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P a g e | 1 Inter n atio na l A s s oci a t ion of R isk a nd Co mpl i a n c e Pr o f e s s io na l s ( I A RCP) 12 0 0 G St re e t N W Su i t e 8 0 0 W a s h i ng t o n, D C 2 000 5 - 67 0 5 U SA T e l : 2 0 2 - 44 9 - 9750 www .ri s k - c ompl i ance-a ss o c i a tion . c om.

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InternationalAssociationofRiskandComplianceProfessionals(IARCP)

1200GStreet NWSuite800Washington,DC20005-6705USATel:202-449-9750www.risk-compliance-association.com

Top10riskandcompliancemanagementrelatednewsstoriesandworldeventsthat(forbetterorforworse)shapedthe week'sagenda,andwhatisnext

DearMember,

Itwas2a.m.andIwasready tosleep,butIalsowantedtocheckmyemailsanothertime.

Yes,Ihavereadthefamousbook“The4-HourWorkweek”byTimothyFerriss,butIdisagreewith

him,soIhavedecidedtodothe opposite:Tocheck emailsmorefrequently.SorryTim.

Oneofthefirstemailswasanimportantone:RedAlert,ChinaoccupiesthePublicCompanyAccountingOversightBoard.

Therewasevenapicture!

InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com


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What?

IknowthatChinaimplementsaChineseSarbanes-Oxley…butwhatisthatnow?

Iread inthepicturethatPCAOB主席JamesR.Doty说:“这份协议是 在跨境执法合作中迈出的重要一步,它也是保护美国资本市场投资者 利益必要的一步。”

What?IsJamesR.Dotywell?

Fortunately,Jamesisverywell.Therewasnoredalert.Oneofmyfriends,John,andattorney,sentmethisemail.

Readmoreabout说:这份协议是在跨境执法合作中迈出的重要一步, 它也是保护美国资本市场投资者利益必要的一步atnumber7ofourlistbelow.

Thefollowingmorning,Ireceivedanotheremail.

Title:“Forecastingis theartofsayingwhatwillhappen,andthenexplainingwhyitdidn't”

Message:Ihateyou.Ourbossisfollowingyourstresstestingrecommendations.Lao Tzuhassaidthatthosewhohaveknowledgedon'tpredict.Thosewho predict,don'thaveknowledge.

Signature:Terminator

Terminator?

ArnoldSchwarzenegger,didyousendthisemail?

Who?LaoTzu?TheChineseagain?Ireplied!

“DearArnold(orotherTerminator),

InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com


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Itisnotme!ItisBaseliiithatasksforaforward-lookingperspective!Baseliiirequiresstresstesting.And,wehaveacrystalballinriskmanagement:TherecommendationsoftheFinancialStabilityBoard(FSB).”

Therecommendations…

Whoreadstheserecommendations?Soimportant...Ihaveledsome classessinceJanuary,nobodyreadsFSB.

TheylaughwhenIsayreadFSBeverymorning,beforereadingFTor WSJ!

ItistimetoreadtherecommendationsoftheFSBcarefully.Itisabout theboard,seniormanagement,risk officers,complianceofficers,internalandexternalauditors.

ThisisourNumber1.Thesepagesaresoimportant.Welcome totheTop10list.

BestRegards,

GeorgeLekatisPresidentoftheIARCP

GeneralManager,ComplianceLLC

1200GStreetNWSuite800,WashingtonDC20005,USATel:(202)449-9750

Email:[email protected]

Web:www.risk-compliance-association.comHQ:1220N.MarketStreetSuite804,WilmingtonDE19801,USA

Tel:(302)342-8828

InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com


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ThematicReviewonRiskGovernancePeerReviewReport

FinancialStabilityBoard(FSB)memberjurisdictionshavecommitted,undertheFSBCharterandintheFSBFrameworkforStrengtheningAdherencetoInternationalStandards,toundergoperiodicpeerreviews.

Tofulfilthisresponsibility,theFSBhasestablishedaregularprogrammeofcountryandthematicpeerreviewsofitsmemberjurisdictions.

ThematicreviewsfocusontheimplementationandeffectivenessacrosstheFSBmembershipofinternationalfinancialstandardsdevelopedbystandard-settingbodiesandpoliciesagreedwithintheFSBinaparticularareaimportantforglobalfinancialstability.

KeynoteLuncheonSpeech

By CommissionerElisseB.Walter

U.S. SecuritiesandExchangeCommission

32ndAnnualSECand FinancialReportingInstituteConference,Pasadena,CA

BackgroundonthePCAOB

StevenB.Harris,BoardMemberKennesawStateGraduateStudentMeetingWashington,DC

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FinancialConglomeratesDirectiveTechnicalReview

ThisPrudentialRegulationAuthority(PRA) policystatementpublishesthefinalrulesimplementingtheFinancialConglomerates

DirectiveTechnicalReview(2011/89/EC)(FICOD1)whichamendstheFinancialConglomeratesDirective(2002/87/EC)andcertainother

Directivesinsofarastheyapplytofinancialconglomerates.

CommitteeontheGlobalFinancialSystemCGFSPapersNo49

Assetencumbrance,financialreformandthedemandforcollateral assets

ReportsubmittedbyaWorkingGroupestablishedby theCommitteeontheGlobalFinancialSystem

TheGroupwaschairedbyAerdtHouben,NetherlandsBank

Giventhatthedemandforcollateralassetsisincreasing,theCommitteeontheGlobalFinancialSystem(CGFS) in May2012establishedaWorkingGroup(chairedbyAerdtHouben,NetherlandsBank)toexploretheimplicationsofthistrendformarketsandpolicy.

ThisreportpresentstheGroup’sfindingsfromasystem-wideperspectiveanddrawsbroadconclusionsforpolicymakers.

Thereportpresentsevidenceofincreasedreliancebybanksoncollateralisedfundingmarketsinrecentyearsforsomeregions,withtheincreasebeingmostpronouncedinEurope.

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PeerReviewofSwitzerlandReviewReport

FSBcountrypeerreviews

TheFSBhasestablishedaregularprogrammeofcountrypeerreviewsofitsmemberjurisdictions.

The objectiveofthereviewsistoexaminethestepstakenorplannedbynationalauthoritiestoaddressInternationalMonetaryFund(IMF)-WorldBankFSAP recommendationsconcerningfinancialregulationandsupervisionaswellasinstitutionalandmarketinfrastructure.

PCAOBEntersintoEnforcementCooperationAgreementwithChineseRegulators

The PublicCompanyAccountingOversightBoardannouncedthatithasenteredintoaMemorandumofUnderstanding(MOU)onEnforcementCooperationwiththeChinaSecuritiesRegulatoryCommission(CSRC)andtheMinistryofFinance(MOF).

TheMOUestablishesacooperativeframeworkbetweenthepartiesfortheproductionandexchangeofauditdocumentsrelevanttoinvestigationsinbothcountries’respectivejurisdictions.

Morespecifically,itprovidesamechanismforthepartiestorequestandreceivefromeachotherassistancein obtainingdocumentsandinformationinfurtheranceoftheir investigativeduties.

InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com


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Islamiccommerceandfinance

OpeningremarksbyDrMichaelGondwe,GovernoroftheBankofZambia,attheworkshopon“Islamiccommerceandfinance”,Lusaka.

