesaffectthelikelihoodoffinancialcontagionthroughvariousfirmsandmarkets. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  16. P age |16 Shadow Banking Shadowbanking,asecondareawecloselymonitor,wasanimportantsourceofinstabilityduringthecrisis. Shadowbankingcomprisesvariousmarketsandinstitutionsthatprovidefinancialintermediationoutsidethetraditional,regulatedbankingsystem. Shadowbankingincludesvehiclesforcreditintermediation,maturity transformation,liquidityprovision,andrisk sharing. Suchvehiclesaretypicallyfundedonalargelyshort-termbasisfromwholesalesources. In therun-up tothecrisis,theshadowbankingsector involvedahigh degreeofmaturitytransformationandleverage. Illiquidloanstohouseholdsandbusinessesweresecuritized,andthetranchesofthesecuritizationswiththehighestcreditratingswerefunded byveryshort-termdebt,suchasasset-backedcommercialpaperandrepurchaseagreements(repos). Theshort-termfundingwasinturnprovidedbyinstitutions,suchas moneymarketfunds, whoseinvestorsexpectedpaymentinfullondemandandhadlittletoleranceforrisktoprincipal. Asitturnedout,theultimateinvestorsdidnotfullyunderstandthequalityoftheassetstheywerefinancing. Investorswerelulledbytriple-Acreditratingsandbyexpectedsupportfromsponsoringinstitutions--supportthatwas,infact, discretionaryand notalwaysprovided. Wheninvestorslostconfidenceinthequalityoftheassetsor intheinstitutionsexpected toprovidesupport,theyran. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  17. P age |17 Theirflightcreatedseriousfundingpressuresthroughoutthefinancialsystem,threatenedthesolvencyofmanyfirms,andinflictedseriousdamageonthebroadereconomy. Securitiesbroker-dealersplayacentralrolein manyaspectsofshadowbankingasfacilitatorsofmarket-basedintermediation. Tofinancetheirownandtheirclients'securitiesholdings,broker-dealerstendtorelyonshort-termcollateralizedfunding,oftenintheformofrepoagreementswithhighlyrisk-averselenders. Thecrisisrevealedthatthisfundingispotentiallyquitefragileiflendershavelimitedcapacity to analyzethecollateralorcounterpartyrisksassociatedwithshort-termsecuredlending,butratherlookatthesetransactionsasnearlyrisk free. Asquestionsemergedaboutthenatureandvalueofcollateral,worriedlenderseithergreatlyincreasedmarginrequirementsor,morecommonly,pulledbackentirely. Borrowersunable tomeetmargincallsandfinancetheirassetholdingswereforced to sell,drivingdownassetpricesfurtherandsettingoffacycleofdeleveragingandfurtherassetliquidation. Tomonitorintermediationbybroker-dealers,theFederalReservein2010createdaquarterlySeniorCreditOfficerOpinionSurveyonDealerFinancingTerms,which asksdealersaboutthecredittheyprovide. Modeledonthelong-establishedSeniorLoanOfficerOpinionSurveyonBankLendingPracticessent to commercialbanks,thesurveyofseniorcreditofficersatdealerstracksconditionsin marketssuchasthoseforsecuritiesfinancing,primebrokerage,andderivativestrading. Thecreditofficersurveyisdesigned tomonitorpotentialvulnerabilitiesstemmingfromthegreateruseofleveragebyinvestors(particularly throughlending backedbyless-liquidcollateral)orincreasedvolumesofmaturitytransformation. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  18. P age |18 Beforethefinancialcrisis,wehadonlyverylimitedinformationregardingsuchtrends. Wehave otherpotentialsourcesofinformationaboutshadowbanking.TheTreasuryDepartment'sOfficeofFinancialResearchandFederalReservestaffarecollaboratingtoconstructdatasetsontripartyand bilateralrepotransactions,whichshouldfacilitatethedevelopmentof bettermonitoringmetricsforrepo activityandimprovetransparencyinthesemarkets. Wealsotalkregularly to marketparticipants aboutdevelopments,payingparticularattentiontothecreationofnewfinancialvehiclesthatfostergreatermaturitytransformationoutsidetheregulatedsector,providefundingforless-liquidassets,ortransformrisksfromformsthataremoreeasilymeasuredtoformsthataremoreopaque. Afairsummaryisthat,whiletheshadowbankingsectorissmallertodaythanbeforethecrisisandsomeofitsleaststablecomponentshaveeitherdisappearedorbeenreformed,regulatorsandtheprivatesectorneedtoaddressremainingvulnerabilities. Forexample,althoughmoneymarketfundswerestrengthenedbyreformsundertakenbytheSecuritiesandExchangeCommission(SEC)in2010,thepossibilityofarunonthesefundsremains--forinstance,ifafundshould"breakthebuck,"orreportanetassetvaluebelow 99.5cents,astheReservePrimaryFunddidin2008. TheriskisincreasedbythefactthattheTreasurynolongerhasthepowertoguaranteeinvestors'holdingsinmoneyfunds,anauthoritythatwascriticalforstoppingthe2008run. In November2012,theFSOCproposedforpubliccommentsomealternativeapproachesforthereformofmoneyfunds. TheSECiscurrentlyconsideringtheseandotherpossiblesteps. Withrespect to thetripartyrepoplatform,progresshasbeenmadeinreducingtheamountofintradaycreditextendedbytheclearingbanks in InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  19. P age |19 thecourseofthedailysettlementprocess,and,asadditionalenhancementsaremade,theextensionofsuchcreditshouldbelargelyeliminatedbytheendof2014. However,importantrisksremainintheshort-termwholesalefundingmarkets. Oneofthekeyrisksishowthesystemwouldrespondtothefailureofabroker-dealerorothermajorborrower. TheDodd-FrankActhasprovidedimportantadditionaltoolstodealwiththisvulnerability,notablytheprovisionsthatfacilitateanorderlyresolutionofabroker-dealerorabroker-dealerholdingcompanywhoseimminentfailureposesasystemicrisk. But,ashighlightedintheFSOC'smostrecentannualreport,moreworkisneededtobetterprepareinvestorsandothermarketparticipantstodealwiththepotentialconsequencesofadefaultbyalargeparticipantintherepomarket. AssetMarkets Assetmarketsareathirdarea thatwecloselymonitor. Wefollow developmentsinmarketsforawiderangeofassets,includingpublicandprivatefixed-incomeinstruments,corporateequities,realestate,commodities,andstructuredcreditproducts,amongothers. Foreignaswellasdomesticmarketsreceivecloseattention,asdogloballinkages,suchastheeffectsoftheongoingEuropeanfiscalandbankingproblemsonU.S.markets. Notsurprisingly,wetrytoidentifyunusualpatternsinvaluations,suchashistoricallyhighorlow ratiosofpricesto earningsinequitymarkets. Weuseavarietyofmodelsandmethods;forexample,weuseempiricalmodelsofdefaultriskandriskpremiumsto analyzecreditspreadsin corporatebondmarkets. