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Recent Developments in Risk Governance and Compliance Management

The International Association of Risk and Compliance Professionals (IARCP) highlights critical advancements in risk governance, following the Financial Stability Board's (FSB) thematic peer review. This review scrutinizes the responsibilities of boards and Chief Risk Officers (CROs) in fostering effective risk management frameworks. It emphasizes the role of independent assessments in strengthening internal controls, as well as latest insights on managing risks linked to foreign exchange transactions. Stay updated on the key news and stories influencing risk and compliance management this week.

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Recent Developments in Risk Governance and Compliance Management

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  1. P age |1 InternationalAssociationofRiskandCompliance Professionals(IARCP) 1200GStreetNWSuite800Washington, DC20005-6705USATel:202-449-9750www.risk-compliance-association.com Top10riskandcompliancemanagementrelatednewsstoriesandworldeventsthat(forbetterorforworse)shapedthe week'sagenda,andwhatisnext DearMember, TheFinancialStabilityBoard(FSB)publishedtodayathematicpeerreviewonriskgovernance. Riskgovernancecollectivelyreferstotheroleandresponsibilitiesoftheboard,thefirm-wideCROandriskmanagementfunction,andtheindependentassessmentoftheriskgovernanceframework. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  2. P age |2 • Boardresponsibilitiesandpractices:Theboardisresponsibleforensuringthatthefirmhasanappropriateriskgovernanceframeworkgiventhefirm’sbusinessmodel,complexityandsizewhichisembeddedintothefirm’sriskculture. • Howboardsassumesuchresponsibilitiesvariesacrossjurisdictions. • Firm-wideriskmanagementfunction:TheCROandriskmanagementfunctionareresponsibleforthefirm’sriskmanagementacrosstheentireorganisation,ensuringthatthefirm’sriskprofileremainswithintheriskappetitestatement(RAS)asapprovedbytheboard. • Theriskmanagementfunctionisresponsibleforidentifying,measuring,monitoring,andrecommendingstrategiestocontrolormitigaterisks,andreportingonriskexposuresonanaggregatedand disaggregatedbasis. • Independentassessmentoftheriskgovernanceframework:Theindependentassessmentofthefirm’sriskgovernanceframework playsacrucialroleintheongoingmaintenanceofafirm’sinternalcontrols,riskmanagementandriskgovernance. • Ithelpsafirmaccomplishitsobjectivesbybringingadisciplinedapproachtoevaluateandimprovetheeffectivenessofriskmanagement,controlandgovernanceprocesses. • Thismayinvolveinternalparties,suchasinternalaudit,orexternalresourcessuchasthird-partyreviewers(e.g.,auditfirms,consultants). • Thisisanexcellentdocumentforriskmanagers.ReadmoreatNumber1ofourlist InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  3. P age |3 Also… Ilikeit.Niceandclear: “Principalriskistheriskthatabankpaysawaythecurrencybeingsold,butfailstoreceivethecurrencybeingbought.Principalriskcanbethemostseriousriskbecausetheamountatriskcanbeequaltothefullvalueofthetrade. ReplacementcostriskistheriskthatanFXcounterpartywilldefaultbeforeatradehassettledandthatthebankmustreplaceitwithanewtradeandadifferentcounterpartyatcurrentmarketprices(potentiallylessfavourableexchangerate). Liquidityriskistheriskthatacounterpartywillnotsettleanobligationforfullvaluewhendue.Liquidityriskdoesnotimplythatacounterpartyisinsolventsinceitmaybeabletosettletherequireddebitobligationsatsomeunspecifiedlatertime.” Great,cleardefinitions,inthe“Supervisoryguidanceformanagingrisksassociatedwiththesettlementofforeignexchangetransactions”fromtheBankofInternationalSettlements. ReadmoreatNumber4belowWelcometotheTop10list. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  4. P age |4 FSBpublishespeerreviewonriskgovernance TheFinancialStabilityBoard(FSB)publishedathematicpeerreviewon riskgovernance. Thereporttakesstockofriskgovernancepracticesatbothnational authoritiesandfirms,notesprogressmadesincethefinancialcrisis,identifiessoundpracticesandoffersrecommendationstosupportfurtherimprovements. GovernorDanielK.Tarullo Dodd-FrankAct BeforetheCommitteeonBanking,Housing,andUrbanAffairs,U.S.Senate,Washington,D.C. InterviewwithCarlosMontalvo,ExecutiveDirector ofEIOPA,conductedbyGarryBooth,Reactionsmagazine(theUK) CanyouexplainwhattheinterimSolvencyIImeasures,sometimesknownasSolvency1.5,encompass? InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  5. P age |5 Supervisoryguidanceformanagingrisksassociatedwiththesettlementofforeignexchangetransactions Thepurposeofthisguidanceistoprovideupdatedguidancetosupervisorsandthebankstheysuperviseon approachestomanagingtherisksassociatedwiththesettlementofFX transactions. FinancialServicesSector DraftrecommendationstotheCharteredInstituteofInternalAuditors Followingthecrisisinthefinancialsystemoverthepastfewyearsawidespreadreviewofgovernanceinfinancialinstitutionshasbeentakingplace. ItwasinevitablethattheroleofInternalAuditwouldbebroughtintothatprocess. TheFinancialTransactionTax(FTT) On14February2013theEuropeanCommissionadoptedaproposalfora CouncilDirectiveimplementingenhancedcooperationintheareaof financialtransactiontax,whichmirrorsthescopeandobjectivesofitsoriginalFTTproposalofSeptember2011. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  6. P age |6 SpeechbyAndrewBailey ManagingDirector,PrudentialBusinessUnitattheCharteredInstitute’sNicholasBarbonLectures,London SuitabilityofmembersoftheManagementBodyandKeyFunctionHolders EMIR:FrequentlyAskedQuestions Note:TheRegulation(EU)No648/2012oftheEuropeanParliamentandoftheCouncilof4July2012onOTCderivatives,centralcounterparties(CCPs)andtraderepositories(TRs)(EMIR)enteredintoforceon16August2012. However,manyprovisionsrequiretechnicalstandardstobedevelopedbyESMAandtheactualdateofapplicationoftheseprovisionswilldependonthedateofentryintoforceofthetechnicalstandards(seesectionontimingformoredetails) CorporateandRiskGovernance: TheIAIS’Self-AssessmentandPeerReviewonICPs4,5,7and8 TheIAIShaslaunchedtheSelf-AssessmentandPeerReview(SAPR)onCorporateandRiskGovernance. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  7. P age |7 FSBpublishespeerreviewonriskgovernance TheFinancialStabilityBoard(FSB)publishedtodayathematicpeerreviewonriskgovernance. Thereporttakesstockofriskgovernancepracticesatbothnational authoritiesandfirms,notesprogressmadesincethefinancialcrisis,identifiessoundpracticesandoffersrecommendationstosupportfurtherimprovements. Therecentglobalfinancialcrisisexposedanumberofriskgovernanceweaknessesinmajorfinancialinstitutions,relatingtotherolesandresponsibilitiesofcorporateboardsofdirectors(the“board”),the firm-wideriskmanagementfunction,andtheindependentassessmentof riskgovernance. Withouttheappropriatechecksandbalancesprovidedbytheboardandthesefunctions,acultureofexcessiverisk-takingandleveragewasallowedtopermeateinmanyofthesefirms. Thepeerreviewfoundthat,sincethecrisis,nationalauthoritieshavetakenseveralmeasurestoimproveregulatoryandsupervisoryoversightofriskgovernanceatfinancialinstitutions. Thesemeasuresincludedevelopingorstrengtheningexistingregulationorguidance,raisingsupervisoryexpectationsfortheriskmanagementfunction,engagingmorefrequentlywiththeboardandmanagement,andassessingtheaccuracyandusefulnessoftheinformationprovidedtotheboardtoenableeffectivedischargeoftheirresponsibilities. Nonetheless,moreworkisnecessary. Inparticular,nationalauthoritiesneedtobetterassesstheeffectivenessofafirm’sriskgovernanceframework,andmorespecificallyitsriskculture, InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  8. P age |8 tohelpensurethesoundmanagementofriskthroughtheeconomiccycle. Supervisorswillneedtostrengthentheirassessmentofriskgovernanceframeworkstoencompassanintegratedviewacrossallaspectsoftheframework. Thepeerreviewalsosurveyed36banksandbroker-dealersthatFSBmembersdeemedassignificantforthepurposeofthereview. Theevaluationoftheirresponsesindicatesthatmanyofthebestriskgovernancepracticesatsurveyedfirmsarenowmoreadvancedthannationalsupervisoryguidance,anoutcomethatmayhavebeenmotivatedbyfirms’needtoregainmarketconfidence. Despitetheseconsiderablestrides,significantgapsremaininanumberofareas,particularlyintheriskmanagementfunction. Atthecoreofstrongriskmanagementisaneffectiveriskappetiteframework,andfirms’progresstodateisuneveninitsdevelopment,comprehensivenessandimplementation. Veryfewfirmswereabletoidentifyclearexamplesofhowtheyusedtheir riskappetiteframeworkinstrategicdecision-makingprocesses. Drawingfromthefindingsofthereview,thereportidentifiesalistofsoundriskgovernancepracticesthatwouldhelpfirmscontinuetoimprovetheirriskgovernanceandnationalauthoritiestoassessitseffectiveness. Thereviewalsosetsoutseveralrecommendationstargetingareaswheremoresubstantialworkisneeded,inparticular: 1.Nationalauthoritiesshouldstrengthentheirregulatoryandsupervisoryguidanceforfinancialinstitutionsanddevoteadequateresourcestoassesstheeffectivenessofriskgovernanceframeworks. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  9. P age |9 Standardsettingbodiesshouldreviewtheirprinciplesforgovernance,takingintoconsiderationthesoundriskgovernancepracticessetoutinthereport. TheFSBshouldexplorewaystoformallyassessriskcultureatfinancialinstitutions. TheFSBshouldprovidegeneralguidanceonthekeyelementsthatshouldbeincludedinriskappetiteframeworksandestablishacommonnomenclaturefortermsusedinriskappetitestatements. TiffMacklem,ChairmanoftheFSB’sStandingCommitteeonStandardsImplementation(SCSI),said: “Thereviewusefullypullstogethergoodriskgovernancepracticesandidentifiesfollow-upworkthatneedstobedonebynationalauthoritiestostrengthentheirabilitytoassesstheeffectivenessoffirms’riskgovernanceframeworks. Recentheadlineeventssurroundingactivitiesatsomelargefinancialinstitutionsunderscoretheimportanceofpromotingandimplementingasoundriskculture.” SweeLianTeo,Chairofthepeerreviewteamonriskgovernance,said:“Whilemeasureshavebeentakentoimproveriskgovernance,thereview showedthattherearestillgapsthatneedtobeaddressedbybothfirmsandsupervisors. Thereportsetsoutrecommendationsthatwillhelpsupervisorseverywhereraisethebarontheirexpectationsforriskgovernancesothatfirms’practicescontinuetoimprovethroughchangingenvironments.” Notes TheFSBhasbeenestablishedtocoordinateattheinternationalleveltheworkofnationalfinancialauthoritiesandinternationalstandardsettingbodiesandtodevelopandpromotetheimplementationofeffective InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  10. P age |10 regulatory,supervisoryandotherfinancialsectorpoliciesintheinterestoffinancialstability. Itbringstogethernationalauthoritiesresponsibleforfinancialstabilityin24countriesandjurisdictions,internationalfinancialinstitutions, sector-specificinternationalgroupingsofregulatorsandsupervisors,and committeesofcentralbankexperts. TheFSBalsoconductsoutreachwith65otherjurisdictionsthroughitssixregionalconsultativegroups. ThepeerreviewonriskgovernanceisthethesixththematicpeerreviewconductedbytheFSBandthefirstthematicreviewusingtherevisedobjectivesandguidelinesfortheconductofpeerreviewssetforthintheDecember2011HandbookforFSBPeerReviews. ThematicreviewsfocusontheimplementationandeffectivenessacrosstheFSBmembershipofinternationalfinancialstandardsdevelopedbystandard-settingbodiesandpoliciesagreedwithintheFSBinaparticularareaimportantforglobalfinancialstability. Thematicreviewsmayalsoanalyseotherareasimportantforglobalfinancialstabilitywhereinternationalstandardsorpoliciesdonotyetexist. Theobjectivesofthereviewsaretoencourageconsistentcross-countryandcross-sectorimplementation;toevaluate(wherepossible)theextent towhichstandardsandpolicieshavehadtheirintendedresults;andtoidentifygapsandweaknessesinreviewedareasandtomakerecommendationsforpotentialfollow-up(includingviathedevelopmentofnewstandards)byFSBmembers. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  11. P age |11 ThematicReviewonRiskGovernancePeerReviewReport Foreword FinancialStabilityBoard(FSB)memberjurisdictionshavecommitted,undertheFSBCharterandintheFSBFrameworkforStrengthening AdherencetoInternationalStandards,toundergoperiodicpeerreviews. Tofulfilthisresponsibility,theFSBhasestablishedaregularprogramme ofcountryandthematicpeerreviewsofitsmemberjurisdictions. ThematicreviewsfocusontheimplementationandeffectivenessacrosstheFSBmembershipofinternationalfinancialstandardsdevelopedbystandard-settingbodiesandpoliciesagreedwithintheFSBinaparticularareaimportantforglobalfinancialstability. Thematicreviewsmayalsoanalyseotherareasimportantforglobalfinancialstabilitywhereinternationalstandardsorpoliciesdonotyetexist. Theobjectivesofthereviewsaretoencourageconsistentcross-countryandcross-sectorimplementation;toevaluate(wherepossible)theextent towhichstandardsandpolicieshavehadtheirintendedresults;andtoidentifygapsandweaknessesinreviewedareasandtomakerecommendationsforpotentialfollow-up(includingviathedevelopmentofnewstandards)byFSBmembers. Thisreportdescribesthefindingsofthethematicpeerreviewonriskgovernance,includingthekeyelementsofthediscussionintheFSBStandingCommitteeonStandardsImplementation(SCSI). Executivesummary Therecentglobalfinancialcrisisexposedanumberofgovernanceweaknessesthatresultedinfirms’failuretounderstandtheriskstheyweretaking. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  12. P age |12 Inthewakeofthecrisis,numerousreportspaintedafairlybleakpictureofriskgovernanceframeworksatfinancialinstitutions,whichconsistsofthethreekeyfunctions:theboard,thefirm-wideriskmanagementfunction,andtheindependentassessmentofriskgovernance. Thecrisishighlightedthatmanyboardshaddirectorswithlittlefinancialindustryexperienceandlimitedunderstandingoftherapidlyincreasingcomplexityoftheinstitutionstheywereleading. Toooften,directorswereunabletodedicatesufficienttimetounderstandthefirm’sbusinessmodelandtoodeferentialtoseniormanagement. Inaddition,manyboardsdidnotpaysufficientattentiontoriskmanagementorsetupeffectivestructures,suchasadedicatedriskcommittee,tofacilitatemeaningfulanalysisofthefirm’sriskexposuresandtoconstructivelychallengemanagement’sproposalsanddecisions. Theriskcommitteesthatdidexistwereoftenstaffedbydirectorsshorton bothexperienceandindependencefrommanagement. Theinformationprovidedtotheboardwasvoluminousandnoteasilyunderstoodwhichhamperedtheabilityofdirectorstofulfiltheirresponsibilities. Moreover,mostfirmslackedaformalprocesstoindependentlyassesstheproprietyoftheirriskgovernanceframeworks. Withouttheappropriatechecksandbalancesprovidedbytheboard,theriskmanagementfunction,andindependentassessmentfunctions,acultureofexcessiverisk-takingandleveragewasallowedtopermeatein theseweaklygovernedfirms. Further,withtheriskmanagementfunctionlackingtheauthority,statureandindependencetoreininthefirm’srisk-taking,theabilitytoaddressanyweaknessesinriskgovernanceidentifiedbyinternalcontrolassessmentandtestingprocesseswasobstructed. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  13. P age |13 Thepeerreviewfoundthat,sincethecrisis,nationalauthoritieshavetakenseveralmeasurestoimproveregulatoryandsupervisoryoversightofriskgovernanceatfinancialinstitutions. Thesemeasuresincludedevelopingorstrengtheningexistingregulationorguidance,raisingsupervisoryexpectationsfortheriskmanagementfunction,engagingmorefrequentlywiththeboardandmanagement,andassessingtheaccuracyandusefulnessoftheinformationprovidedtotheboardtoenableeffectivedischargeoftheirresponsibilities. Nonetheless,moreworkremains;nationalauthoritiesneedtostrengthentheirabilitytoassesstheeffectivenessofafirm’sriskgovernance,andmorespecificallyitsriskculturetohelpensuresoundriskgovernancethroughchangingenvironments. Supervisorswillneedtoundergoasubstantialchangeinapproachsinceassessingriskgovernanceframeworksentailsforminganintegratedviewacrossallaspectsoftheframework. Thepeerreviewalsoaskedsupervisorstoevaluateprogressmadebytheirsurveyedfirm(s)towardenhancedriskgovernanceinsevenareas. Toprovidesomeconsistencytothisexercise,thereviewteamdevelopedhigh-levelcriteriatoassistsupervisoryevaluationsoffirms’progress,drawingfromacompilationofrelevantprinciples,recommendationsandsupervisoryguidance. Thehigh-levelcriteriawereviewedasfundamentalprerequisitesforriskgovernanceframeworks. Thisevaluationfoundthatmanyofthebestriskgovernancepracticesatsurveyedfirmsarenowmoreadvancedthannationalguidance. Thisoutcomemayhavebeenmotivatedbyfirms’needtoregainmarketconfidenceratherthanregulatoryrequirements. Firmshavemadeparticularprogressin: InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  14. P age |14 • assessingthecollectiveskillsandqualificationsoftheboardaswellastheboard’seffectivenesseitherthroughself-evaluationsorthroughtheuseofthirdparties; • institutingastand-aloneriskcommitteethatiscomposedonlyofindependentdirectorsandhavingacleardefinitionofindependence; • establishingagroup-widechiefriskofficer(CRO)andriskmanagementfunctionthatisindependentfromrevenue-generatingresponsibilitiesandhasthestature,authorityandindependencetochallengedecisionsonriskmadebymanagementandbusinesslines;and • integratingthediscussionsamongtheriskandauditcommitteesthroughjointmeetingsorcross-membership. • Althoughmanysurveyedfirmshavemadeprogressinthelastfewyears,significantgapsremain,relativetothecriteriadeveloped,particularlyinriskmanagement. • Therewerealsodifferencesinprogressacrossregionswithfirmsinadvancedeconomieshavingadoptedmoreofthedesirableriskgovernancepractices. • Theresultsofthesupervisoryevaluationsweregroupedby: • allsurveyedfirms; • firmsidentifiedbytheFSBandBaselCommitteeonBankingSupervision(BCBS)asglobalsystemicallyimportantfinancialinstitutions,orG-SIFIs;and • firmsthatresideinadvancedeconomies(AEs)oremergingmarket anddevelopingeconomies(EMDEs). • Insummary,acrossthesevenareasevaluated,firmshavemadethemostprogressindefiningtheboard’sroleandresponsibilities,andreasonableprogressintheirapproachtoriskgovernanceandtheindependentassessmentofriskgovernance. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  15. P age |15 • Thesupervisoryevaluations,however,indicatethatsurveyedfirmsshouldcontinuetoworktowarddefiningtheresponsibilitiesoftheriskcommitteeandstrengtheningtheirriskmanagementfunctionsasnearly 50percentofsurveyedfirmsdidnotmeetalloftheevaluationcriteriain theseareas. • Bytypeofinstitution,surveyedG-SIFIsaremoreadvancedthanotherfinancialinstitutionsindefiningtheresponsibilitiesoftheboardandriskcommittee,conductingindependentassessmentsofriskgovernance,providingrelevantinformationtotheboardandriskcommittee,andtosomeextentmoreadvancedintheriskmanagementfunction. • Theseresultssupportthefindingthatthefirmsintheregionshardesthitbythefinancialcrisishavemadethemostprogress. • Meanwhile,supervisoryevaluationsoffirmsthatresideinEMDEsshowthatnearly65percentdidnotmeetallofthecriteriafortheriskmanagementfunction. • Thesegapsneedimmediateattentionbybothsupervisorsandfirms.Othersignificantfindingscomingoutofthereviewincludethefollowing: • Nationalauthoritiesdonotengageonasufficientlyregularandfrequentbasiswiththeboard,riskcommitteeandauditcommittee.Severaljurisdictionsholdsuchmeetingsonlyonceayearoronanas-needed basis. • GoodprogresshasbeenmadetowardelevatingtheCRO’sstature,authority,andindependence. • Inmanyfirms,theCROhasadirectreportinglinetothechiefexecutiveofficer(CEO)andarolethatisdistinctfromotherexecutivefunctionsandbusinesslineresponsibilities(e.g.,no“dual-hatting”). • Thiselevation,however,needstobesupportedbytheinvolvementoftheriskcommitteeinreviewingtheperformanceandsettingtheobjectivesoftheCRO,ensuringthattheCROhasaccesstotheboardandrisk InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  16. P age |16 • committeewithoutimpediment(includingreportingdirectlytotheboard/riskcommittee),andfacilitatingperiodicmeetingswithdirectorswithoutthepresenceofexecutivedirectorsorothermanagement. • Moreworkisneededonthepartofbothnationalauthoritiesandfirmsonestablishinganeffectiveriskappetiteframework(RAF).Assessingafirm’sRAFisachallengingtaskthatrequiresgreaterclarityandanelevatedlevelofconsistencyamongnationalauthorities. • Supervisoryexpectationsfortheindependentassessmentofinternalcontrolsystemsbyinternalauditorotherindependentfunctionwerewell-establishedpriortothecrisis. • Assuch,thisisanareathatdemonstratedrelativelysoundpracticesacrosstheFSBmembershipatbothnationalauthoritiesandfirms. • However,nojurisdictionhadspecificexpectationsforinternalaudittoperiodicallyprovideafirm-wideassessmentofriskmanagementorriskgovernanceprocesses. • Nearlyallfirmshaveanindependentchiefauditexecutive(CAE)whoreportsadministrativelytotheCEOandtheauditcommitteechairandwhodirectlyreportsauditfindingstoapermanentauditcommittee. • However,thereisstillroomforimprovingtheCAE’saccesstodirectorsbeyondthoseontheauditcommittee. • Drawingfromthefindingsofthereview,includingdiscussionswithindustryorganisationsaswellasriskcommitteedirectorsandCROsofseveralfirmsthatparticipatedinthereview,thereportidentifiessomeofthebetterpracticesexemplifiedbynationalauthoritiesandfirmstocollectivelyformalistofsoundriskgovernancepractices(seeSectionV). • Italsodrawsonsomeoftherelevantprinciplesandrecommendationsforriskgovernancepublishedbyotherorganisationsandstandardsettingbodies. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  17. P age |17 • Noonesingleauthorityorfirm,however,demonstratedallofthesesound practices. • Thisintegratedandcoherentlistofsoundpracticesaimstohelpnational authoritiestakeamoreholisticapproachtoriskgovernance,ratherthanlookingateachfacetinisolation,andmayprovideabasisfor considerationbyauthoritiesandstandardsettingbodiesastheyreviewtheirguidanceandstandardsforstrengtheningriskgovernancepractices. • Thereviewsetsoutseveralrecommendationstoensuretheeffectivenessofriskgovernanceframeworkscontinuetoimprovebytargetingareaswheremoresubstantialworkisneeded. • Whilethereviewfocusedonbanksandbroker-dealersthataresystemicallyimportant,theserecommendationsapplytoothertypesoffinancialinstitutions,includinginsurersandfinancialconglomerates. • Recommendations: • Toensurethatfirms’riskgovernancepracticescontinuetoimprove,FSBmemberjurisdictionsshouldstrengthentheirregulatoryandsupervisoryguidanceforfinancialinstitutions,inparticularforSIFIs,and devoteadequateresources(bothinskillsandquantity)toassesstheeffectivenessofriskgovernanceframeworks. • Inparticular,nationalauthoritiesshouldconsiderthefollowingsoundriskgovernancepractices: • Setrequirementsontheindependenceandcompositionofboards,includingrequirementsonrelevanttypesofskillsthattheboard,collectively,shouldhave(e.g.,riskmanagement,financialindustryexpertise)aswellasthetimecommitmentexpected. • Holdtheboardaccountableforitsoversightofthefirm’sriskgovernanceandassessifthelevelandtypesofriskinformationprovidedtotheboardenableeffectivedischargeofboardresponsibilities. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  18. P age |18 Boardsshouldsatisfythemselvesthattheinformationtheyreceivefrommanagementandthecontrolfunctionsiscomprehensive,accurate,completeandtimelytoenableeffectivedecision-makingonthefirm’sstrategy,riskprofileandemergingrisks. Thisincludesestablishingcommunicationproceduresbetweentheriskcommitteeandtheboardandacrossotherboardcommittees,mostimportantlytheauditandfinancecommittees. SetrequirementstoelevatetheCRO’sstature,authority,andindependenceinthefirm. ThisincludesrequiringtheriskcommitteetoreviewtheperformanceandobjectivesoftheCRO,ensuringtheCROhasunfetteredaccesstotheboardandriskcommittee(includingadirectreportinglinetotheboardand/orriskcommittee),andexpectingtheCROtomeetperiodicallywithdirectorswithoutexecutivedirectorsandmanagementpresent. TheCROshouldhaveadirectreportinglinetotheCEOandadistinct rolefromotherexecutivefunctionsandbusinesslineresponsibilities(e.g.,no“dual-hatting”). Further,theCROshouldbeinvolvedinactivitiesanddecisions(fromariskperspective)thatmayaffectthefirm’sprospectiveriskprofile(e.g.,strategicbusinessplans,newproducts,mergersandacquisitions,internalcapitaladequacyassessmentprocess,orICAAP). Requiretheboard(orauditcommittee)toobtainanindependentassessmentofthedesignandeffectivenessoftheriskgovernanceframeworkonanannualbasis. Engagemorefrequentlywiththeboard,riskcommittee,auditcommittee,CEO,CRO,andotherrelevantfunctions,suchastheCFO,toassessthefirm’sriskculture(e.g.,the“toneatthetop”),whetherdirectorsprovideeffectivechallengetomanagement’sproposalsanddecisions,andwhethertheriskmanagementfunctionhastheappropriateauthoritytoinfluencedecisionsthataffectthefirm’sriskexposures. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  19. P age |19 Therelevantstandardsettingbodies(e.g.,BCBS,IAIS,IOSCO,OECD)shouldreviewtheirprinciplesforgovernance,takingintoconsiderationthesoundriskgovernancepracticeslistedinSectionV. Riskcultureplaysacriticalroleinensuringeffectiveriskgovernanceenduresthroughchangingenvironments. TheFSBSupervisoryIntensityandEffectivenessgrouphasagreedtoimplementtherecommendationfromthe2012FSBprogressreportonenhancedsupervisiontoexplorewaystoformallyassessriskculture,particularlyatG-SIFIs. ThisworkshouldbecompletedbySeptember2013. Toimprovetheirabilitytoassessfirms’progresstowardmoreeffectiveriskmanagement,nationalauthoritiesshouldprovideguidanceonthekeyelementsthatareincorporatedineffectiveriskappetiteframeworks. Toenablefirmstodefineframeworkswithaminimumamountofcomparabilitydespitetheirfirm-specificnature,acommonnomenclaturefortermsusedinriskappetitestatements(e.g.,“riskappetite”,“riskcapacity”,“risklimits”)shouldbeestablished. TheFSBSupervisoryIntensityandEffectivenessgroup,incollaborationwithrelevantstandardsetters,hasagreedtofinalisethisworkbytheendof2013. TheFSBshouldconsiderlaunchingafollow-upreviewonriskgovernanceafter2016(i.e.,aftertheG-SIFIpolicymeasuresbegintobephasedin),toassessnationalauthorities’implementationoftherecommendationstostrengthentheirsupervisoryguidanceandoversightofriskgovernance. ThereviewalsoshouldincludetheG-SIFIsidentifiedin2014bytheFSBincollaborationwiththeBCBSandIAIS. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  20. P age |20 (ImportantPart) IncreasingtheintensityandeffectivenessofsupervisiontoreducethemoralhazardposedbySIFIsisakeycomponentoftheFSB’spolicymeasures,endorsedbyG20Leaders. Sincetheonsetoftheglobalcrisis,supervisorshaveintensifiedtheiroversightoffinancialinstitutions,particularlySIFIs,soastoreducetheprobabilityoftheirfailure. Specifically,supervisoryexpectationsofriskmanagementfunctionsandoverallriskgovernanceframeworkshaveincreased,asthiswasanareathatexhibitedsignificantweaknessesinmanyfinancialinstitutionsduringtheglobalfinancialcrisis. Whilesupervisorsareresponsibleforassessingwhetherafirm’sriskgovernanceframeworkandprocessesareadequate,appropriateandeffectiveformanagingthefirm’sriskprofile,thefirm’smanagementisresponsibleforidentifyingandmanagingthefirm’srisk. InOctober2011,theFSBagreedtoconductathematicpeerreviewonriskgovernancetoassessprogresstowardenhancingpracticesatnational authoritiesandfirms(banksandbroker-dealers). Forpurposesofthisreview,riskgovernancecollectivelyreferstotheroleandresponsibilitiesoftheboard,thefirm-wideCROandriskmanagementfunction,andtheindependentassessmentoftheriskgovernanceframework(seeChart2). InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  21. P age |21 • Boardresponsibilitiesandpractices:Theboardisresponsibleforensuringthatthefirmhasanappropriateriskgovernanceframeworkgiventhefirm’sbusinessmodel,complexityandsizewhichisembeddedintothefirm’sriskculture. • Howboardsassumesuchresponsibilitiesvariesacrossjurisdictions. • Firm-wideriskmanagementfunction:TheCROandriskmanagementfunctionareresponsibleforthefirm’sriskmanagementacrosstheentireorganisation,ensuringthatthefirm’sriskprofileremainswithintheriskappetitestatement(RAS)asapprovedbytheboard. • Theriskmanagementfunctionisresponsibleforidentifying,measuring,monitoring,andrecommendingstrategiestocontrolormitigaterisks,andreportingonriskexposuresonanaggregatedand disaggregatedbasis. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  22. P age |22 -Independentassessmentoftheriskgovernanceframework:Theindependentassessmentofthefirm’sriskgovernanceframework playsacrucialroleintheongoingmaintenanceofafirm’sinternalcontrols,riskmanagementandriskgovernance. Ithelpsafirmaccomplishitsobjectivesbybringingadisciplinedapproachtoevaluateandimprovetheeffectivenessofriskmanagement,controlandgovernanceprocesses. Thismayinvolveinternalparties,suchasinternalaudit,orexternalresourcessuchasthird-partyreviewers(e.g.,auditfirms,consultants). InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  23. P age |23 GovernorDanielK.Tarullo Dodd-FrankAct BeforetheCommitteeonBanking,Housing,andUrbanAffairs,U.S.Senate,Washington,D.C. ChairmanJohnson,RankingMemberCrapo,andothermembersofthecommittee,thankyoufor theopportunitytotestifyonimplementationoftheDodd-FrankWall StreetReformandConsumerProtectionActof2010(Dodd-FrankAct). Intoday'stestimony,IwillprovideanupdateontheFederalReserve'srecent activitiespertinenttotheDodd-FrankActanddescribeourregulatoryandsupervisoryprioritiesfor2013. TheFederalReserve,inmanycasesjointlywithotherregulatoryagencies,hasmadesteadyandconsiderable progressinimplementingtheCongressionalmandatesintheDodd-FrankAct,thoughobviouslysomeworkremains. Throughoutthiseffort,theFederalReservehasmaintainedafocuson financialstability. Intheprocessofruledevelopment,wehaveplacedparticularemphasisonmitigatingsystemicrisks. Thus,amongotherthings,wehaveproposedvaryingtheapplicationoftheDodd-FrankAct'sspecialprudentialrulesbasedontherelativesizeandcomplexityofregulatedfinancialfirms. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  24. P age |24 Thisfocusonsystemicriskisalsoreflectedinourincreasinglysystematicsupervisionofthelargestbankingfirms. RecentRegulatoryReformMilestones Strongbankcapitalrequirements,whilenotalonesufficienttoguaranteethesafetyandsoundnessofourbankingsystem,arecentraltopromotingtheresiliencyofbankingfirmsandthefinancialsectorasawhole. Capitalprovidesacushiontoabsorbafirm'sexpectedandunexpectedlosses,helpingtoensurethatthoselossesarebornebyshareholdersratherthantaxpayers. Thefinancialcrisisrevealed,however,thattheregulatorycapitalrequirementsforbankingfirmswerenotsufficientlyrobust. Italsoconfirmedthatnosinglecapitalmeasureadequatelycapturesabankingfirm'srisksofcreditandtradinglosses. Agoodbitofprogresshasnowbeenmadeinstrengtheningandupdatingtraditionalcapitalrequirements,aswellasdevisingsomecomplementarymeasuresforlargerfirms. Asyouknow,inDecember2010theBaselCommitteeonBankingSupervision(BaselCommittee)issuedtheBaselIIIpackageofreformstoitsframeworkforminimumcapitalrequirements,supplementinganearliersetofchangesthatincreasedrequirementsforimportantclassesoftradedassets. Lastsummer,theFederalReserve,theOfficeoftheComptrolleroftheCurrency(OCC),andtheFederalDepositInsuranceCorporation(FDIC)issuedforcommentasetofproposalstoimplementtheBaselIIIcapitalstandardsforalllarge,internationallyactiveU.S.bankingfirms. Inaddition,theproposalswouldapplyrisk-basedandleveragecapitalrequirementstosavingsandloanholdingcompaniesforthefirsttime. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  25. P age |25 TheproposalsalsowouldmodernizeandharmonizetheexistingregulatorycapitalstandardsforallU.S.bankingfirms,whichhavenotbeencomprehensivelyupdatedsincetheirintroductiontwenty-fiveyearsago,andincorporatecertainnewlegislativeprovisions,including elementsofsections171and939AoftheDodd-FrankAct. TohelpensurethatallU.S.bankingfirmsmaintainstrongcapitalpositions,theBaselIIIproposalswouldintroduceanewcommonequitycapitalrequirement,raisetheexistingtier1capitalminimumrequirement,implementacapitalconservationbufferontopoftheregulatoryminimums,andintroduceamorerisk-sensitivestandardizedapproachforcalculatingrisk-weightedassets. Large,internationallyactivebankingfirmsalsowouldbesubjecttoasupplementaryleverageratioandacountercyclicalcapitalbufferandwouldfacehighercapitalrequirementsforderivativesandcertainothercapitalmarketsexposurestheyhold. Takentogether,theseproposalsshouldmateriallyreducetheprobabilityoffailureofU.S.bankingfirms--particularlytheprobabilityoffailureofthelargest,mostcomplexU.S.bankingfirms. InOctober2012,theFederalReservefinalizedrulesimplementingstresstestingrequirementsundersection165oftheDodd-FrankAct. Consistentwiththestatute,therulesrequireannualsupervisorystresstestsforbankholdingcompanieswith$50billionormoreinassetsandanynonbankfinancialcompaniesdesignatedbytheFinancialStabilityOversightCouncil(Council). Therulesalsorequirecompany-runstresstestsforabroadersetof regulatedfinancialfirmsthathave$10billionormoreinassets. ThenewDodd-FrankActsupervisorystresstestrequirementsaregenerallyconsistentwiththestressteststhattheFederalReservehasbeenconductingonthelargestU.S.bankholdingcompaniessincetheSupervisoryCapitalAssessmentPrograminthespringof2009. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  26. P age |26 ThestresstestsallowsupervisorstoassesswhetherfirmshaveenoughcapitaltoweatherasevereeconomicdownturnandcontributetotheFederalReserve'sabilitytomakeassessmentsoftheresilienceoftheU.S.bankingsystemunderadverseeconomicscenarios. Thestresstestsareanintegralpartofourcapitalplanrequirement,which providesastructuredwaytomakehorizontalevaluationsofthecapitalplanningabilitiesoflargebankingfirms. TheFederalReservealsoissuedinDecemberoflastyearaproposaltoimplementenhancedprudentialstandardsandearlyremediationrequirementsforforeignbanksundersections165and166ofthe Dodd-FrankAct. TheproposalisgenerallyconsistentwiththesetofstandardspreviouslyproposedforlargeU.S.bankholdingcompanies. TheproposalgenerallywouldrequireforeignbankswithalargeU.S.presencetoorganizetheirU.S.subsidiariesunderasingleintermediateholdingcompanythatwouldserveasaplatformforconsistentsupervisionandregulation. TheU.S.intermediateholdingcompaniesofforeignbankswouldbesubjecttothesamerisk-basedcapitalandleveragerequirementsasU.S.bankholdingcompanies. Inaddition,U.S.intermediateholdingcompaniesandtheU.S.branchesandagenciesofforeignbankswithalargeU.S.presencewouldberequiredtomeetliquidityrequirementssimilartothoseapplicabletolargeU.S.bankholdingcompanies. Theproposalsrespondtofundamentalchangesinthescopeandscaleof foreignbankactivitiesintheUnitedStatesinthelastfifteenyears. TheywouldincreasetheresiliencyandresolvabilityoftheU.S.operationsofforeignbanks,helpprotectU.S.financialstability,andpromotecompetitiveequityforalllargebankingfirmsoperatingintheUnitedStates. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  27. P age |27 ThecommentperiodforthisproposalclosesattheendofMarch. Prioritiesfor2013 TheFederalReserve'ssupervisoryandregulatoryprogramin2013willconcentrateonfourtasks: ContinuingkeyDodd-FrankActandBaselIIIregulatoryimplementationwork; Furtherdevelopingsystematicsupervisionoflargebankingfirms; Improvingtheresolvabilityoflargebankingfirms;and Reducingsystemicriskintheshadowbankingsystem. CarryingForwardtheKeyDodd-FrankActandBaselIIIRegulatoryImplementationWork Capital,Liquidity,andOtherPrudentialRequirementsforLargeBankingFirms. Giventhecentralityofstrongcapitalstandards,atopprioritythisyearwillbetoupdatethebankregulatorycapitalframeworkwithafinalruleimplementingBaselIIIandtheupdatedrulesforstandardized risk-weightedcapitalrequirements. Thebankingagencieshavereceivedmorethan2,000commentsontheBaselIIIcapitalproposal. Manyofthecommentshavebeendirectedatcertainfeaturesoftheproposedruleconsideredespeciallytroublingbycommunityandsmallerregionalbanks,suchasthenewstandardizedriskweightsformortgagesandthetreatmentofunrealizedgainsandlossesoncertaindebtsecurities. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  28. P age |28 Thesecriticismsunderscorethedifficultyinfashioningstandardizedrequirementsapplicabletoallbanksthatbalancerisksensitivitywiththeneedtoavoidexcessivecomplexity. Here,though,Ithinkthereisawidespreadviewthattheproposedruleerredonthesideoftoomuchcomplexity. Thethreebankingagenciesarecarefullyconsideringtheseandallcommentsreceivedontheproposalandhopetofinalizetherulemakingthisspring. TheFederalReservealsointendstoworkthisyeartowardfinalizationofitsproposalstoimplementtheenhancedprudentialstandardsandearlyremediationrequirementsforlargebankingfirmsundersections165and166oftheDodd-FrankAct. Aspartofthisprocess,weintendtoconductshortlyaquantitativeimpactstudyofthesingle-counterpartycreditlimitselementoftheproposal. Oncefinalized,thesecomprehensivestandardswillrepresentacorepartofthenewregulatoryframeworkthatmitigatesrisksposedbysystemicallyimportantfinancialfirmsandoffsetsanybenefitsthatthesefirmsmaygainfrombeingperceivedas"toobigtofail." Wealsoanticipateissuingnoticesofsomeimportantproposedrulemakingsthisyear. TheFederalReservewillbeworkingtoproposearisk-basedcapitalsurchargeapplicabletosystemicallyimportantbankingfirms. ThisrulemakingwillimplementforU.S.firmstheapproachtoasystemicsurchargedevelopedbytheBaselCommittee,whichvariesinmagnitudebasedonthemeasureofeachfirm'ssystemicfootprint. FollowingthepassageoftheDodd-FrankAct,whichcalledforenhancedcapitalstandardsforsystemicallyimportantfirms,theFederalReservejoinedwithsomeotherkeyregulatorsfromaroundtheworldin InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  29. P age |29 successfullyurgingtheBaselCommitteetoadoptarequirementofthissortforallfirmsofglobalsystemicimportance. AnotherproposedrulemakingwillcoverimplementationbythethreefederalbankingagenciesoftherecentlycompletedBaselIIIquantitativeliquidityrequirementsforlargeglobalbanks. Thefinancialcrisisexposeddefectsintheliquidityriskmanagementoflargefinancialfirms,especiallythosewhichreliedheavilyonshort-termwholesalefunding. Thesenewrequirementsincludetheliquiditycoverageratio(LCR),whichisdesignedtoensurethatafirmhasasufficientamountofhighqualityliquidassetstowithstandaseverestandardizedliquidityshockovera30-dayperiod. TheFederalReserveexpectsthattheU.S.bankingagencieswillissueaproposalin2013toimplementtheLCRforlargeU.S.bankingfirms. TheBaselIIIliquiditystandardsshouldmateriallyimprovetheliquidityriskprofilesofinternationallyactivebanksandwillserveasakeyelementoftheenhancedliquiditystandardsrequiredundertheDodd-FrankAct. VolckerRule,SwapsPush-out,andRiskRetention. Section619oftheDodd-FrankAct,knownasthe"Volckerrule,"generallyprohibitsabankingentityfromengaginginproprietarytradingoracquiringanownershipinterestin,sponsoring,orhavingcertainrelationshipswithahedgefundorprivateequityfund. InOctober2011,thefederalbankingagenciesandtheSecuritiesandExchangeCommissionsoughtpubliccommentonaproposaltoimplementtheVolckerrule. TheCommodityFuturesTradingCommissionsubsequentlyissuedasubstantiallysimilarproposal. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  30. P age |30 Therulemakingagencieshavespentthepastyearcarefullyanalyzingthenearly19,000publiccommentsontheproposalandhavemadesignificantprogressincraftingafinalrulethatisfaithfultothelanguageofthestatuteandmaximizesbanksafetyandsoundnessandfinancialstabilityattheleastcosttotheliquidityofthefinancialmarkets,creditavailability,andeconomicgrowth. Section716oftheDodd-FrankActgenerallyprohibitstheprovisionof federalassistance,suchasFDICdepositinsuranceorFederalReservediscountwindowcredit,toswapdealersandmajorswapparticipants. TheFederalReserveiscurrentlyworkingwiththeOCCandtheFDICtodevelopaproposedrulethatwouldprovideclarityonhowandwhenthesection716requirementswouldapplytoU.S.insureddepositoryinstitutionsandtheiraffiliatesandtoU.S.branchesofforeignbanks. Weexpecttoissueguidanceontheimplementationofsection716beforetheJuly21,2013,effectivedateoftheprovision. Toimplementtheriskretentionrequirementsinsection941oftheDodd-FrankAct,theFederalReserve,alongwithotherfederalregulatory agencies,issuedinMarch2011aproposalthatgenerallywouldforcesecuritizationsponsorstoretainatleast5percentofthecreditriskoftheassetsunderlyingasecuritization. Theagencieshavereviewedthesubstantialvolumeofcommentsontheproposalandthedefinitionofaqualifiedmortgageintherecentfinal"ability-to-pay"ruleoftheConsumerFinancialProtectionBureau(CFPB). Asyouknow,theCFPB'sdefinitionofqualifiedmortgageservesasthefloorforthedefinitionofexemptqualifiedresidentialmortgagesintheriskretentionframework. Theagenciesareworkingcloselytogethertodeterminenextstepsintheriskretentionrulemakingprocess,withaviewtowardcraftingadefinitionofaqualifiedresidentialmortgagethatisconsistentwiththelanguage InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  31. P age |31 andpurposesofthestatuteandhelpsensurearesilientmarketforprivate-labelmortgage-backedsecurities. ImprovingSystematicSupervisionofLargeBankingFirms Giventheriskstofinancialstabilityexposedbythefinancialcrisis,theFederalReservehasreorienteditssupervisoryfocustolookmorebroadlyatsystemicrisksandhasstrengtheneditsmicro-prudentialsupervisionoflarge,complexbankingfirms. WithintheFederalReserve,theLargeInstitutionSupervisionCoordinatingCommittee(LISCC)wassetuptocentralizethesupervisionoflargebankingfirmsandtofacilitatetheexecutionofhorizontal,cross-firmanalysisofsuchfirmsonaconsistentbasis. TheLISCCincludesseniorstafffromvariousdivisionsoftheBoardandfromtheReserveBanks. Itfostersinterdisciplinarycoordination,usingquantitativemethodstoevaluateeachfirmindividually,relativetootherlargefirms,andaspartofthefinancialsystemasawhole. OnemajorsupervisoryexerciseconductedbytheLISCCeachyearisaComprehensiveCapitalAnalysisandReview(CCAR)ofthelargestU.S.bankingfirms. Buildingonsupervisoryworkcomingoutofthecrisis,CCARwasestablishedtoensurethateachofthelargestU.S.bankholdingcompanies Hasrigorous,forward-lookingcapitalplanningprocessesthateffectivelyaccountfortheuniquerisksofthefirmand Maintainssufficientcapitaltocontinueoperationsthroughouttimesofeconomicandfinancialstress.CCAR,whichusestheannualstresstestasakeyinput,enablestheFederalReservetomakeacoordinated,horizontalassessmentoftheresilienceandcapitalplanningabilitiesof InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  32. P age |32 thelargestbankingfirmsand,indoingso,createscloserlinkagebetweenmicro-prudentialandmacro-prudentialsupervision. LargebanksupervisionattheFederalReservewillincludemoreofthesesystematic,horizontalexercises. ImprovingtheResolvabilityofLargeBankingFirms Oneimportantgoalofpost-crisisfinancialreformhasbeentocountertoo-big-to-failperceptionsbyreducingtheanticipateddamagetothefinancialsystemandeconomyfromthefailureofamajorfinancialfirm. Tothisend,theDodd-FrankActcreatedtheOrderlyLiquidationAuthority(OLA),amechanismdesignedtoimprovetheprospectsforanorderlyresolutionofasystemicfinancialfirm,andrequiredalllargebankholdingcompaniestodevelop,andsubmittosupervisors,resolution