Threequestionsonthenatureandmanagementofrisk

KeynotespeechbyMrNormanTLChan,ChiefExecutiveoftheHongKongMonetaryAuthority,at

theHongKongMonetaryAuthority-GlobalAssociationofRisk

Professionals(GARP)GlobalRiskForumOpeningDinner,HongKong.

InvestorProtectionThroughEconomicAnalysis

ByCraigM.Lewis,ChiefEconomistandDirector

DivisionofRisk,Strategy,andFinancialInnovation,U.S.SecuritiesandExchangeCommission

SpeechatthePennsylvaniaAssociationofPublicEmployeeRetirementSystemsAnnualSpringForumHarrisburg,PA

InternationalAssociationofRiskandComplianceProfessionals(IARCP)www.risk-compliance-association.com


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ThematicReviewonRiskGovernance

PeerReviewReportForeword

FinancialStabilityBoard(FSB)memberjurisdictionshavecommitted,undertheFSBCharterandintheFSBFrameworkforStrengtheningAdherencetoInternationalStandards,toundergoperiodicpeerreviews.

Tofulfilthisresponsibility,theFSBhasestablishedaregularprogrammeofcountryandthematicpeerreviewsofitsmemberjurisdictions.

ThematicreviewsfocusontheimplementationandeffectivenessacrosstheFSBmembershipofinternationalfinancialstandardsdevelopedbystandard-settingbodiesandpoliciesagreedwithintheFSBinaparticularareaimportantforglobalfinancialstability.

Thematicreviewsmayalsoanalyse otherareasimportantforglobalfinancialstabilitywhereinternationalstandardsorpoliciesdonotyetexist.

The objectivesofthereviewsaretoencourageconsistentcross-countryandcross-sectorimplementation;toevaluate(wherepossible)theextent towhichstandardsandpolicieshavehadtheirintendedresults;and toidentifygapsandweaknessesinreviewedareasandtomakerecommendationsforpotentialfollow-up(includingviathedevelopmentofnewstandards)byFSBmembers.

Thisreportdescribes thefindingsofthethematicpeerreviewonriskgovernance,includingthekeyelementsofthediscussionintheFSBStandingCommitteeonStandardsImplementation(SCSI).

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ThedraftreportfordiscussionwaspreparedbyateamchairedbySweeLianTeo(MonetaryAuthorityofSingapore),comprisingTedPrice(CanadaOfficeoftheSuperintendentofFinancialInstitutions),XiangQi(ChinaBankingRegulatoryCommission),JérômeLachand(FranceAutoritédeContrôlePrudentiel),SofiaNikopoulos(GermanBaFin),AdrianaElizondo(MexicoNationalBankingandSecuritiesCommission),FranciscoGil(BankofSpain),Mike Brosnan(UnitedStatesOfficeoftheComptrolleroftheCurrency),Xavier-Yves Zanota(memberoftheBaselCommitteeonBankingSupervisionSecretariat),MatsIsaksson(OrganisationforEconomicCo-operationandDevelopment),andLauraArd(WorldBank).

Merylin CoombsandGraceSone(FSBSecretariat)providedsupport totheteamandcontributed to thepreparationofthepeerreviewreport.

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Executivesummary

Therecentglobalfinancialcrisisexposedanumberofgovernanceweaknessesthatresultedin firms’failure to understandtheriskstheyweretaking.

In thewakeofthecrisis,numerousreportspaintedafairlybleakpictureofriskgovernanceframeworksatfinancialinstitutions,whichconsistsofthethreekeyfunctions:

Theboard,thefirm-widerisk managementfunction,andtheindependentassessmentofrisk governance.

Thecrisishighlightedthatmanyboardshaddirectorswithlittlefinancialindustryexperienceandlimitedunderstandingoftherapidlyincreasingcomplexityoftheinstitutionstheywereleading.

Toooften,directorswereunabletodedicatesufficienttimetounderstandthefirm’sbusinessmodelandtoodeferentialtoseniormanagement.

In addition,manyboardsdidnotpaysufficientattention to riskmanagementorsetupeffectivestructures,suchasadedicatedriskcommittee,tofacilitatemeaningfulanalysisofthefirm’sriskexposuresandtoconstructivelychallengemanagement’sproposalsanddecisions.

Theriskcommitteesthatdidexistwereoftenstaffedbydirectorsshorton bothexperienceandindependencefrommanagement.

Theinformationprovidedtotheboardwasvoluminousandnoteasily understoodwhichhamperedtheabilityofdirectors to fulfiltheirresponsibilities.

Moreover,mostfirmslackedaformalprocesstoindependentlyassesstheproprietyoftheirriskgovernanceframeworks.

Withouttheappropriatechecksandbalancesprovidedbytheboard,theriskmanagementfunction,andindependentassessmentfunctions,a

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cultureofexcessiverisk-takingandleveragewasallowed topermeateintheseweaklygovernedfirms.

Further,withtheriskmanagementfunctionlackingtheauthority,statureandindependencetoreininthefirm’srisk-taking,theabilityto addressanyweaknessesinrisk governanceidentifiedbyinternalcontrolassessmentandtestingprocesseswasobstructed.

Thepeerreviewfoundthat,sincethecrisis,nationalauthoritieshavetakenseveralmeasurestoimproveregulatoryandsupervisoryoversightofriskgovernanceatfinancialinstitutions.

Thesemeasuresincludedevelopingorstrengtheningexistingregulationorguidance,raisingsupervisoryexpectationsfortheriskmanagementfunction,engagingmorefrequentlywiththeboardandmanagement,andassessingtheaccuracyandusefulnessoftheinformationprovided totheboardtoenableeffectivedischargeoftheirresponsibilities.

Nonetheless,moreworkremains;nationalauthoritiesneedtostrengthentheirability to assess theeffectivenessofafirm’sriskgovernance,andmorespecificallyitsriskculturetohelpensuresoundrisk governancethroughchangingenvironments.

Supervisorswillneed toundergoasubstantialchangein approachsinceassessingrisk governanceframeworksentailsforminganintegratedviewacrossallaspectsoftheframework.

Thepeerreviewalsoaskedsupervisorstoevaluateprogressmadebytheirsurveyedfirm(s)towardenhancedrisk governanceinsevenareas.

Toprovidesomeconsistencytothisexercise,thereviewteamdevelopedhigh-levelcriteriatoassistsupervisoryevaluationsoffirms’progress,drawingfromacompilationofrelevantprinciples,recommendationsandsupervisoryguidance.

Thehigh-levelcriteriawereviewedasfundamentalprerequisitesforriskgovernanceframeworks.

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  • Thisevaluationfoundthatmanyofthebestriskgovernancepracticesatsurveyedfirmsarenow moreadvancedthannationalguidance.

  • Thisoutcomemayhavebeenmotivatedbyfirms’needto regainmarketconfidenceratherthanregulatoryrequirements.