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  20. P age |20 Theseassessmentsarecomplementedbyotherinformation,includingmeasuresofvolumes,liquidity,andmarketfunctioning,aswellasintelligencegleanedfrommarketparticipantsandoutsideanalysts. In lightofthecurrentlow interestrateenvironment,wearewatchingparticularlycloselyfor instancesof"reachingforyield"andotherformsofexcessiverisk-taking,whichmayaffectassetpricesandtheirrelationshipswithfundamentals. Itisworthemphasizingthatlookingforhistoricallyunusualpatternsorrelationshipsin assetprices canbeusefulevenifyoubelievethatassetmarketsaregenerallyefficientinsettingprices. Forthepurposeofsafeguardingfinancialstability,wearelessconcernedaboutwhetheragivenassetpriceisjustifiedinsomeaveragesensethaninthepossibilityofasharpmove. Assetpricesthatarefarfromhistoricallynormallevelswouldseemtobemoresusceptibletosuchdestabilizingmoves. Fromafinancialstabilityperspective,however,theassessmentofassetvaluationsisonlythefirststepoftheanalysis. Also tobeconsideredarefactorssuchastheleverageanddegreeofmaturitymismatchbeingusedbytheholdersoftheasset,theliquidityoftheasset,andthesensitivityoftheasset'svaluetochangesinbroadfinancialconditions. Differencesinthesefactorshelpexplainwhythecorrectioninequitymarketsin2000and2001didnotinducewidespreadsystemicdisruptions,whilethecollapseinhousepricesandinthequalityofmortgagecreditduringthe2007-09crisishadmuchmorefar-reachingeffects: Thelossesfromthestockmarketdeclinesin2000and2001werewidelydiffused,whilemortgagelosseswereconcentrated--and,throughvariousfinancialinstruments,amplified--incriticalpartsofthefinancialsystem,resultingultimatelyinpanic,assetfiresales,andthecollapseofcredit markets. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  21. P age |21 NonfinancialSector Ourfinancialstabilitymonitoringextends tothenonfinancialsector,includinghouseholdsandbusinesses. Researchhasidentifiedexcessivegrowthin creditandleveragein theprivatenonfinancialsectoraspotential indicatorsofsystemicrisk. Highlyleveragedorfinanciallyfragilehouseholdsandbusinessesarelessable to withstandadversechangesinincomeorwealth,includingthosebroughtaboutbydeterioratingconditionsinfinancialandcreditmarkets. Ahighlyleveragedeconomyisalsomorepronetoso-calledfinancialacceleratoreffects,aswhenfinanciallystressedfirmsareforcedto layoffworkerswho, inturn,lackingfinancialreserves,sharplycuttheir ownspending. Financialstressin thenonfinancialsector--forexample,higherdefaultratesonmortgagesorcorporatedebt--canalsodamagefinancialinstitutions,creatingapotentialadversefeedbackloopastheyreducetheavailabilityofcreditandshedassetsto conserve capital,therebyfurtherweakeningthefinancialpositionsofhouseholdsandfirms. Thevulnerabilitiesofthenonfinancialsectorcanpotentiallybe captured bybothstock measures(suchaswealthandleverage)andflow measures(suchastheratioof debt service to income). Sector-widedataareavailablefromanumberofsources,importantlytheFederalReserve'sflow offunds accounts,whichisasetofaggregateintegratedfinancialaccountsthatmeasuressourcesandusesoffundsformajorsectorsaswellasfortheeconomyasawhole. Theseaccountsallow ustotrace theflow ofcreditfromitssources,suchasbanks orwholesalefundingmarkets,tothehouseholdandbusinesssectorsthatreceiveit. TheFederalReservealsonowmonitorsdetailed consumer-and business-leveldatasuitedforpickingupchangesinthenatureof InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  22. P age |22 borrowingandlending,aswellasfortrackingfinancialconditionsofthosemostexposedtoacyclical downturnorareversaloffortunes. Forexample,duringthehousingboom,theaggregatedata accuratelyshowedtheoutsizedpaceofhomemortgageborrowing,butitcouldnotrevealthepervasivedeteriorationinunderwritingthatimpliedasubstantialincreaseintheunderlyingcreditrisk fromthatactivity. Morerecently,gainsin householdnetworthhavebeenconcentratedamongwealthierhouseholds,whilemanyhouseholdsinthemiddleorlowerpartsofthedistributionhaveexperienceddeclinesinwealthsincethecrisis. Moreover,manyhomeownersremain"underwater,"withtheirhomesworthlessthantheprincipalbalancesontheirmortgages. Thus,moredetailedinformationclarifiesthatmanyhouseholdsremain morefinanciallyfragilethanmightbeinferredfromtheaggregatestatisticsalone. Conclusion In closing,letmereiteratethatwhiletheeffectiveregulationandsupervisionofindividualfinancialinstitutionswillalwaysbecrucialtoensuringawell-functioningfinancialsystem,theFederalReserveismovingtowardamoresystemicapproachthatalsopayscloseattentiontothevulnerabilitiesofthefinancialsystemasa whole. Towardthatend,wearepursuingan activeprogramoffinancialmonitoring,supportedbyexpandedresearchanddata collection,often undertakeninconjunctionwith otherU.S.financialregulatoryagencies. Ourstepped-upmonitoringandanalysisisalreadyproviding importantinformationfortheBoardandtheFederalOpenMarketCommitteeaswellasforthebroaderregulatorycommunity. Wewillcontinue toworktowardimprovingourabilitytodetectandaddressvulnerabilitiesinourfinancialsystem. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  23. P age |23 ErkkiLiikanen:Bankingstructureandmonetarypolicy–whathavewelearnedinthelast20years? PresentationbyMrErkkiLiikanen,GovernoroftheBankofFinlandandChairmanoftheHighlevelExpertGrouponthestructureoftheEUbankingsector,attheconference“Twentyyearsoftransition– experiencesandchallenges”,arrangedbytheNationalBankofSlovakia,Bratislava. Howistoday’sperspectiveonmonetarypolicydifferentfromwhatprevailed 20yearsago? Twentyyearsago,theworldoftodaywasbeingformedinmanyways. 1993wastheyearwhentheEconomicandMonetaryUnionprojectwasbecomingpoliticalreality:theMaastrichttreatyhadbeensignedandwasintheprocessofbeingratified. Itwasalsothetimewhenthemainstreamapproach tomonetarypolicywasbeginningto convergetotheflexibleinflationtargetingframework. Anumberofcountrieshadthenjustadoptedanexplicitinflationtargetingstrategy. In thesphereofbankingregulation,too,anewerawasbeginning. Asignificantreorientationwasgoingon,awayfromregulatingtheconductofbanks and towardsthenewrisk-basedapproach. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  24. P age |24 Theregulatorytrend,basedonincreasedfreedomforbanksbutsubjecttorisk based capitalrequirements,wouldcontinueallthewayto theeruptionofthefinancialcrisisin2008. IntheEU,thesecondbankingdirectivetookeffectfromthebeginningof1993,creatingasinglemarketinbanking. Thedirectivesoughtto preventdiscriminationand to increaseefficiencythroughcompetition. Therewasdiscussionontheimplicationsofthisforsupervision,butlittleaction. So,whileEuropeanbankingmarketswerebeing integrated,financialsupervisionremainedanationalcompetence. In theU.S.,deregulationwasalsomovingforward. ForinstancetheGlass-SteagallAct,separatingbankingfromsecuritiesandinsurance,wasundergrowingcriticismandwouldbeultimatelyrepealedin 1995. OnereasonforthedissatisfactionwiththeGlass-SteagallsystemintheUSwascompetitionfromEuropeanbankswhichwerelessrestrictedinwhattheycoulddo. Twentyyearsago,thestrikingimprovementinmacroeconomicperformance,laternamed“thegreatmoderation”bychairmanBernanke,wasspreadingtothewholedevelopedworld. Thealmostsurprisingsuccessofmonetarypolicy inimprovingpricestabilityandreducingfluctuationsineconomic activity,whilealsokeepinginterestratesathistoricallylowlevels,wasinterpretedasamajorvictoryfortheartofeconomicpolicymaking. Nowweknowthattherewastroublebrewingunderthesurface. Theunderpinningsofglobalfinancialstabilitywerebecomingweaker. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  25. P age |25 Global indebtednessincreased,fuelledbycurrentaccountbalancesandthe“deepening”ofinternationalfinancialmarkets(read:recyclingthesamefundsseveraltimesover). Thedeclineofinflationwasnotonlydueto monetarypolicy,butalsotheavalancheofcheapconsumergoodsfromtheemergingeconomiessuchasChinacontributed to it. Forbanks,thenewfinancialenvironmentwascharacterizedbylowinterestratesandlowperceivedrisks. Italsoturnedoutthatthenewrisk-basedcapitalrequirementsallowedthebanks toexpandtheirbalancesheetsenormouslywithoutincreasingtheirequity capitalinthesameproportion. So,graduallythelargebankinggroupsstarted to increasetheirtradingportfolios. Thisdevelopmenthappenedinagradualfashioninthe1990’sbutaccelerateddramaticallyfromabout2004. Banksredirectedtheirbusinessfocusfrominterestmarginstofee-basedandtradingactivities. Universalbanking,asithadbeenknowninEurope,startedtochange. Theassetmixofthelargestbanks changedsothatsecuritiesportfoliosactivitiesgrewmoreandmoreimportant. Onlynow,fromtheperspectivegivenbytheworstfinancialcrisissincetheSecondWorldWar,doweseeclearlythefragilityandweaknessoftheregulatoryarrangementswhichcameintoforcein the1990s. From today’spointofview,theyperformedwellonlyaslongasnomajorsystemicrisksmaterialized. Evenworse,theyallowedriskstoaccumulateinthefinancialsystemwhichwereonlywaitingtoberealized. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  26. P age |26 Thencame2007andthecollapseoftheUSpropertymarket;2008andthecollapseofinterbankmoneymarketsfollowingtheLehmanBrotherscrisis;and2009withTheGreatRecession. Thepainfulprocessofcompetitivedeleveragingstarted. Thereassessmentofeconomicpoliciesfollowedinthelasttwo decadeshasalsostarted. Especiallyfinancialregulationhasbeenreconsideredandisbeingstrengthened. Weneedtothinkofmonetarypolicy,too,especiallyin itsconnection tofinancialstability. Monetarypolicyandfinancialstability Thereisacommondictumthatastablefinancialsystemisanecessaryconditionforsuccessfulmonetarypolicy,andthatpricestabilityinturncreatesthebestpreconditionsforfinancialstability. Iagree. Still,theexperienceofthiscrisishasthoughtusalotmore. Firstofall,wenowknowthatpricestabilitydoesnotbyitselfguaranteefinancialstability. Risks can accumulatein thebankingsystemevenifmonetarypolicysucceedsinmaintainingpricestabilityandcontrollinginflationaryexpectationsreallywell. Second,wealsoknowthatcentralbankscanmaintainanadmirabledegreeofpricestabilityevenwhenfinancialstabilityisunderalotofstrain. Dothesetwopointsmeanthatfinancialstabilityandmonetarypolicyare notconnectedafterall? InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  27. P age |27 No. Theyareverycloselyrelated. Independenceofmonetarypolicy