plans. Certainothercountriesthatarehometolarge,globallyactivebankingfirmsareworkingalongroughlyparallellines. TheBaselCommitteeandtheFinancialStabilityBoardhavedevotedconsiderableattentiontotheorderlyresolutionobjectivebydevelopingnewstandardsforstatutoryresolutionframeworks,firm-specificresolutionplanning,andcross-bordercooperation. Althoughmuchworkremainstobedonebyallcountries,the Dodd-FrankActreformshavegenerallyputtheUnitedStatesaheadofitsglobalpeersontheresolutionfront. SincethepassageoftheDodd-FrankAct,theFDIChasbeendevelopingasingle-point-of-entrystrategyforresolvingsystemicfinancialfirmsundertheOLA. AsexplainedbytheFDIC,thisstrategyisintendedtoeffecta creditor-fundedholdingcompanyrecapitalizationofthefailedfinancialfirm,inwhichthecriticaloperationsofthefirmcontinue,but InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  33. P age |33 shareholdersandunsecuredcreditorsabsorbthelosses,culpablemanagementisremoved,andtaxpayersareprotected. KeytotheabilityoftheFDICtoexecutethisapproachistheavailabilityofsufficientamountsofunsecuredlong-termdebttosupplementequityinprovidinglossabsorptioninafailedfirm. InconsultationwiththeFDIC,theFederalReserveisconsideringthemeritsofaregulatoryrequirementthatthelargest,mostcomplexU.S.bankingfirmsmaintainaminimumamountoflong-termunsecureddebt. Aminimumlong-termdebtrequirementcouldlendgreaterconfidencethatthecombinationofequityownersandlong-termdebtholderswould besufficienttobearalllossesattheconsolidatedfirm,therebycounteractingthemoralhazardassociatedwithtaxpayerbailoutswhileavoidingdisorderlyfailures. ReducingSystemicRiskintheShadowBankingSystem MostofthereformsIhavediscussedareaimedataddressingsystemicriskposedbyregulatedbankingorganizations,andallinvolveactiontheFederalReservecantakeunderitscurrentauthorities. Importantasthesemeasuresare,however,itisworthrecallingthatthetriggerfortheacutephaseofthefinancialcrisiswastherapidunwindingoflargeamountsofshort-termfundingthathadbeenmadeavailabletofirmsnotsubjecttoconsolidatedprudentialsupervision. Today,althoughsomeofthemostfragileinvestmentvehiclesandinstrumentsthatwereinvolvedinthepre-crisisshadowbankingsystemhavedisappeared,non-depositshort-termfundingremainssignificant. Insomeinstancesitinvolvesprudentiallyregulatedfirms,directlyorindirectly. Inothersitdoesnot. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  34. P age |34 Thekeyconditionoftheso-called"shadowbankingsystem"thatmakesitofsystemicconcernisitssusceptibilitytodestabilizingfundingruns,somethingthatismorelikelywhentherecipientsoftheshort-termfundingarehighlyleveraged,engageinsubstantialmaturitytransformation,orboth. Manyofthekeyissuesrelatedtoshadowbankingandtheirpotentialsolutionsarestillbeingdebateddomesticallyandinternationally. U.S.andglobalregulatorsneedtotakeahard,comprehensivelookatthesystemicriskspresentinwholesaleshort-termfundingmarkets. AnalysisoftheappropriatewaystoaddressthesevulnerabilitiescontinuesasaprioritythisyearfortheFederalReserve. Intheshortterm,though,thereareseveralkeystepsthatshouldbetakenwithrespecttoshadowbankingtoimprovetheresilienceofourfinancialsystem. First,theregulatoryandpublictransparencyofshadowbankingmarkets,especiallysecuritiesfinancingtransactions,shouldbeincreased. Second,additionalmeasuresshouldbetakentoreducetheriskofrunson moneymarketmutualfunds. TheCouncilrecentlyproposedasetofseriousreformoptionstoaddressthestructuralvulnerabilitiesinmoneymarketmutualfunds. Third,weshouldcontinuetopushtheprivatesectortoreducetherisksinthesettlementprocessfortri-partyrepurchaseagreements. Althoughanindustry-ledtaskforcemadesomeprogressontheseissues,theFederalReserveconcludedthatimportantproblemswerenotlikelytobesuccessfullyaddressedinthisprocessandhasbeenusingsupervisoryauthorityoverthepastyeartopressforfurtherandfasteractionbytheclearingbanksandthedealeraffiliatesofbankholdingcompanies. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  35. P age |35 Theamountofintradaycreditbeingprovidedbytheclearingbanksinthetri-partyrepomarkethasbeenreducedandisscheduledtobereducedmuchfurtherinthecomingyearsasaresultoftheseefforts. Butvulnerabilitiesinthismarketremainaconcern,andaddressingthesevulnerabilitieswillrequirethecooperationofthebroadarrayofparticipantsinthismarketandtheirfederalregulators. TheFederalReservewillcontinuetoreporttoCongressandpubliclyon progressmadetoaddresstherisksinthetri-partyrepomarket. Inadditiontotheseconcretestepstoaddressconcreteproblems,regulatorsmustcontinuetocloselymonitortheshadowbankingsectorandbewaryofsignsthatexcessiveleverageandmaturitytransformationaredevelopingoutsideofthebankingsystem. Conclusion Thefinancialregulatoryarchitectureisstrongertodaythanitwasintheyearsleadinguptothecrisis,butconsiderableworkremainstocompleteimplementationoftheDodd-FrankActandthepost-crisisglobalfinancialreformprogram. Overthecomingyear,theFederalReservewillbeworkingwithotherU.S.financialregulatoryagencies,andwithforeigncentralbanksandregulators,toproposeandfinalizeanumberofongoinginitiatives. Inthisendeavor,ourgoalistopreservefinancialstabilityattheleastcosttocreditavailabilityandeconomicgrowth. Wearefocusedonthemonitoringofemergingsystemicrisks,reducingtheprobabilityoffailureofsystemicfinancialfirms,improvingthe resolvabilityofsystemicfinancialfirms,andbuildingupbuffersthroughoutthefinancialsystemtoenablethesystemtoabsorbshocks. Aswetakethisworkforward,itisimportanttorememberthatpreventingafinancialcrisisisnotanendinitself. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  36. P age |36 Financialcrisesareprofoundlydebilitatingtotheeconomicwell-beingofthenation. Thankyouforyourattention.Iwouldbepleasedtoansweranyquestionsyoumighthave. Notes DanielK.TarullotookofficeonJanuary28,2009,tofillanunexpiredtermendingJanuary31,2022. PriortohisappointmenttotheBoard,Mr.TarullowasProfessorofLawatGeorgetownUniversityLawCenter,wherehetaughtcoursesin internationalfinancialregulation,internationallaw,andbankinglaw. PriortojoiningtheGeorgetownLawfaculty,Mr.TarulloheldseveralseniorpositionsintheClintonadministration. From1993to1998,Mr.Tarulloserved,successively,asAssistantSecretaryofStateforEconomicandBusinessAffairs,DeputyAssistanttothePresidentforEconomicPolicy,andAssistanttothePresidentforInternationalEconomicPolicy.HealsoservedasaprincipalonboththeNationalEconomicCouncilandtheNationalSecurityCouncil.From1995to1998,Mr.TarulloalsoservedasPresidentClinton'spersonalrepresentativetotheG7/G8groupofindustrializednations. Mr.TarullowasborninNovember1952inBoston,Massachusetts.HereceivedhisA.B.fromGeorgetownUniversityin1973andhisM.A.fromDukeUniversityin1974.In1977,Mr.TarulloreceivedhisJ.D.(summacumlaude)fromtheUniversityofMichiganLawSchool,whereheservedasArticleandBookReviewEditoroftheMichiganLawReview. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  37. P age |37 InterviewwithCarlosMontalvo,ExecutiveDirectorofEIOPA,conductedbyGarryBooth,Reactionsmagazine(theUK) CanyouexplainwhattheinterimSolvencyIImeasures,sometimesknownasSolvency1.5, encompass? PerhapsIshouldstartwithadisclaimer:IthinkthenameSolvency1.5isunfortunate. WearenotbuildingfromSolvencyI,wearepreparingforRiskBasedSupervision. EIOPAwillissueGuidelinesaddressedtonationalsupervisorsonhowtoproceedintheinterimphaseleadinguptoSolvencyII. TheseGuidelineswillcoverthesystemofgovernance,includingriskmanagementsystemandaforwardlookingassessmentoftheundertaking'sownrisks(basedontheORSAprinciples),pre+applicationofinternalmodels,andreportingtosupervisors. FormoreinformationyoumaywishtoconsulttheEIOPAOpiniononinterimmeasuresregardingSolvencyII: https://eiopa.europa.eu/fileadmin/tx_dam/files/publications/opinions/EIOPA_Opinion+Interim+Measures+Solvency+II.pdf InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  38. P age |38 DoestheproposalhaveacceptanceamongEUcountrysupervisors?Willeveryonemoveforwardtogether? TheabovementionedOpinionofEIOPAwasfirstwelcomed,andthenapprovedbytheEIOPABoardofSupervisors,whichconsistsofthenationalsupervisoryauthoritiesoftheEUMemberStates. EIOPAexpectsthatallourBoardofSupervisorsmembersarecommittedtosetthegroundstodevelopaconsistentandconvergentsupervisoryapproachwithrespecttothepreparationofSolvencyII. EIOPA'sGuidelineswillensurethatimportantaspectsofthenewregimewillbephasedin,takingintoaccountdueproportionality. However,bynaturetheseInterimGuidelinesaresoftregulation(i.e.usedonasocalled"ComplyorExplainbasis"),sotherewillbenosanctionsifsomeNationalSupervisoryAuthorities(NSAs)donotfullycomplywiththeGuidelinesatthisstage. Whyhaveyoudecidedtoissueguidelines(Spring2013)?What'sintheguidelines? IntheabsenceofafinalagreementonSolvencyIIinthescheduledtimeline,EIOPAhasexpressedanopinioninordertoensureandenhancesoundriskbasedsupervisionandpreparetheindustryforthefinalSolvencyIIDirective. InsteadofreachingconsistentandconvergentsupervisionintheEU,differentnationalsolutionsmayemergetothedetrimentofagoodfunctioninginternalmarket. InordertoavoidthisscenarioEIOPAdecidedtodevelopguidelinesandtotakealeadinthepreparatoryprocessaimedataconsistentandconvergentapproachwithrespecttothepreparationofSolvencyII. EIOPAGuidelineswillallowsupervisorsandundertakingstobebetterpreparedfortheapplicationofthenewregulatoryframework. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  39. P age |39 Tocutalongstoryshort,theguidelinesareanexcellentwayforallpartiestousetheextratimeofthedelayasawaytobebetterpreparedforimplementation. TheCROofglobalreinsurerrecentlytoldme,'Weareexperiencingeverincreasingrequirementsforinternalmodelapproval,witheachcountry carryingoutitsownassessment,withlimitedrelationtoproportionality... Thisprocessconsumesalotofresourceswithoutcreatingvalueithasevenstartedtodestroyvalue.AndthesituationmightgetevenworseuntilthefullformalimplementationofallSolvencyII'sthreepillarsin2015/16(oreven17). ItismysincerehopethatEIOPAwillhavethepowertoconvincelocalsupervisorstosticktotheoriginalintention:aprinciplebasedapproachfollowingtheprincipleofproportionality.' What'syourresponse? TherequirementsfortheuseofinternalmodelsaresetoutintheSolvencyIIDirective,andwillindeedbefurtherdevelopedintheupcomingimplementingmeasures,andEIOPAstandardsandguidelines. Suchrequirementswillhavetobefulfilledbyallundertakings(irrespectiveoftheirsize)iftheywanttouseaninternalmodelforSCR calculationsunderSolvencyII. EIOPAhasbeensupportingtheroleofInternalModelsinariskbasedframework,evenaftertheexperienceoftheBankingsector,wheremodelswhichweretooprinciplebasedhadasignificantroleinthecrisis. Thissupportshouldbeacknowledged,andtheneedtolearnfromwhathappenedaswell. EIOPArecognisesthattheusesoftheinternalmodelwillvaryfromundertakingtoundertakingandwillpointouttoNSAsthattheyhavetoassesscompliancewithrequirementsbasedonproportionality,according InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  40. P age |40 tothenature,scaleandcomplexityoftherisksandbusinessoftheundertaking. Havingsaidthat,itisfairtosaythatEIOPArecognisesthatdifferencesbetweensupervisorycultures,MemberStates'legalregimesandanumberofresourcesavailable,haveled,intheshortterm,tosomeinconsistenciesinthesupervisoryapproacheswithrespecttointernalmodelreviewsinpreapplication. Preciselybecauseofthat,whenyoulookatourWorkProgramandobjectivesfor2013onwards,youwillseethatEIOPAisbuildingaCenterofExpertiseforInternalModelsthatwillworkonenhancingconsistencyandsupportingthosesupervisorsthatmayneedhelpachievingit. There’sbeenalotofuncertaintyaroundtheimplementationdateofSolvencyII.Realistically,whenwilltheprojectbecompleted? Let’sstartwithwhatmattersmost:SolvencyIIwillbeimplemented,andthereshouldbenodoubtsaboutit. Ontheapplicationdate,weareconfidentthattheframeworkwillbeapplicablein2016thoughIcannotgiveyou100%reassurancebecausethedecisionisnotmadeattheEIOPAlevel. ThedecisionhastobemadebyagreementbetweentheEuropean Council,EuropeanParliamentandtheEuropeanCommission. IcanconfirmthatEIOPAwilldothenecessaryworktomaketheimplementationofSolvencyIIhappenonJanuary2016. Butlet’sbeclear,oncewesettlethependingissueofLongTermGuarantees,partiesmustavoidthetemptationofreopeningmoreissues. SolvencyIIisagoodframework,itwillnotbeperfectonday1,butthisshouldnotbeanobstacletostart. DrElkeKoenig,presidentoftheGermansupervisorBafinrecentlysaidofSolvencyII,“Youhavecreatedamassivelycomplexsystemwhichis InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  41. P age |41 probablyonlyfullyunderstandableforthosethathavecreatedit.”What’syourresponse? Thebasisofthesystemisquitesimple:itstrivesforriskbasedsupervisionthatincorporatestransparency,callsforaclearunderstandingofriskandgoodgovernance. Sotheideaissimplebutthewayithastobetranslatedintoaregulatoryframeworkiscomplex. SoDrKoenigisrightinthatsense. Whyisitsocomplex? Iwouldsaythatitiseverybody’sresponsibility(theregulators,theEuropeanCommission). Butinmanycasesthecomplexityisalsobeingdrivenbytheindustry. Whatcanwedotomakethingslesscomplex? Weneedtoenhancetheprincipleofproportionalitywhilebearinginmindthatthesameobjectivescanbemetindifferentwaysinparticular forthecompaniesthatarenotdoingcomplicatedbusiness,forSMEsetc. EIOPAisalsoaimingatreducingpartofthiscomplexity,withinitiativessuchasanITtoolkitforundertakingsthatcouldincludeawaytocalculatetheSCR,etc. Wedon’tjustacknowledgetheproblem,wetrytocomewithsolutions. AnotherCROtoldmethatregulatorsappeartonolongerfollowtheoriginalSolvencyIIframeworkrouteofprinciplebasedregulation. Forexample,theLevelThreeproposaltoaddacompliancefunctionandanactuarialfunction,withtheaddedrequirementthatnopersoncanbesimultaneouslyresponsibleformorethanonefunction. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  42. P age |42 ShouldSolvencyII,asaprinciplebasedregime,forcecompaniestomakesuchdepartmentalchanges? Iwassurprisedatthisquestion. TheactionstheCROrefersto,areexplicitlycapturedinthelevel1Directive(articles46and48). Thereisafullarticleontheactuarialfunction(Article48)thatcontainsnumberofrequirements. Thelevel1textisprinciplebasedandthereisasecondlevelwhichgetsintomorenittygrittydetailstodowithbestpracticearoundthecomplianceandactuarialfunctions. Buttheprincipleofproportionalityshouldalwaysbekeptinmind.Furthermore,theintentionofSolvencyIIisnottoforcecompaniestodo theirbusinessinonewayoranother. Itshouldensurethatrisksareaddressedandthatthemeanstodoso,subjecttoproportionality,areimplemented. Onthatbasiswearenotgoingtoforcecompaniestorecruitapersontobeacomplianceofficeroranythinglikethat. Whatweexpectisthattheycomplywiththeprinciplesstatedinlevels1and2–complyinasoundwaybutnotinthesamewayforallthecompanies. Someindividualsinterprettheprinciplesasprescriptivebutitisnotourintentiontotellcompanieshowtostructuretheirbusiness. Weusethewordactuarialfunctionbutfunctiondoesnotmeanperson.Soinatinycompanyyoucouldhaveanactuarialfunctionthatdoesnot havetobeperformedbya‘pure’actuarybutinsteadbysomeonewhohas strongmathematicalknowledge. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  43. P age |43 ArecountrysupervisorsstrayingfromtheoriginalSolvencyIIscript? Ourdutyistomakesurethatall27NSAsunderstandtheprincipleofriskbasedsupervisioninaconvergentwayandapplyitconsistently. Someofourmembershavetoldusthattheyneedtoenhanceriskmanagement,internalcontrols,ordisclosure. Sotheyhadsomeinternalprojectsonholdbecausetheseprojects weretobechannelledviaSolvencyII,whichisthesameforeverybody. NowSolvencyIIisnotcominginJanuary2014astheyexpectedandtheywanttomoveinthoseareas. SoexactlythenecessitytoavoidthedevelopmentofnationalsolutionswasstatedinEIOPAOpiniononInterimMeasuresRegardingSolvencyII,wherewearetalkingaboutnumberofareasforwhichtherewillbeinterimguidelinestargetedtoenhancepreparednesstowardsSolvency2. TheseGuidelinesindicatethatsupervisorsaresupportingtheoriginalideaofconvergenceandharmonization,theybelieveintheconceptofriskbasedsupervision,andEIOPAistakingtheleadtoensurethatimplementationwilltakeplaceinaconsistentway. EIOPAwantsto“pavethewayforfurthermutualunderstandingandfutureconvergencebetweentheEUandtheU.S.oninsuranceregulationandsupervision”. ButmanypeopleintheUSarguestronglyagainstconvergence.Whyisconvergenceimportantinyouropinion? Theconvergenceisimportantforouroverridingaim,whichistodevelopstrongglobalregulatoryandsupervisorystandards. ThepurposeoftheEU+USInsuranceDialogueistoenhancemutualunderstandingandcooperationaswellastopromotebusinessopportunity,consumerprotectionandeffectivesupervision. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  44. P age |44 Weremainrespectfullyawareofthecommonalitiesanddifferencesofbothregimes,continuetostrivetoaddressimportantissuesintechnicaldetail,andmay,overtime,movetowardimprovedcompatibilitythatwillbenefitinsuranceconsumers,industryparticipants,andtheeconomy. ThereisagrowingviewthatSolvencyIIwillleadtorestructuringinthere/insuranceindustrywithM&Aandconsolidationtofollow.Doyouagreethiscouldbeanunintendedconsequence? Ihavebeenhearingthisforthelast15yearsandalsooftenaskedthisquestionatconferencesbyrepresentativesofsmallercompanies. AndIusedtogivesuchanexample: IliketobuybooksandIbuymybooksinatinybookshopinMadrid.Theownerreadsalotandheknowswhatthecustomerlikesandalways givesmegreatrecommendations. IcouldbuymybooksatBarnes&NobleoratAmazon.ButaslongasIgetsuchalevelofservice[frommylittlebookshop]Iwillneverdothat. Ifsmallerinsurancecompaniesunderstandtheneeds,bringaddedvaluetotheircustomersandalsounderstandthespecificsofthebusinesstheyunderwrite,theywillsucceed. TheywillevenbenefitfromSolvencyIIbecauseitgivesthemtheright incentivestohavebetterriskmanagement. Asforcompaniesthataresubjectedtorestructuringormergers,theywillfacesuchissuesbecausetheirproblemsarerelatedtoglobalisationand nottoSolvencyII. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  45. P age |45 Supervisoryguidanceformanagingrisksassociatedwiththesettlementofforeignexchangetransactions ThepurposeofthisguidanceistoprovideupdatedguidancetosupervisorsandthebankstheysuperviseonapproachestomanagingtherisksassociatedwiththesettlementofFXtransactions. Thisguidanceexpandson,andreplaces,theBCBS'sSupervisoryguidanceformanagingsettlementriskinforeignexchangetransactionspublishedinSeptember2000. SincetheBCBS'sSupervisoryguidanceformanagingsettlementriskinforeignexchangetransactions(2000)waspublished,theforeignexchangemarkethasmadesignificantstridesinreducingtherisksassociatedwiththesettlementofFXtransactions. SubstantialFXsettlement-relatedrisksremain,however,notleastbecauseoftherapidgrowthinFXtradingactivities. Thedocumentprovidesamorecomprehensiveanddetailedviewongovernancearrangementsandthemanagementofprincipalrisk,replacementcostriskandallotherFXsettlement-relatedrisks. Inaddition,itpromotestheuseofpayment-versus-paymentarrangements,wherepracticable,toreduceprincipalrisk. Theguidanceisorganizedintoseven"guidelines"thataddressgovernance,principalrisk,replacementcostrisk,liquidityrisk,operationalrisk,legalrisk,andcapitalforFXtransactions. Thekeyrecommendationsemphasizethefollowing: InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  46. P age |46 AbankshouldensurethatallFXsettlement-relatedrisksareeffectivelymanagedandthatitspracticesareconsistentwiththoseusedformanagingothercounterpartyexposuresofsimilarsizeandduration. AbankshouldreduceitsprincipalriskasmuchaspracticablebysettlingFXtransactionsthroughtheuseofFMIsthatprovidePVParrangements. WherePVPsettlementisnotpracticable,abankshouldproperlyidentify,measure,controlandreducethesizeanddurationofitsremainingprincipalrisk. Abankshouldensurethatwhenanalysingcapitalneeds,allFXsettlement-relatedrisksshouldbeconsidered,includingprincipalrisk andreplacementcostriskandthatsufficientcapitalisheldagainstthesepotentialexposures,asappropriate. Abankshouldusenettingarrangementsandcollateralarrangementstoreduceitsreplacementcostriskandshouldfullycollateraliseits mark-to-marketexposureonphysicallysettlingFXswapsandforwardswithcounterpartiesthatarefinancialinstitutionsandsystemicallyimportantnon-financialentities. Annex FXsettlement-relatedrisksandhowtheyarise 1.IntheperiodbetweenFXtradeexecutionandfinalsettlement,abankisexposedtoanumberofdifferentrisks. Therisksvarydependingonthetypeofpre-settlementandsettlementarrangements. AbankneedstounderstandtherisksassociatedwithFXtransactionsinordertoadequatelymanagethem. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  47. P age |47 SectionAdescribesprincipalrisk,replacementcostriskandliquidityrisk.SectionBidentifiesanddescribesthepresenceofoperationalandlegalrisksbetweentradeexecutionandfinalsettlement. Finally,SectionCdiscussesthevariouspre-settlementandsettlementarrangementsandtheirimpactonrisks. Forthepurposesofexposition,therisksaredescribedfromthepointofviewof“abank”andafailedFX“counterparty”ofthatbank.SectionAdescribestherisksrelatingtoasingleFXtradebetweenabankanditscounterparty. ThisisgeneralisedtomultipletradesinSectionsBandC. A.Risksrelatingtocounterpartyfailuretodelivertheexpectedcurrency ThethreemainrisksassociatedwithFXtransactionsareprincipalrisk,replacementcostriskandliquidityrisk,whichariseduetothepossibilitythatacounterpartymayfailtosettleanFXtrade. Thisfailuremaybetemporary(egoperationalorliquidityproblemsofthecounterparty)orpermanent(egcounterparty’sinsolvency). Abankmaybecomeawareofapotentialfailureatanytimebetweentradingandthecompletionofsettlement,particularlyiftheproblemisduetoinsolvency. However,sometimes,abankmayonlyknowthataproblemhasoccurredonoraftersettlementdaywhenitdoesnotreceivethecurrencythatthecounterpartywasexpectedtodeliver. Initially,abankmaynotbeabletoidentifythecauseofthefailure,nordeterminewhetherthefailureistemporaryorpermanent. Abankisexposedtoprincipalrisk,replacementcostriskandliquidityriskuntilitreceivestheboughtcurrencywithfinality. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  48. P age |48 Principalrisk Principalriskistheriskthatabankpaysawaythecurrencybeingsold,butfailstoreceivethecurrencybeingbought. Principalriskcanbethemostseriousriskbecausetheamountatriskcan beequaltothefullvalueofthetrade. Principalriskexistswhenabankisnolongerguaranteedthatitcan unilaterallycancelthepaymentofthecurrencyitsold(theunilateral cancellationdeadline). Giventhatabank’sunilateralpaymentcancellationdeadlinemaybeoneormorebusinessdaysbeforethesettlementdate,thisriskcanlastforasignificantperiodoftime. Replacementcostrisk ReplacementcostriskistheriskthatanFXcounterpartywilldefaultbeforeatradehassettledandthatthebankmustreplaceitwithanewtradeandadifferentcounterpartyatcurrentmarketprices(potentiallylessfavourableexchangerate). Assuch,thebankmayincuralossrelativetotheoriginaltrade.Replacementcostriskexiststhroughouttheperiodbetweentradeexecutionandfinalsettlement. Liquidityrisk Liquidityriskistheriskthatacounterpartywillnotsettleanobligationforfullvaluewhendue. Liquidityriskdoesnotimplythatacounterpartyisinsolventsinceitmaybeabletosettletherequireddebitobligationsatsomeunspecifiedlatertime. Liquidityriskexistsinadditiontoreplacementcostrisk. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  49. P age |49 • Whetheradefaultisjustareplacementcostproblemorturnsintoaliquidityshortagedependsonwhetherabankcanreplacethefailedtradeintimetomeetitsobligationsor,atleast,toborrowthenecessarycurrencyuntilitcanreplacethetrade. • Inprinciple,liquidityriskcanexistthroughouttheperiodbetweentrade executionandfinalsettlement. • Inpractice,theprobabilityoftheproblemmaterialisingasaliquidityshortageandareplacementcostdependsonmanyfactors,including: • Thetimingofthedefault.Thecloserthedefaultistothesettlementdate,thelesstimeabankhastomakeotherarrangements. • Whetherabankhasalreadyirrevocablypaidawaythecurrencyitisselling.Ifso,thebankmayhavefewerliquidassetsavailabletopayforthereplacementtradeortouseascollateraltoborrowthecurrencyitneeds. • Thenatureofthetrade.Thelessliquidthecurrencybeingpurchasedand/orthelargerthevalueofthetrade,theharderitmaybetoreplace. • 11.Abankmayfindithardtopredicttheprobabilityofaliquidityshortage,asitcannotmakeasoundjudgmentbasedsolelyonnormalmarketconditions. • However,thereisastrongpositivecorrelationbetweenacounterpartydefaultandilliquidmarkets(iethedefaultmaybethecauseofthemarketilliquidityoraneffectofit). • Inaddition,tradesthatareeasytoreplaceinnormalconditionsmaybeimpossibletoreplacewhenmarketsarelessliquidandexperiencingstressedconditions. • B.Operationalandlegalrisks • 12.AbankmayalsofaceFXsettlement-relatedriskscausedbyweaknessesinitsownoperationsandweaknessesinthelegal InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

  50. P age |50 enforceabilityofcontractualtermsandthegoverninglawapplicabletoitstransactions. Ifabankhasinadequateoperationalcapabilitiesorifthereareweaknessesinthelegalbasisforthepre-settlementandsettlementarrangements,itcanfaceincreasedprincipalrisk,replacementcostriskandliquidityriskrelatingtocounterpartyfailure. Operationalriskistheriskoflossduetoexternaleventsorinadequateorfailedinternalprocesses,peopleandsystems. Thisdefinitionincludeslegalriskandexcludesstrategicandreputationalrisk. Inadequateskillsandinsufficientprocessingcapacitymayincreasepotentialexposures. Theseweaknessescancauseoperationaldelays,inaccurateconfirmationandreconciliation,oraninabilitytoquicklycorrectorcancelpayment instructions. Legalriskoccurswhenacounterparty’scontractualFXobligationsarenon-binding,unenforceableandsubjecttolossbecause: Theunderlyingtransactiondocumentationisinadequate; Thecounterpartylackstherequisiteauthorityorissubjecttolegaltransactionrestrictions; Theunderlyingtransactionorcontractualtermsareimpermissibleand/orconflictwithapplicablelaworregulatorypolicies;or Applicablebankruptcyorinsolvencylawslimitoraltercontractualremedies. 16.Legalproblemsmayaffectsettlementofaforeignexchangetransaction. InternationalAssociationofRiskandComplianceProfessionals(IARCP) www.risk-compliance-association.com

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