  • Firmshavemadeparticularprogressin:

  • assessingthecollectiveskillsandqualificationsoftheboardaswellastheboard’seffectivenesseitherthroughself-evaluationsorthroughtheuseofthirdparties;

  • institutingastand-alonerisk committeethatiscomposedonlyofindependentdirectorsandhavingacleardefinitionofindependence;

  • establishingagroup-widechiefriskofficer(CRO)andriskmanagementfunctionthatisindependentfromrevenue-generatingresponsibilitiesandhasthestature,authorityandindependencetochallengedecisionsonrisk madebymanagementandbusinesslines;and

  • integratingthediscussionsamongtheriskandauditcommitteesthroughjointmeetingsorcross-membership.

  • Althoughmanysurveyedfirmshavemadeprogressinthelastfewyears,significantgapsremain,relative tothecriteriadeveloped,particularlyinriskmanagement.

  • Therewerealsodifferencesinprogressacrossregionswithfirmsinadvancedeconomieshavingadoptedmoreofthedesirableriskgovernancepractices.

  • Theresultsofthesupervisoryevaluationsweregroupedby:

  • allsurveyedfirms;

  • firmsidentifiedbytheFSBandBaselCommitteeonBankingSupervision(BCBS)asglobalsystemicallyimportantfinancialinstitutions,orG-SIFIs;and

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  • (iii)firmsthatresideinadvancedeconomies(AEs)oremergingmarketanddevelopingeconomies(EMDEs).

  • In summary,acrossthesevenareasevaluated,firmshavemadethemostprogressindefiningtheboard’sroleandresponsibilities,andreasonableprogressintheirapproachtorisk governanceandtheindependentassessmentofrisk governance.

  • Thesupervisoryevaluations,however,indicatethatsurveyedfirmsshouldcontinuetoworktowarddefiningtheresponsibilitiesoftheriskcommitteeandstrengtheningtheirriskmanagementfunctionsasnearly 50percentofsurveyedfirmsdidnotmeetalloftheevaluationcriteria intheseareas.

  • Bytypeof institution,surveyedG-SIFIsaremoreadvancedthanotherfinancialinstitutionsin definingtheresponsibilitiesoftheboardandriskcommittee,conducting independentassessmentsofriskgovernance,providingrelevantinformationtotheboardandrisk committee,andtosomeextentmoreadvancedintheriskmanagementfunction.

  • Theseresultssupport thefindingthatthefirmsintheregionshardesthitbythefinancialcrisishavemadethemostprogress.

  • Meanwhile,supervisoryevaluationsoffirmsthatresideinEMDEsshowthatnearly65percentdidnotmeetallofthecriteriafortheriskmanagementfunction.

  • Thesegapsneedimmediateattentionbybothsupervisorsandfirms.Othersignificantfindingscomingoutofthereviewincludethefollowing:

  • Nationalauthoritiesdonotengageonasufficientlyregularandfrequentbasiswiththeboard,risk committeeandauditcommittee.

  • Severaljurisdictionshold suchmeetingsonlyonceayearoronanas-neededbasis.

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  • GoodprogresshasbeenmadetowardelevatingtheCRO’sstature,authority,andindependence.

  • In manyfirms,theCROhasadirectreportinglinetothechiefexecutiveofficer(CEO)andarolethatisdistinctfrom otherexecutivefunctionsandbusinesslineresponsibilities(e.g.,no“dual-hatting”).

  • Thiselevation,however,needstobesupportedbytheinvolvementoftheriskcommitteeinreviewingtheperformanceandsettingtheobjectivesoftheCRO,ensuringthattheCROhas accesstotheboardandriskcommitteewithoutimpediment(includingreportingdirectlyto theboard/riskcommittee),andfacilitatingperiodicmeetingswithdirectorswithoutthepresenceofexecutivedirectorsorothermanagement.

  • Moreworkisneededonthepartofbothnationalauthoritiesandfirmsonestablishinganeffectiverisk appetiteframework(RAF).

  • Assessingafirm’sRAFisachallengingtaskthatrequiresgreaterclarityandanelevatedlevelofconsistency amongnationalauthorities.

  • Supervisoryexpectationsfortheindependentassessmentofinternalcontrolsystemsbyinternalauditorother independentfunctionwerewell-establishedpriortothecrisis.

  • Assuch,thisisanarea thatdemonstratedrelativelysoundpracticesacrosstheFSBmembershipatbothnationalauthoritiesandfirms.

  • However,nojurisdictionhadspecificexpectationsfor internalaudit toperiodicallyprovideafirm-wideassessmentofriskmanagementorriskgovernanceprocesses.

  • Nearlyallfirmshaveanindependentchief auditexecutive(CAE)whoreportsadministrativelytotheCEO andtheauditcommitteechairandwhodirectlyreportsauditfindings to apermanentauditcommittee.

  • However,thereisstillroomforimprovingtheCAE’saccesstodirectorsbeyondthoseontheauditcommittee.

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Drawingfromthefindingsofthereview,includingdiscussionswithindustryorganisationsaswellasrisk committeedirectorsandCROsofseveralfirmsthatparticipatedinthereview,thereportidentifiessomeofthebetterpracticesexemplifiedbynationalauthoritiesandfirms to collectivelyformalistofsoundrisk governancepractices.

Italsodrawsonsomeoftherelevantprinciplesandrecommendationsforriskgovernancepublishedbyotherorganisationsandstandardsettingbodies.

Noonesingleauthorityorfirm,however,demonstratedallofthesesound practices.

Thisintegratedandcoherentlistofsoundpracticesaimstohelpnationalauthoritiestakeamoreholisticapproach to riskgovernance,ratherthanlookingat eachfacet in isolation,andmayprovideabasisforconsiderationbyauthoritiesandstandardsettingbodiesastheyreviewtheirguidanceandstandardsforstrengtheningriskgovernancepractices.

Thereviewsetsoutseveralrecommendations to ensuretheeffectivenessofriskgovernanceframeworkscontinuetoimprovebytargetingareaswheremoresubstantialworkisneeded.

Whilethereviewfocusedonbanksandbroker-dealersthataresystemicallyimportant,theserecommendationsapply to othertypesoffinancialinstitutions,includinginsurersandfinancialconglomerates.

Recommendations:

1.Toensurethatfirms’risk governancepracticescontinuetoimprove,FSBmemberjurisdictionsshouldstrengthentheirregulatoryandsupervisoryguidanceforfinancialinstitutions,inparticularforSIFIs,and devoteadequateresources(bothinskillsandquantity)toassesstheeffectivenessofriskgovernanceframeworks.

In particular,nationalauthoritiesshouldconsiderthefollowingsoundriskgovernancepractices:

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Setrequirementsontheindependenceandcompositionofboards,includingrequirementsonrelevanttypesofskillsthattheboard,collectively,shouldhave(e.g.,risk management,financialindustryexpertise)aswellasthetimecommitmentexpected.

Holdtheboardaccountableforitsoversightofthefirm’sriskgovernanceandassessifthelevelandtypesofriskinformationprovidedtotheboardenableeffectivedischargeofboardresponsibilities.

Boardsshouldsatisfythemselvesthattheinformationtheyreceivefrommanagementandthecontrolfunctionsiscomprehensive,accurate,completeandtimelyto enableeffectivedecision-makingonthefirm’sstrategy,risk profileandemergingrisks.

Thisincludesestablishingcommunicationproceduresbetweentheriskcommitteeandtheboardandacrossotherboardcommittees,mostimportantlytheauditandfinancecommittees.