Oneofthelastinglessonslearnedinthelastdecadesisthevalueoftheindependenceofmonetarypolicy. Theindependenceofcentralbankshasbeenessentialkeepinginflationexpectationsaswellanchoredastheyhavebeeninthiscrisisdespitealltheturmoilinthefinancialmarkets. Independencehasalsomadeiteasierforcentralbanks to actquicklywhenithasbeennecessaryin ordertomaintainfinancialstability. Itisespeciallyimportant to avoidtwothreatstoindependence:fiscaldominanceandfinancialdominance. Fiscaldominanceisthe olderconceptofthetwo. Itwouldariseifthegovernmentfinancingconstraintwouldbecomeanoverridinginfluenceonmonetarypolicy. Theidea offiscaldominancewasformalizedbyTomSargentandNeilWallacein 1981,butofcoursetheworrythatdeficitfinancingmay causeinflationhasmuchlongerrootsinmonetarythought. Theidea thattightmonetarypolicymaybecomeimpossiblewithoutaccompanyingfiscaladjustmentwasalsowellunderstoodwhentheblueprintsfortheEMUwerebeingprepared. ThisiswhytheMaastrichttreatyhaditsfiscalpolicyclausesandalsowhy theStabilityandGrowthPactwasconcluded. Alsotheprohibitionofdirectcentralbankcredit to thegovernmentandtheinstitutional independenceofthecentralbanks areineffectprotectionsagainstfiscaldominance. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  28. P age |28 Nowweknow,ofcourse,thatthefiscalframeworkasputinplacebeforethestartoftheEMUwasnotstrongenough topreventfiscalproblemsfromemerging. Somehavearguedthatfiscaldominancehas takenholdinthein thebigindustrializedcountriesduringthecrisiswhenthecentralbanks haveusedgovernmentbondpurchasesinordertostabilizethemarkets(astheECB)orto produceadditionalmonetarystimuluswhentheinterestrateinstrumenthasalreadybeenusedtothemaximum(like theFederalReserveandtheBankofJapan). Astotheeuroarea,formethereisnownoevidenceoffiscaldominance.Fiscaldominanceimpliesthatmonetarypolicywouldbreakitspricestabilityobjectiveforthesakeofmaintainingthesolvencyofthegovernmentsector. Thisisnotthecase. Pricestabilityhasnotandwillnotbeabandoned. Wehavewellknownfiscalproblemsinsomeoftheeuroareacountries. Still,theECB’sabilitytogoonmaintainingpricestabilityhasnotbeenweakened. In particulartheinflationexpectations,whicharethemostessentialindicatorsofthecredibilityofmonetarypolicy,haveremainedwellinlinewiththepricestabilityobjective. Theparallelidea offinancialdominanceismorerecentthanfiscaldominance. Financialdominancereferstothepossibilitythattheconditionofthebankingsystemcouldbecomeaconstraint,ordominantinfluence,onmonetarypolicy,effectivelyforcingthecentralbanktopursuesecond-orthird-bestmonetarypoliciesin ordertomaintainfinancialstability. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  29. P age |29 Isthespill-overfromfinancialinstability to monetarypolicyarealisticthreat? Canfinancialstabilityconsiderationsleadthecentralbankstotoleratetoohighinflation,justto keepthebankingsectorafloat? In principleitiseasy to seewhyitcouldbe. Onecanimagineacentralbankwhichwouldhavetotightenitsmonetarypolicy forpricestabilityreasons,butispreventedfromdoingsoforthefearthatthevalueoftheassetsofthebankingsystemwoulddecreaseandafinancialcrisiscouldensue. Episodeswhichfitthedescriptionoffinancialdominancehavebeenobservedin emergingeconomiesaftersomebankingcrisesinthepast. Butlookingatrecentexperience,thishasnotbeenthe caseinthedevelopedeconomies. Thebustofthecreditboomhasnotledmonetarypolicytotolerateahigher-than-mandatedrateofinflation. Instead,inthelargedevelopedeconomiesatleast,theburstingofthebubblehascoincidedwithasuddencontractionofprivatedemandandadeeprecession. Thenegativeeffectofthebustoneconomic activityhasactuallyreducedinflationarypressuresandinsomecases(suchasinJapaninthe1990’s)createdarealdangerofdeflation. Themainproblemhasthenbecomehowtopreventthecreditcontractionfromstartingadeflationaryspiral. In suchconditions,thesamemonetarypolicy willthenbotheasethestrainonthebankingsectorandsupportpricestability. Thisobservationdoesnotmeanthatfinancialinstabilitywouldnotposeaseriouschallengetomonetarypolicy. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  30. P age |30 Onthecontrary,thedownwardimpactofabust,ifitislarge,maybemoredifficulttocontrolthantheprecedingperiodofcreditexpansion. TherewasafamousdiscussiononhowmonetarypolicyshouldrelatetoassetpricesintheJacksonHoleconferenceof2007,whereRick Mishkinintroducedthe topic. Atthattime,theprevalentthinkingincentralbankingcircleswaswhatprofessorIssinglatercalled“theJacksonHoleconsensus”,meaningthatitisbetterformonetarypolicy only to “clean”(upafterwards)than to“lean”(againstthewind). Afterthehardlessonswelearnedoverthelastfiveyearsthecaseforbenignneglectofassetboomsandonlypickingupthepiecesafterwardsisnotsostronganymore. Thecrisisexperiencesupportsrathertheideathatfinancialexcessesarebetterpreventedastheyhappenthanonlymanagedaftertheyhavecausedarecession. Thiswouldbethebestway toprevent“downwardfinancialdominance”whichcouldariseifmonetarypolicycouldnoteffectivelycounteractcreditcontraction. Unconventionaltoolsandtheindependenceofmonetarypolicy Recentexperienceshowsthatthecentralbanks’boxofpotentialtoolsisactuallyverydeep,andifithasbecomenecessarytoutilizeunconventionaltools,asin thepresentcrisis,thesenewtoolshavebeen developedanddeployed. In thecaseoftheECB,thenewtoolshaveincludedthetransitiontofullallotmentauctions,thelongtermrefinanceoperationsuptothreeyears,wideningofthescopeofeligiblecollateral,andthevariousbond purchaseprogrammes. ThemostrecentoftheseistheOMTprogrammeannouncedlastsummerbutnotyetcommencedinpractice. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  31. P age |31 Thedevelopmentofnewtoolshasbeenjustified. The slipofthedepressedeconomiestodangerousdeflationhasbeenaverted,andthedebtandbankingproblemshavenotdevelopedintosystemicfinancialmeltdownsintheaffectedcountries. Wehaveseenthatcentralbanks canpursuesuccessfulpricestabilitypolicy alsounderverydifficultconditions. TheeventsaroundtheworldsincethecollapseofLehmanBrothersareevidenceofthat. Deflationhasbeenavoideddespiteasevererecessioninmanycountries. However,therearealsocertainproblemswithrelyingontheenlargedtoolkitofthecentralbanks. Theabilitytoactincrisishasled to thecentralbanksbeingevencalled“theonlygameintown”. Weshouldresistthisidea andbewareofthedangerthatproblemswhicharefundamentallypoliticalcouldbepushedtocentralbanksto solve. Adivisionofresponsibilitiesbetweenappointedofficialsandelected politiciansshouldbepreserved. Monetarypolicy cannotadministertheneededstructuraltransformationintherealsectoroftheeconomyorsolveexcessivedeficitproblemsofgovernments. Therearesituationswherethecentralbanks justhaveto actanddotheirbest to stabilizetheeconomy,eveniftheywouldhave tousetoolswhichgobeyondjustadjustingtheshortrateofinterestortheaggregateliquidityofthebankingsystem. Thepresentfinancialcrisishasconstitutedonesuchsituation. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  32. P age |32 Avoidingthebustswhichseemtofollow creditboomsandperiodsof“financialexuberance”wouldmakethetasks ofmonetarypolicy much easierandprotecttheindependenceofcentralbanks. Buttherearealsodifficultieswiththeleaningagainstthewind. Onehastodowiththeproblemofdetectingthecreditcycleintime,andcorrectlytimingthemonetarypolicyresponse. Anotherproblemisthatpricestabilitymightgetlessattention. Tomitigatetheseproblems,somethingelsebesidesmorevigilantinterestratepolicyisneededto preventlowandstableinterestratesfromleadingtoexcessesinbanksandfinancialmarkets. Onedevelopmentcanbethedevelopmentofmacro-prudentialinstrumentswhicharedesigned to improvethestabilityofthefinancialsystemasawhole. ThemajorworkinthisfieldwasdonebythedeLarosièregroup. OtmarIssingwasamemberofthegroup. Especiallyinterestingarethosemacro-prudentialinstrumentswhichhaveatimedimensionsothatthey canbeadjustedaccordingtothechangingsituationinthecreditmarkets. Suchinstrumentsinclude,inparticular,thecountercyclicalcapitalrequirements,aswellastheadjustablerestrictionsonLoan-to-Valueratios. TheCRDIVdirectivewillmaketheformerinstrumentobligatory intheEUcountries;implementationofthelatterisleft tonationaldiscretion. Nowitisveryimportant to establishaneffectivetoolkitforbothEuropeanandnationalauthorities. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  33. P age |33 • Wemustalsocreateinstitutionalconditionswhichdonotpreventthesetoolstobeusedwhenneeded. • Therefore,weneedcleardecisionmakingcompetencesatalllevels. • Theconnectionbetweenmacro-prudentialpolicy anditstimedimensionwithmonetarypolicyissointimatethatcentralbanksmustbecloselyinvolvedinmacro-prudentialanalysisanddecisionmaking. • Macro-prudentialpolicy isimportant,butitneeds tobesupportedbystructuralreformswhichwouldmake thebankingsystemmoreresilient,and -Iemphasise -lesspronetounstablebehaviour. • TheStructuralreformproposals • In ordertopreventthepresentcrisisfrombeingeverrepeated,governmentsandauthoritieshavestartedalarge-scaleoverhauloffinancialregulation. • Theregulatoryagenda canbebroadlydividedintothefollowingareas: • Strengtheningoftheprudentialregulationofsolvencyandliquidity • Improvingtheinstitutionalbasisforsupervisionandcrisismanagement • Introductionofmacro-prudentialinstrumentstopreventsystemicrisksinthebankingsystemandfinancialmarkets • Regulatingthestructureofthebankingsector • Thestructuralreformproposalswhichappearasthelastitemonthislistaimtoseparatetheriskiestsecuritiesandderivativesbusinessfromthedepositbankingactivities. • ThisistheessentialcontentoftheproposalsbytheEUHighLevelExpertGroup,whichIchaired,publishedlastautumn. • ItisalsoatthecoreoftheVolckerrulewhichisbeingimplementedin InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  34. P age |34 theUS,andtheVickersproposal intheUK. ThecurrentlegislativeproposalswhichareunderwayinFranceandGermanyarealsointhesamevein. Aparticularconcernoftheseproposalshasbeentolimittheextentofexplicitorimplicit publicguarantees,sothattheywouldnotinduceadditionalrisk taking. Thiskindofcompetitivedistortioncouldresultinsecuritiestradinggettingconcentrated in thelargestdepositbanks,andthesedepositbanksbecomingenormousriskconcentrationsbuiltonimplicitorevenexplicitpublicguarantees. Separationproposalstrytoisolatesecuritiesbusinessfromthesourcesofthisdistortionandreducetheincentivesto excessiverisktakingandriskconcentration. In mustbeemphasizedthatthestructuralreformweproposedisnotacure-allbutshouldbeseenasapartofacomprehensiveregulatoryagendawhichisalreadymovingforward. Thisincludesbettersolvencyandliquidityrules. Also,theEUwillfinallygetsupervisionandresolutionframeworksattheunionlevel. Thedifferentcomponentsofthecurrentregulatoryagendacomplementandsupporteach other. InthisEuropeancontext,thestructureandstabilityofthebankingsectorisofvitalimportance to theeconomy. Itisimperative to improveitsresiliency. TheHighLevelExpertGroupreportcontainsfivemainrecommendationsonhow to reformthebankingsector. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  35. P age |35 • Iwilljustrefertothreeofthemhere: • Thefirstistoseparateanysignificantproprietarytradinginsecuritiesandderivativesfromdepositbanks. • Theseactivitiescouldbecarriedoutinaseparatelycapitalizedandfundedsubsidiary,atradingentity,whichcouldbelongtothesamebankinggroupasthedepositbank. • Weproposedthatalsomarketmakingbeallocated to thetradingsubsidiaryinordertopreventtheuseoftrading inventory tocircumventtheprohibitiononproprietarytrading. • Theuseoftradingsubsidiaries wouldallow thebankinggroups tooffer“one-stopbanking”totheirclients,butwithoutthepossibilityoffundingtradingactivitieswithinsuredretaildeposits. • Financiallinkagesbetweenthedepositbankandthetradingunitwould have toberestricted in accordancetonormallargeexposurerules. • Anotherofourproposalsis todevelopspecific,designatedbail-ininstrumentstoimprovethelossabsorbencyofbanks. • Arequirement to issuesuchbail-indebtwouldhelpensuretheparticipationofinvestorstotherecapitalizationofabankifthisshould becomenecessary. • Suchdesignatedbail-ininstrumentswouldclarifythehierarchyofdebtcommitmentsandallowinvestorstopredicttheeventualtreatmentoftherespectiveinstrumentsin caseofrecapitalizationorresolution. • Thegroupalsoproposedthatthecapitalrequirementsontradingassetsandrealestaterelatedloansbereviewed. • Bothoftheseassetcategoriescame tohaveverylow riskweightsintheBaselIIregime,mostlybecausethewayinternalmodelswereapplied. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  36. P age |36 Whybankingstructuremattersformonetarypolicy Letmerecapitulatemymainpoints. First,formonetarypolicy,financialstabilityisveryimportant. Whilemonetarypolicyhasproventobeabletopursuepricestabilityeven underratherstrainedfinancialconditions,thecentralbanksarenotabletoinsulatetherealeconomycompletelyfromtheafter-effectsoffinancialcrises. Amorestablebankingsectorwhichislesspronetocrisiswillreducethelikelihoodofcrisesandthereforeprotectthebalancesheetsofthecentralbankfromfinancialrisksandtherebyprotectitsindependenceandcredibility. Second,themostimportantpartofstabilitypolicy iscrisisprevention. Improvinglossabsorbencyofbanks andthecrisismanagementpowersoftheauthoritiesarenecessary,butitisevenmoreimportant to makesurethatexcessivegrowthofcreditandindebtednesscanbebettercontrolledinthefuture. In thisway,creditcrunchesandbankingcrises canbemadelesslikely– andmilder,shouldtheyhappen. Third,financialstabilitywouldbenefitfromstructuralreformofthebankingsystem. Byseparatingthemostriskysecuritiesandderivative activitiesfromdepositbanking,thespilloverfromdepositprotectiontospeculativerisktakingwouldbeprevented. Thiswouldreducethedistortedincentivestoexpandtradingactivitiesandconcentraterisksin depositbanksbecauseoftheirprivilegedpositioninthedepositmarket. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  37. P age |37 Finally,thestructuralreformofbankingisacomplement,notasubstituteforotherregulatoryimprovements. Forcentralbanks,thedevelopmentofmacro-prudentialpoliciesandinstrumentsisespeciallyrelevant. Thosemacro-prudentialinstrumentswhichcanbeadjustedovertimetomanagetheconditionsinthecreditmarketwillofferawaytobettercontroltheaccumulationofexcessrisk andhelppreventfuturecrises. Theseinstrumentsoperatesoclose tomonetarypolicythatcentralbanksshouldbeverycloselyinvolved,if notthemselvesresponsible,indevelopingandusingthem. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  38. P age |38 TheimpactofthecrisisonfinancialintegrationinCentralandEasternEurope SpeechbyMrIgnazioVisco,GovernoroftheBankofItaly,attheconference“Twentyyears oftransition–experiencesandchallenges”,hosted bytheNationalBankofSlovakia,Bratislava. Iwishtothankforuseful discussionandhelpEmidioCocozza,PaoloDelGiovaneandValeriaRolli. Introduction Theglobalfinancialcrisishasbeensevereandwidespread,andhasaffecteddifferenteconomiesindifferentandlong-lastingways. ThetransitioncountriesofCentralandEasternEuropewerenoexception:theirquiterapidfinancialintegrationoverthepast twenty-yearsbrought aboutlastingeconomicbenefits,butalsoleft them relativelyexposedtotheglobalfinancialturmoil,in particularthroughtheirlinks withWesternEuropeanbankswhichholddominantstakesintheregion’smarkets. Financialstabilityhasonceagainbecomeafundamentalobjectiveof policymaking,andcentralbanksarebeing heavilyinvolvedinthisendeavor. Thiscallsforasubstantialoverhaulinfinancialregulationandsupervision. Thefinancialsystemoftomorrow willbedifferentfromtheonethathasdevelopedoverthelasttwo decades. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  39. P age |39 Globalfinancialintegrationduringthepastdecade In thedecadebeforethefinancialcrisisboththesizeofthefinancialsystemanditsroleandpervasivenessintheeconomyincreaseddramatically. Theprocesshasonlysloweddownsincethecrisis. Intheeuroarea,theoverallamountoffinancialresourcescollectedbytheprivatesector(bankcredit,bondsissueddomesticallyandstock market capitalization)rosefrom160percentofGDP in 1996to240in2007,andthendeclinedto230in2011. AsimilarpatternisfoundfortheUnitedStates,wheretheratiorosefrom230percentin1996to330in2007andthendeclinedto260in2011(Fig.1). Drivenbythebreakthroughsininformationtechnologyandtelecommunicationsandtheprocessoffinancialintegration,thesupplyofderivativesproducts,thesecuritizationofbanks’assets,togetherwiththegrowthofso-calledstructuredfinancialinstruments,expandedconsiderably. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  40. P age |40 The totaloutstanding notional amountofover-the-counter(OTC)andexchange-tradedderivativeshasrisenfromabout94trillionU.S.dollarsattheendof1998 to around670trillionattheendof2007,hoveringaroundthatlevelafterwards(Fig.2). Animportantdimensionofthisprocesshasbeentheincreasedinternationalfinancialintegration. In thelastdecadeindustrialcountries’grossexternalfinancialassetsandliabilitiesmorethandoubledinproportiontoGDP,reaching440percentattheendof2007(Fig.3). InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  41. P age |41 Thedevelopmentoffinancialmarketsinemergingeconomieshasalsobeendramatic. Theoverallamountoffinancialresources collectedbytheprivatesector(outstandingstocksofbankcredit,domesticdebtsecuritiesandequitymarketcapitalization)increasedfromabout120to230percentofGDPbetween1996and2007fortheaverageofemergingAsia,andfrom about 40toalmost100percentfortheaverageofCEEcountries(Fig.4). InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  42. P age |42 Internationalfinancialintegration– withforeigndirectandportfolioinvestmentsandtheinvolvementofforeignbanks indomesticfinancialsystems–washelpedbytheremovalofearlierobstacles:macroeconomicinstability,vulnerableexternalpositionsandinefficientinstitutionalandregulatorysetups. Sincethemid2000s,thisprocesswashugelysupportedbyexceptionallyfavorableglobalfinancialconditions,withabundantliquidity,low risk aversion,andfallinglong-terminterestrates. FinancialintegrationinCentralandEasternEurope Thetransitioncountriesin CentralandEasternEuropeweretherecipientsofalargeinflux ofinternationalcapital,mostlyflowinginfromWesternEurope. Between2003and2008 capitalinflowsreachedsustainedlevels– more than12percentofGDP onaverage– wellabovetheoverallaverageforemergingmarketcountries(about6percent)(Fig.5). InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  43. P age |43 Transitioncountrieswereperceivedasattractiveoutlets:potentialhighreturns,underpinnedbyrelativelylow wagesand capital-outputratios,weremagnifiedbytheprospectsforfasterincomeconvergenceentailedbytheeconomicandinstitutionaldevelopmentsinthecontextofEUmembership,andbytheexpectationsofrapidinterestrateconvergencelinkedtotheeventualeuroadoption. FinancialintegrationintheCEEhastendedtobequiteunique. Internationalbanksplayedafundamentalroleindeedinspurringfinancialintegrationin theregion. In theyearsrunninguptotheglobalfinancialcrisis,WesternEuropean banksexpandedrapidly,gaininglargemarketsharesthroughtheirsubsidiariesandbranches,up to about80percentoftotalbankingassetsby2008. Theentryofforeignintermediarieswithlong-termstrategicgoalsandtheensuingprofoundtransformationoftheownershipstructureofbankingsystemsinCEEcountrieswasacrucialelementofdisciplineandstabilityinbreakingtheviciouscycleofsystemicbankingcrisesand macroeconomicvolatilitythathadcharacterizedtheearlyyearsoftransition. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  44. P age |44 Itisgenerallyacceptedthatinternationalfinancialintegrationhastendedtoplayapositiverolein thelong-termeconomicconvergenceprocessinCEEtransitioncountries: Long-termpercapitaGDP growthintheregionbeforethecrisiswaspositivelycorrelatedwithconventionalmeasuresoffinancialintegration,suchastheratioofgrossforeignassetsandliabilitiestoGDP (Fig.6). Thecorrespondingevidenceforotheremergingareas tendsto belessclearcut. Theaforementionedfavourablefeaturepossiblyreflectstheinteractionwithinstitutionalconvergence,implicitintheEUaccessionprocess,asakeycontributingfactor. Thankstothisuniqueandfavourablecombination,financialintegrationinitselfmostlikelyactedasacatalystforthedevelopmentofthedomesticfinancialsectorandtheadoptionofstructuralreforms to strengthentheinstitutionalframework. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  45. P age |45 Yetabalancedaccountoftheprocessoffinancialintegrationinthisregionshouldnotoverlookitsdrawbacksin termsofexcessive,cheaplending,currencymismatchesanddemandoverheatingintheyearsrunninguptothecrisis. Between2003and2008,manyeconomiesrecordedrapidimportgrowth,realestatebubblesandwageincreaseswellaboveproductivitygains– sometimesrootedinoverlyoptimisticexpectationsoffastincome convergence. Inflationarypressuresspilledoverintothetradablesectorandworsenedexportperformance. Balanceofpaymentscurrent accountdeficitswidened(Fig.7). Severalcountriesbuiltuphighexternaldebtlevels(Fig.8),largelyprivateanddenominatedinforeigncurrency,makingthemvulnerable to capitalflow reversalsandcurrencydepreciation. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  46. P age |46 WhentheeffectsoftheglobalcrisisreachedtheCEEcountries,theireconomieswerehitbyasharpdeclineincapitalinflowsandtheensuingslowdowninbankcredit(Fig.9). Notwithstandingconcernsregardingapossible meltdownofdomesticfinancialsystemsdrivenbyarunfortheexitofforeignbanks,a InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  47. P age |47 fully-fledgedfinancialcrisis–similarto theoneswhichoccurredinEastAsiain1997–98–didnotmaterialize. Overall,theregionevenexperienced, inthefirstphaseofthecrisis,alessseverereversalofcapitalflowsthan otheremergingareas. In somecases(Hungary,LatviaandRomania) largeinternationalfinancialsupportbytheEUandthemaininternationalfinancialinstitutions(IFIs)wasakeyfactor inavoidingtheworst;coordinationeffortsbyhomeandhostcountryauthorities,IFIsandmultinationalbanks,inthecontextoftheViennaInitiative,alsohelpedpreventcollective actionproblemsthatcouldhavetriggeredthedreadedmassivewithdrawalfromthesemarketsbyforeignbanks. ThereisevidencethatforeignbanksthatparticipatedintheViennaInitiativewererelativelystablelenders. Moreover,thedistinctivemodeloffinancialintegrationintheCEEregion–whereforeignbanks operatemainlythroughtheirlocalsubsidiariesandbranchesintheretailmarket–probablyprovidedahigh degreeofrisksharingandstabilityduringthecrisis,asparentbanksweregenerallylesssensitivetoinformationasymmetryandcounterpartycredit riskandmorecommittedtolong-termmarketprospects,giventheimportantsunkcostsassociatedtothesestructures. Thiscomparesfavourablytothepatternprevailing intheotherEUcountries,whereexternalborrowingbydomesticbanksoccursmainlyviacrossborderwholesalemarkets. Thedifferentintensityoftheboom-bustcycleobservedacross theCEEcountriessuggeststhat,inadditiontotheinfluenceofspecificstructuralfeatures(suchasdifferencesinstartingincomelevels,internationaltradeandfinanciallinks),domesticpolicy hadarole,althoughcapitalinflowsofthemagnitudesobservedintheregionintherunuptotheglobalcrisiswouldcertainlyhavestrainedanytoolkitavailabletonationalpolicymakers. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  48. P age |48 Monetaryandexchangerateregimesmostlikelyplayedacriticalroleindeterminingthecountry’sability to counteracttheeffectsofcapitalinflows,asthereweredifferencesinthesizeoftheinternalandexternalimbalancesbetweenfixedandfloatingexchangeratecountries. Indeed,countriesadoptingafixedexchangeregimeexperiencedmorepronouncedcreditbooms,higherinflationratesandlargeraccountdeficitsthantheaverageforfloatingexchangesregimecountries. Yet,theassessmentofthecontributionoftheexchangerateregimeremainsanopenissue,asitisuncleartowhatextentthemostpronouncedboom-bustcyclewasmainlydrivenbythefixedexchangeregimeperseorbytheinconsistencyoftheoverall policymixpursuedincountrieswherethissettingwasin place; in particular,astricterfiscalstanceandabetterframeworkofmacroprudentialpolicy couldhaveatleastpartlycompensatedfortheabsenceofexchangerateflexibility. Asformonetarypolicy,theexperienceofCEEcountriestendstoconfirmthatin small,financiallyopeneconomiesitisalesseffectiveleverforrestrainingcreditbooms. Thisisthecaseevenforfloatingexchangeregimes,asanumbersoffactors– currencysubstitutionintheformofbalancesheeteffectsassociatedwithinitialhigheuroization,ortheshifts to foreign-currency-denominatedlending–couldrestraintheeffectivenessofmonetarypolicytightening,orevenreverseitsintendedeffects. Thisunderscorestheimportanceofmaintainingprudentfiscalstancesduringcreditbooms. Indeed, intherunup to thecrisis,headlinefiscalpositionsremained broadlybalancedinmostCEEcountries;yettheseoutcomeswerefrequentlytheresultofexceptionalrevenuesassociatedtocyclicaldemandandassetpricebooms. Onceadjustedforthelatterunderlyingfiscalpositionslookedmuchlesshealthy. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  49. P age |49 Onerecognizes,inretrospect,theneedforaconservativeapproachintheassessmentoftaxrevenuesduringaboomphase,andtheusefulroleofautomaticstabilizers(particularlyincome taxesandwelfarespending) inorder to increasefiscal policy flexibilityanddampeneconomicfluctuations. In additiontostandardmacropolicytools,CEEcountriesalsoadoptedawiderangeofprudentialactionsbeforethelastglobalcrisis. Prudentialinstrumentshavethepotentialtopreventorcontainsystemicfinancialrisksintheupswings(affectingtheincentivesassociatedwithassetpricebooms,foreignexchangelending,excessiverisktakingandtheerosionoflendingstandards)andalso to buildbuffersthat cancushiontheimpactofdownturns. In generaltheevidenceisthatthesemeasuresproducedtheintendedeffectsintheshortrun,buttheysometimesfailed tohavealonglastingimpactoncreditdynamics. Indeed, insomeinstancescircumventionthroughdirectcross-borderfinancingand/orlendingfromnonbank(unregulated)financialintermediariesproved tobeamajorissue;thishasbeenthecaseforexampleformeasuresconsisting indirectlimitsoncreditgrowth. Amoreeffectiverolein containingsystemicfinancialriskshasbeen playedbymeasuresspecificallydevisedtobuildliquidityand loss-absorbingcapitalbuffers,suchasreserveand capitalrequirements. Moreover,whenappropriatelyformulated,prudentialregulationshelpedtocurbthegrowthofforeignexchangeloansandtokeeprelateddefaultrateslowerduringthecrisis. Lessonslearntfromtheglobalcrisis:insearchofbetterregulation Globalfinancialdeepeningandinternational integrationhasallowedgreaterrisksharingandhasmadefinanceaccessibletolargernumbersof InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

  50. P age |50 countries,householdsandfirms,thusbeing instrumentaltobroadeningeconomicdevelopment. Butaninterlinkedandmoreconnectedfinancialsystemheightenstheriskthatcontagionsetsoffandspreadsmorewidely. Mostimportantly,thecrisishasshownthatmarketparticipantswerenotcapableofmasteringtheinherentcomplexityofthesystemthatthey themselveshadcontributed todevelop. Andithashighlightedthelimitsoftheidea thatself-regulationandmarketdisciplinearesufficient to ensurestablefinancialsystems. Inthisregard,acceptingtheideathatbenignneglectwastherightcourseofactionwasacriticalmistakeonthepartofregulators. Rather,financialregulationandsupervisionmustkeeppacewith developmentsinthefinancialindustry. Moreover,nationalauthoritiesneed tobeawareoftherisk thattheirpowersmaybecomenarrow comparedtothesphereofinfluenceoftheglobalfinancialplayers. Thecoordinationoffinancialsupervisionacrossbordersandacrosssectorsisa keyconditionforthestabilityoftheglobalfinancialsystem. Amajoreffortisrequired,atanationalbutespeciallyataninternationallevel,in ordertostrengthentheregulatoryandsupervisoryframework. Attheinternationallevel,underthepoliticalimpulseoftheG-20,theFinancialStabilityBoard(FSB)andtheBaselCommitteeonBankingSupervision(BCBS)haveintroducedsubstantialregulatorychanges topreventnewfinancialcrisesandincreasetheresilienceofeconomicsystems. Muchhasbeenalreadyachieved. InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com

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