SetrequirementstoelevatetheCRO’sstature,authority,andindependenceinthefirm.

ThisincludesrequiringtheriskcommitteetoreviewtheperformanceandobjectivesoftheCRO,ensuringtheCROhasunfetteredaccesstotheboardandrisk committee(includingadirectreportinglinetotheboardand/orriskcommittee),andexpectingtheCROtomeetperiodicallywithdirectorswithoutexecutivedirectorsandmanagementpresent.

TheCRO shouldhaveadirectreportingline totheCEOandadistinctrolefrom otherexecutivefunctionsandbusinesslineresponsibilities(e.g.,no“dual-hatting”).

Further,theCROshouldbeinvolvedinactivitiesanddecisions(fromariskperspective)thatmayaffectthefirm’sprospectiverisk profile(e.g.,strategicbusinessplans,newproducts,mergersandacquisitions,internalcapitaladequacyassessmentprocess,orICAAP).

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Requiretheboard(orauditcommittee)toobtainanindependentassessmentofthedesignandeffectivenessoftherisk governanceframeworkonanannualbasis.

Engagemorefrequentlywiththeboard,risk committee,auditcommittee,CEO,CRO,andotherrelevantfunctions,suchastheCFO,toassessthefirm’sriskculture(e.g.,the“toneatthetop”),whetherdirectorsprovideeffectivechallengetomanagement’sproposalsanddecisions,andwhethertheriskmanagementfunctionhastheappropriateauthority to influencedecisionsthataffect thefirm’srisk exposures.

Therelevantstandardsettingbodies(e.g.,BCBS,IAIS,IOSCO, OECD)shouldreviewtheirprinciplesforgovernance,takingintoconsiderationthesoundrisk governancepracticeslistedinSectionV.

Risk cultureplaysacriticalrolein ensuringeffectiverisk governanceenduresthrough changingenvironments.

TheFSBSupervisoryIntensityandEffectivenessgrouphasagreed toimplementtherecommendationfromthe2012FSBprogressreportonenhancedsupervision to explorewaystoformallyassessriskculture,particularlyatG-SIFIs.

ThisworkshouldbecompletedbySeptember2013.

To improvetheirability to assessfirms’progresstowardmoreeffectiveriskmanagement,nationalauthoritiesshouldprovideguidanceonthekeyelementsthatareincorporatedineffectiverisk appetiteframeworks.

To enablefirmstodefineframeworkswithaminimumamount ofcomparabilitydespitetheirfirm-specificnature,acommonnomenclaturefortermsusedin riskappetitestatements(e.g.,“riskappetite”,“riskcapacity”,“risklimits”)shouldbeestablished.

TheFSBSupervisoryIntensityandEffectivenessgroup,incollaborationwithrelevantstandardsetters,hasagreed to finalisethisworkbytheend of2013.

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  • TheFSBshouldconsiderlaunchingafollow-upreviewonriskgovernanceafter2016(i.e.,aftertheG-SIFIpolicy measuresbegintobephasedin),to assessnationalauthorities’implementationoftherecommendationstostrengthentheirsupervisoryguidanceandoversightofriskgovernance.

  • ThereviewalsoshouldincludetheG-SIFIs identifiedin2014bytheFSBincollaborationwiththeBCBSandIAIS.

    • Introduction

  • Increasingtheintensityandeffectivenessofsupervision to reducethemoralhazardposedbySIFIsisakeycomponentoftheFSB’spolicymeasures,endorsedbyG20Leaders.

  • Sincetheonsetoftheglobalcrisis,supervisorshaveintensifiedtheiroversightoffinancialinstitutions,particularlySIFIs,soastoreducetheprobabilityoftheirfailure.

  • Specifically,supervisoryexpectationsofriskmanagementfunctionsandoverallrisk governanceframeworkshaveincreased,asthiswasanareathatexhibitedsignificantweaknessesinmanyfinancialinstitutionsduringtheglobalfinancialcrisis.

  • Whilesupervisorsareresponsibleforassessingwhetherafirm’sriskgovernanceframeworkandprocessesareadequate,appropriateandeffectiveformanagingthefirm’sriskprofile,thefirm’smanagementisresponsibleforidentifyingandmanagingthefirm’srisk.

  • InOctober2011,theFSBagreedtoconductathematicpeerreviewonriskgovernancetoassessprogresstowardenhancingpracticesatnationalauthoritiesandfirms(banksandbroker-dealers).

  • Forpurposesofthisreview,riskgovernance collectivelyrefers to theroleandresponsibilitiesoftheboard,thefirm-wideCROandriskmanagementfunction,andtheindependentassessmentoftheriskgovernanceframework(seeChart2).

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  • Boardresponsibilitiesandpractices:Theboardisresponsibleforensuringthatthefirmhasanappropriaterisk governanceframeworkgiventhefirm’sbusinessmodel,complexityandsizewhichisembeddedintothefirm’srisk culture.

  • Howboardsassumesuchresponsibilitiesvariesacrossjurisdictions.

  • Firm-wideriskmanagementfunction:TheCROandriskmanagementfunctionareresponsibleforthefirm’sriskmanagementacrosstheentireorganisation,ensuringthatthefirm’sriskprofileremainswithintheriskappetitestatement(RAS)asapprovedbytheboard.

  • Therisk managementfunctionisresponsiblefor identifying,measuring,monitoring,andrecommendingstrategiestocontrolormitigaterisks,andreportingonriskexposuresonanaggregatedanddisaggregated basis.

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  • Independentassessmentoftheriskgovernanceframework:Theindependentassessmentofthefirm’srisk governanceframeworkplaysacrucialroleintheongoingmaintenanceofafirm’s internalcontrols,riskmanagementandriskgovernance.

  • Ithelpsafirmaccomplishitsobjectivesbybringingadisciplinedapproachtoevaluateandimprovetheeffectivenessofriskmanagement,controlandgovernanceprocesses.

  • Thismayinvolveinternalparties,suchasinternalaudit,orexternalresourcessuchasthird-partyreviewers(e.g.,auditfirms,consultants).

  • Thepeerreviewdidnotfocuson otherrelevantdimensionsofriskgovernance,suchasriskdisclosuresandfirm-widecompensation practices(sincetheseareashavebeencoveredbypreviousFSBpeerreviews)orrisk dataaggregation capabilitiesatbanks (sincethistopicisbeingcoveredbyataskforceoftheBCBS.

  • Separately,theInternationalAssociationofInsuranceSupervisors(IAIS)launchedapeerreviewattheendof2012againstitsCorePrinciplesongovernanceandriskmanagementandinternalcontrols.

  • Thereiscurrentlynosinglesetofprinciplesandstandardsthatcomprehensivelyaddressesandintegratesriskgovernancerequirements;however,anumberofdifferentstandardsandrecommendationsongoodgovernanceframeworksarerelevant.

  • Thereviewthereforedidnotassesscompliancewithanyspecific standard,butusedacompilationofexistingstandardsand recommendations(asappropriate)totakestockofriskgovernancepracticesatbothnationalauthoritiesandfirms,andtoidentifyanygapstherein.

  • Supervisorswereaskedtoevaluatefirms’progressandthereview teamdevelopedhigh-levelcriteriatoprovidesomeconsistencytothisexercise.

  • ThefindingsofthereviewwerebasedontheresponsestoquestionnairesfromFSBmemberjurisdictions11andfromthe36banks and

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broker-dealersthatFSBmembersdeemedassignificantforthepurposeofthereview.

SectionIItakes stockofnationalauthorities’initiatives to strengthenoversightoffirms’riskgovernanceframeworksanddescribestherangeofsupervisorypracticesin fourbroadareas:

Theboardanditscommittees;

Thefirm-widerisk managementfunction,includingtheCRO;

Theindependentassessmentofthefirm-wideriskmanagementframeworkbyinternalauditand/orthirdparties;and

Thesupervisoryassessmentofrisk governanceframeworks.

SectionIIIexaminesriskgovernancepracticesatsurveyedfirmsandthechangesmadesincethefinancialcrisis.

Inadditiontotheresponsestothequestionnaire,thefindingsdrawontheoutcomesofdiscussionswithindustryorganisationsaswellasriskcommitteedirectorsandCROsofseveralfirmsthatparticipatedinthereview.

Nationalsupervisorswereaskedto assessfirms’progress towardenhancingkeyriskgovernancefunctions,aswellastheaccuracyandcompletenessoftheresponsesprovidedbyfirmsheadquarteredintheirjurisdiction.

SectionIVsetsouttheconclusionsandrecommendationsdrawnfromthefindingsofthereview,whichisfollowedbyalistofsoundriskgovernancepracticesthatencompassanoverlayofsupervisoryexpectationsforsound practicesatfirms.

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  • II.Nationalauthorities’oversightofriskgovernancepractices

  • Sincethefinancialcrisis,nationalauthoritieshaveincreasedtheirsupervisoryfocusonrisk governance,whichisacriticalelementforpromotingamoreresilientfinancialsystem.

  • Underpinningtherangeofreformsis theissuancein 2010oftheBCBSPrinciplesforEnhancingCorporateGovernanceandtheOECDpublicationonCorporateGovernanceandtheFinancialCrisis– ConclusionsandEmergingGoodPractices.

  • Someofthenotablechangesembeddedinregulatoryandsupervisoryguidanceinclude:

  • introducingexplicitrequirementsfortheestablishmentofariskcommittee;

  • conveyingexpectationstostrengthentherisk managementfunction,includingthestatureandqualificationsoftheCRO;

  • introducingadditionalrequirementsforriskgovernanceatSIFIs;

  • enhancingthemandateandresourcesofsupervisoryauthoritiesinrelationtorisk governanceoversight;

  • increasingtheintensityofengagementbetweenthesupervisorandtheboardandseniormanagementonrisk governanceissues;and

  • adjustingthesupervisoryrisk assessmentprocess,particularlyincreasingthefocusonriskgovernanceacrossdifferentbusinessmodels.

  • AnnexCprovidesmoredetailsontheinitiativesFSBmembershavetakentostrengthenoversightofrisk governancepractices,includingimplementationofotherrelevantprinciplessuchastheFSBprinciplesforsoundcompensationpracticesandrecommendationsputforwardinthe2009reportbytheSeniorSupervisorGroup(SSG)onriskmanagementpracticesduringthefinancialcrisis.

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  • Whilesupervisoryguidancehasimproved,progresshasbeenuneven acrossthefunctionsthatcollectivelyformtheriskgovernanceframework.

  • Basedonthefindingsfromthereview,someareaswheremoresupervisoryrequirementsand/orguidancewouldbeusefulinclude:

  • Acleardefinitionofindependencewhichisseparatefromnon-executivedirector;

  • Theestablishmentofastand-aloneriskcommitteethatiscomposedofindependentdirectors;

  • Thelevelandtypesofriskinformationfirmsshouldprovideaswellasthefrequencyofriskreporting;

  • Thekeyfeaturesofaneffectiverisk appetiteframeworktohelpsupervisoryevaluations;and

  • Thewaysinternalauditcanprovidefeedbackonwhetherafirm’sriskgovernanceprocessesarekeepingpacewithtrendsand/oralignwith bestpractices.

  • Thenextfoursub-sectionssummariseexistingsupervisoryexpectationsforthethreekeyriskgovernancefunctionsandexamineauthorities’approachestoassessingtheimplementationofsupervisoryexpectations.

  • 1.Theboardandits committees

  • RegulatoryandsupervisoryguidancespecifyingtheroleandresponsibilitiesoftheboardareprevalentacrosstheFSBmembership,includingamongotherthingsforriskgovernance.

  • Akeyresponsibilityoftheboardis to approve thefirm’soverallbusinessstrategyandRAF.

  • Assuch,theboardhasultimateresponsibilityforthefirm’sriskmanagement,includingsettingtheriskcultureofthefirmandoverseeingmanagement’simplementationoftheagreedbusinessstrategy.

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Toensurethatboardsarefocusedonthehigher-levelstrategicandriskissues,supervisorsareengagingmorefrequentlywiththeboardinparticularwithindependentdirectors.

Thedefinitionofwhatconstituteseffectiverisk governanceisevolving,however,supervisorshighlighttheimportanceoftheboardsettingthe“toneatthetop”inregardtothefirm’sstrategyandrisk cultureandchallengingmanagementontheadherencetotheagreedriskappetite.

1.1Boardcomposition

Theleadershipstructuretooverseethefirm’srisk managementvariesacrossjurisdictions.

Mostjurisdictionsrequire theestablishmentofapermanentauditcommittee,whichhasalongerhistorythanotherboardsub-committees,drivenbyrequirementsfromsecuritiesregulatorstoprovideassurance tothequalityofthefinancialinformationprovidedbyregisteredfinancialinstitutions.

Assuch,morespecificregulatoryandsupervisoryrequirementsforthecompositionandindependenceoftheauditcommitteearesetoutthanfortherisk committee.

Forexample,anumberofjurisdictionsrequiretheauditcommitteetocompriseamajorityofindependentornon-executivedirectors,severaljurisdictionsrequiretheauditcommitteechairtobeindependent(or insomecasesanon-executive),andinafewjurisdictionstheparticipationofthechairoftheboardisrestricted.

Theestablishmentofastand-alonerisk committeeislessprevalentandtherequirementtypicallyapplies to large,complexfinancialinstitutions(e.g.,firmswithmanylegalentitiesand/orcross-borderoperations).

Wherestand-alonerisk committeesexist,severaljurisdictions19requireriskcommitteememberstohaveexpertisein risk-relateddisciplinesandonlyafewjurisdictionsrequireaminimumnumberofindependentdirectors.

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  • In HongKong, however,forthcomingchangeswillrequireall,orthemajority,ofthemembersoftherisk committeetobenon-executivedirectors.

  • AnnexDprovidesfurtherdetailsontheregulatoryandsupervisoryguidanceforthecompositionoftheboardandsub-committees,butsomeofthekeyfeaturesinclude:

  • Independence:Manyjurisdictionshaveestablishedgeneral requirementsconcerningtheindependenceoftheboard to ensurethat thereisobjectivejudgementanddecision-makingontheboard.

  • Manyjurisdictionsalsosetoutquantitativeminimumsforthenumberofindependentdirectorsontheboard.

  • Some otherjurisdictionsonlysetquantitativeminimumsforthenumberofnon-executivedirectorswhichdoesnotnecessarilyensureindependentjudgementontheboard.

  • Expertise:Regardlessoftheboardstructure,theboardneeds tocomprisememberswhocollectivelybringabalanceofexpertise,skills,experienceandperspectiveswhileexhibitingtheobjectivitytoensuredecisionsarebasedonsoundjudgementandthoughtfuldeliberations.

  • Manyjurisdictionsconductperiodicreviewsoftheperformance,trainingandskillsneededintheboardandrisk committee.

  • Requiringspecificskillsforalldirectorsareacommonpractice(usuallysubsumedin“fitandproper”tests)andtypicallyincluderelevantknowledge,experienceandskillsin financeand/orbusiness.

  • Severaljurisdictionsnotonlylookatindividualqualificationsbutalsotakeaholisticviewoftheboard,examiningtheircollectiveskillsandqualifications.

  • In additiontohavingcertainskillsandqualifications,somejurisdictionsrequiredirectors tohave thecapacity todedicatesufficienttimeand

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energyinreviewinginformationanddevelopinganunderstandingofthekeyissuesrelatedtothefirm’sactivities.

1.2Governanceoftheboard

Fortheboardtoeffectivelysuperviseandmanagethefirm’sadherencetotheagreedbusinessstrategyandrisk appetite,directorsshouldbeprovidedandhaveaccess to comprehensiveinformationaboutthefirm’srisks.

Thisinvolvesensuringtherearecommunicationandreportingproceduresacrossboardsub-committees,andseveralnationalauthoritiessetoutsuchrequirementsintheirguidance(seeAnnexE).

However,thereislittlesupervisoryguidanceprovidedonthelevelandtypesofriskinformationfirmsshouldprovideaswellasthefrequencyofriskreporting.

Importantly,theriskmanagementreportsprovidedtotheboardshouldcontribute to soundriskmanagementanddecision-making.

Theboardanditscommittees,however,shouldnotjustrelyontheinformationmanagementreportsprovided.

Theyshouldconsiderifthereisaneedforadditionalrisk-relatedinformationwhichshouldbemadeavailabletothemwhenneeded.

Onlyafewjurisdictions,however,requiretheboard tohavesuchaccess.

2.Thefirm-wideriskmanagementfunction

Sincethefinancialcrisis,nationalauthoritieshaveintensifiedtheiroversightoffirms’risk managementpracticesandraisedtheirexpectationsforwhatisconsideredstrongrisk management,whichisintegralto thecorebusinessofafinancialinstitution.

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  • Thefailure tohaveastrong, independentrisk managementfunctioncanlead to ill-informedboardsandseniormanagementteamsaswellasimprudentdecisions.

  • Therisk managementfunctionshouldberesponsibleforthefirm’sriskmanagementframeworkacross theentireorganisation,ensuringthatthefirm’srisklimitsareconsistentwiththeRASandthatrisk-takingremainswithinthoselimits.

  • Stress testsandscenarioanalysesareviewedasausefultoolforidentifyingfirms’vulnerabilitiesanddevelopingrisk managementstrategiestoaddresstherisksidentified.

  • Tofulfiltheseresponsibilities,riskmanagementfunctionsshouldbeled byaninfluentialandhighlyeffectiveCRO.

  • 2.1Governanceoftheriskmanagementfunction

  • SupervisorshaveincreasedtheirexpectationsfortheriskmanagementfunctionandareevaluatingtheCRO’sstature,authority,qualifications,andindependencewithinthefirm.

  • Asthecrisisdemonstrated,theseareprerequisitesfortheCROtobeabletoinfluencethefirm’srisk-takingactivitiesdirectlyandthroughtheriskmanagementfunction,andtoeffectivelyinformtheboardasrisksevolve,are identified,andaretaken.

  • AnnexFprovidesmoreinformationonthegovernancearoundtheriskmanagementfunction,butsomesupervisorypracticesregardingtheCROfunctioninclude:

  • Independence:MostjurisdictionsrequiretheCROand/orriskmanagementfunction tobeindependent;thatis,tohaveadistinctrolefromthe otherexecutivefunctions,revenue-generatingfunctionsand businesslineresponsibilities.

  • Stature:TheCROandriskmanagementfunctionshouldhavesufficientstatureintheorganisationtoinfluencethefirm’srisk-takingactivities.

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  • Inthisregard,somejurisdictionshavesupervisoryguidancethatrequirestheCROtoreportandhavedirectaccess to theboard.

  • ToelevatetheCRO’sstature,SingaporeexpectsthedismissaloftheCROtobeapprovedbytheboard.

  • Authority:Toeffectivelyfulfilitsrole,manyjurisdictions30require theCROtohavetheauthority to influencedecisionsthataffectthefirm’sexposuretorisk,andseveraljurisdictionssetoutexplicitexpectationsfortheCROtobeabletochallengemanagement’srecommendationsanddecisionsandcommunicatedirectlywithseniormanagementandwiththeboard.

  • Qualifications:“Fitandproper”testsarecommonlyusedtoassessthequalificationsandcompetenciesoftheCROinmanyFSBmemberjurisdictions.

  • In addition,theappointmentoftheCROisapprovedbyauthoritiesinChina,Germany(iftheCROisamemberofthemanagementboard),andSingapore,whiletheUnitedKingdominterviewsCROcandidates.

  • ManyjurisdictionsevaluatetheCROthroughtheiron-goingsupervisoryprocesses.

  • 2.2Riskappetiteframework

  • Assessingafirm’sRAFisachallengingtaskthatrequiresgreaterclarityandanelevatedlevelofconsistencyamongnationalauthorities.

  • AtthecoreoftheRAFisthefirm’sRAS,whichhas becomeaneffectivetoolforenhancingthediscussionsbetweensupervisorsandboardsaboutthefirm’sstrategicdirectionintermsofrisk taking.

  • However,akeychallenge towardassessingtheeffectivenessofafirm’sRASisalackofcommonterminologyforriskappetite,riskprofile,andriskcapacityusedwithinfirms,acrossfirmsandacrossnationalauthorities.

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Thisisanarea thatisdevelopinginmanyjurisdictions;forinstance,India,RussiaandSaudiArabiahavelookedatrisk appetiteonlyincontextoftheBCBSICAAP,while inCanada,FranceandtheUnitedStates,separateprocessesarecontinuingto beputinplacetoassessfirms’RAFs,oftendrawingonassessmentcriteriaoutlinedintheworkoftheSSG.

Supervisoryreviewsareunderwayin Canadaoffirms’integrationoftheirRAF withthestrategic,financialandcapitalplanningprocessesandcompensationpractices.

InHongKong,firms’risk appetiteisreviewedfromanintegratedfirm-wideperspectivetaking intoaccountallrisks(financialand non-financial).

Thesupervisordetermineswhetherthefirm’sRASiscomprehensiveandincludes theappropriaterisktargetsthatareconsistentwitheachother.

ThesupervisorwillalsodeterminewhethertheRAShasawiderangeofmeasuresandactionableelementsandwhetherrobustproceduresandcontrolsare inplaceforthesettingandmonitoringoftheagreedriskappetite.

NationalauthoritiesinSingaporeassessannuallyfirms’linkbetweenriskappetite,strategicobjectives,capitalplanningandoperationalbudgetplanning.

Supervisorsalsoreviewthefirm’sprogressinthetranslationofriskappetiteintolimitsandtriggersbyrisk type,aswellastheirmonitoringandreportingprocedures.

InSwitzerland,supervisorsregularlyreviewtherisklimitframeworksandthere mustbeanestablishedlinkbetweenthelimitsandthestrategy.

2.3Stress testing

The objectiveofstresstestsandscenarioanalysesistoassesstheunanticipatedlossesthatafirmmayincurundercertainstressscenarios

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andtheimpactthatmayhaveonitsbusinessplans,riskmanagementstrategiesorcapitalplans.

Theuseofstresstests infirms’riskgovernanceandcapitalplanninghasincreasedin recentyearswiththeresultsservingasaninputintothefirm’sstrategicdecision-making.

Asfirmsareincreasinglylinkingstress testresultstorisk appetite,ICAAP,contingencyplanning,andrecoveryandresolutionplans,supervisoryapproachestostresstestingareevolvingaccordingly.

InCanada,supervisorsassesswhetherchosenscenariosareappropriatefortheportfoliooftheinstitution, includingsevereshocksandperiodsofsevereandsustained downturns,andwhererelevant,anepisodeofmarketturbulenceorashock tomarketliquidityandwhetherthefrequencyandtimingofstresstestingissufficient to supporttimelymanagementaction.

Similarly,supervisorsinHongKongassessthecoverageofstresstestsandthetypesofstressscenariosandparameterschoseninrelationtothefirm’srisktolerance,overallrisk profileandbusinessplan;appropriatenessofassumptions;adequacyofpoliciesandprocedures;theadequacyofthefirm’scontingencyplanningforactiontobetakenshouldaparticularstressscenariohappen;thelevelofoversightexercisedbytheboardandseniormanagementonthestress-testingprogramandresultsgenerated;andtheadequacyofthefirm’s internalreviewandauditofitsstress-testingprogram.

Indeed,supervisoryattentionnowincludesboththeoutcomesofstresstestsandtheeffectivenessofthefirms’stresstestingprocesses.

Forinstance,Singapore,SwitzerlandandUnitedKingdomhavededicatedteamstoreviewstresstestingpracticesatfirms,andChina,Germany,andHongKongexpectfirms’internalauditfunctionstoassesstheeffectivenessofrisk managementsystemsingeneral,includingstresstests.

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  • 3.Independentassessmentoffirms’riskgovernanceframework

  • Strong internalcontrolsystemsareakeyelementofsoundriskgovernance.

  • Theboardisresponsibleforoverseeingtheimplementationofaneffectiveriskgovernanceframework,andassuch,shoulddirectlyoverseetheindependentassessmentprocess.

  • Anassessmentthatisindependentfromthebusinessunitandtheriskmanagementcontrolfunctioncanassisttheboardinjudgingwhethertheriskgovernanceframework,internalcontrolsandoversightprocessesareoperatingasintended.

  • Thismaybeperformedbyinternalauditorbythirdpartiessuchasauditfirmsorconsultants.

  • Regardlessoftheapproach,itiscriticalthattheassessmentresultinanoverallopiniononthedesignandeffectivenessoftherisk governanceframeworkandbeperformedbyindividualswiththeskillsneededtoproduceareliableassessment.

  • Currently,auditfunctionsatonlyafewfirmsprovideoverallopinionsregardingtherisk governanceframework.

  • 3.1Internalaudit

  • Across theFSBmembership,regulatoryorsupervisoryexpectationsexistforinternalaudit.

  • AnnexGprovidesacomparisonofkeyregulatoryandsupervisoryexpectationswiththemostnotableelements,including:

  • Independence:Nearlyalljurisdictions38requirefirmstohaveapermanentinternalauditfunctionthatisindependentfrombusinesslines,supportfunctions(e.g.,treasury,legal),andrisk management.

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  • Firmsarealsorequiredtoexplicitlylinktheindependenceofinternalaudittoauditorcompensationorcareerplans.

  • Regardlessofthedirectreportinglines,mostjurisdictionsexpectinternalaudittohaveunfetteredaccesstotheboardwhenreportinginternalauditresults.

  • Stature:Severaljurisdictionsexpectinternalaudittoreportdirectlytotheboard,acommitteethereof,oranindependentdirector.

  • Thedirectreportingrelationshipinvolves theresponsiblepartydeterminingtheCAE’scompensation,completingtheCAE’sannualperformanceevaluation,approvingtheCAE’sbudget,and/orotherwiseensuringtheCAEisnotundulyinfluencedbytheCEOorothermembersofthemanagementteam.

  • WhiletheCAEmayreporttotheCEOonday-to-dayadministrativematters,allsubstantivedecisionsregardingtheCAEandinternalaudit functionaremadeattheboardlevel.

  • In Singapore,HongKong,andIndonesia,thedismissaloftheCAErequirestheauditcommittee’sapproval.

  • Qualifications:AllFSBmembershaveestablishedrequirementsorexpectationsfortheCAEandinternalauditstafftohave theskillsnecessarytoeffectivelycarryouttheirduties.

  • Supervisoryassessmentsgenerallyconsiderthetechnicalknowledge, experience,andcharacterofindividualswithintheinternalauditfunction.

  • Scope,coverage,andfrequency:Manyjurisdictions41expectinternalaudittoassessand/oropineonrisk managementorrisk governanceprocesses,aswellasinternalcontrols.

  • Expectationsforthescope,coverage,andfrequencyofsuchassessmentsvarywidely.

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  • However,almostalljurisdictionsexpectinternalaudit to assesstheorganisationandmandatesoftherisk managementfunction(s)andtheadequacyofsystemsandprocessesforassessing,controlling,respondingto,andreportingthefirm’srisks.

  • Nojurisdictionindicatedthatitexpectsinternalaudit toperiodicallyprovideafirm-wideassessmentofriskmanagementorriskgovernanceprocesses.

  • Riskappetiteframework:Manyjurisdictionsexpectinternalaudit toassesscompliancewiththeboard-approvedrisk appetite.

  • In theUnitedKingdom, internalauditisexpectedtoensurethatproceduresareinplacetoreportbreachesinthefirm’sriskappetitetotheboard.

  • Benchmarking:Mostjurisdictionsindicatethatinternalauditshouldbeawareofindustrytrends/bestpracticesandthatauditorsshouldconsidersuchknowledgewhenconductingtheirwork.

  • However,nojurisdictionhadspecificexpectationsfor internalaudit toopineonwhetherafirm’srisk governanceprocessesarekeepingpacewithtrendsand/oralignwithbestpractices.

  • Remediationprocess:Thereisawiderangeofexpectationsfor internalaudittofollow-uponremedialactionstoaddressmaterialdeficienciesandseveraljurisdictionsexpectinternalaudit to reporttheresultsofitsfollow-up activitiestotheboard.

  • Nearlyalljurisdictionsindicatedthattheyrequiresomeformoffollow-upandreporting.

  • Chiefauditexecutive:AlljurisdictionsindicatethatsupervisorsconsidertheCAE’sperformancewhenassessingthequalityofinternalaudit.

  • Suchassessmentsmaybeperformedoff-site,withinon-siteinspections,and/orthroughregularmeetingswiththeCAEandinternalauditstaff.

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InSaudiArabia,theappointmentoftheCAErequiresa“noobjection”fromthecentralbank,andin Indonesia,banksarerequiredtoreporttobanksupervisorstheappointmentanddismissaloftheirCAE.

3.2Thirdparties

Employingthirdpartiescouldhelptoenhancethequalityoffirms’independentassessmentsbyprovidinganunbiasedopinionofafirm’sriskgovernanceframeworkasmanyinternalauditfunctionsarestaffedwithindividualswhoseexperiencemaybelimited tothepracticesemployedbyoneortwo firms.

In addition,thirdpartiesoftenhaveabroaderunderstandingofleadingindustrypractices,especiallyinhighlytechnicalareas.

Mostjurisdictionsallow theuseofthirdpartiestoassessafirm’sriskgovernanceframework,andin ChinaandtheNetherlands,theexternalauditoralsoassessestheeffectivenessoftheinternalauditfunction.

Manyjurisdictionsappropriatelystipulatethroughregulationorguidancethat:

Theuseofathirdpartydoesnotrelinquishtheboardormanagementfromultimateresponsibilityforensuringthereliabilityoftheindependentassessments,and

Largeandcomplexfirmsshouldnotbecomeoverlyreliantonthird partiestoprovideexpertisethatshouldbedevelopedwithinthefirm’sinternalauditfunction.

Francespecificallyrequiresthatoutsourcingarrangementsbeengagedandoverseenbyinternalaudittoensureindependenceandthatinternalauditmaintains accountabilityforthescope,coverage,andfrequencyofwork.

Severaljurisdictions,however,restricttheuseofthirdparties.

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Forinstance,inItaly,internalauditworkcanbeoutsourcedonlybysmallcreditinstitutionswithlimitedoperationalcomplexity.

Meanwhile,inSouthAfricathecentralbankmustapproveanyoutsourcingactivity,andinKorea,theuseofthirdpartiestoassessafirm’sriskgovernanceframeworkisnotregulated.

4.Supervisoryapproachestowardassessingriskgovernanceframeworks

Supervisorsplayacrucialrole inassessingtheadequacyofafirm’sriskgovernanceframeworkandthepracticesemployedbyafirmtoindependentlyassessitsframework.

Supervisoryexpectationsforriskgovernancepracticesoutlinedabovearegenerallysetoutwithin thelegalframeworkthroughacombinationoflegislation,regulationandsupervisoryguidance;however,theapproachvariesconsiderablyacrossjurisdictions.

AustraliaandCanadacomplementtheirstandardswithwrittenguidanceprovided totheindustrytoassistwiththeimplementationofprudentialrequirementsandadoptionofgoodpractices.

Supervisoryapproachestowardassessingimplementationofregulatoryorsupervisoryguidanceencompassavarietyofsteps(e.g.,on-siteinspections,off-sitereviews,horizontalreviews).

Supervisoryassessmentsgenerallyoccuratleastonceayearacross theFSBmembership,thoughinArgentinaassessmentstakeplaceevery18monthsandtheUnitedKingdomismovingfromabi-annualassessment towardasystemofcontinuoussupervision.

Severaljurisdictionstakearisk-basedapproach to on-siteexaminations,focusingonriskierinstitutions.

In theUnitedStates,nationalauthoritieshaveon-siteteamswithexpertisetoassessthegovernancepracticesatthelargestandmostcomplexbanksonarealtimebasis.

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In China,jointregulatorymeetingsareheldonaregularbasisbetweenthefirm’sheadoffice,itsbranches,andtheregulatoryauthoritywherethebranchesarelocated.

Meetingswithdirectorsandseniormanagementprovideanotheravenuefornationalauthoritiestoassessfirms’risk governancepractices.

AnnexHprovidesmoreinformationontheapproachestaken toassessingfirms’riskmanagementframeworks.

Supervisorsreceiveawiderangeofriskreportsor informationfromfirmsontheirriskmanagementpractices, includingfromexternalauditorsorotherthirdpartiesaswellassupportingdocumentationrequestedduringon-siteinspections.

Standardisedfinancialandrisk reportingareacommonpractice;however,thetypesofreportsorinformationprovidedvaries.

Forinstance,inArgentina,newreportingrequirementswillrequestquantitativemeasuresforrisk governanceandformalexposurelimitsforeachofthesignificantrisksandstresstestinformation;inHongKongandelsewhere,regularprudentialreportingdataandadhocrequestsforpeergroupanalysisareutilised,e.g.,stresstestcapitalanalysisand horizontalcreditreviewsofcommon(problem)loan accounts;andinCanadaandSingapore,supervisory teamsworkwithriskspecialists toidentifytrendsthatcantriggeradditionalinvestigationsorreviews.

Nationalauthoritieshaveaccesstoabroadsetofsupervisorytoolstoincentivisefirms to remediatedeficiencieswithintheirrisk governanceframework,dependingontheseverityofthedeficiency.

Thesetoolsincludemoralsuasion,capitalsurcharges,restrictionsoncertainbusinessactivities,imposingfinesandpenalties,andtheultimatepenaltyofwithdrawingbanklicences.

Whilealargenumberofsupervisoryauthoritiescanuseanumberofthesetools,afewhavelimitedsupervisorypowers to scale thesanctionbased

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  • ontheseverityoftheinfraction,raisingconcernsovertheirability toeffectivelyinterveneearlywherenecessarywhenrisksstart tosurface.

  • Moreover,eventhoughsomenationalauthoritieshavetheauthoritytoimposefines,thisisdifficulttoimplementinpractice,forinstance,duetocumbersomeprocessesorsupervisorslackingthewilltoact.

  • III.Firms’riskgovernancepractices

  • Thefinancialcrisisspurredfundamentalchangesinrisk governancepracticesatfinancialinstitutions,andinmanycases,surveyedfirmsareaheadofregulatoryandsupervisoryguidance.

  • Ingeneral,surveyedfirmsthatweremostaffectedbythecrisishavemadethegreatestadvancements,perhapsnecessitatedbyaneedtore-gainmarketconfidence.

  • Firmsthatwerelesstroubledfromthecrisis,however,haveincreasedtheintensityofthemeasuresthattheyhadinplace pre-crisis.

  • Someofthemostobviouschangesinclude:

  • Consolidatingandraisingtheprofileoftheriskmanagementfunction acrossbankinggroupsthroughtheestablishmentofagroupCRO,increasingthestatureandauthorityoftheCROandincreasingtheCRO’sinvolvementinrelevantinternalcommittees.

  • Changingthereportinglinesoftheriskmanagementfunctionsothat theCROnow reportsdirectly totheCEOwhilealsohavingadirectlinktotherisk committee.

  • Intensifyingtheoversightofrisk issuesattheboardthroughcreationofastand-aloneriskcommittee,supportedbygreaterlinks withtheriskmanagementfunctionand otherrisk-relatedboardcommittees,particularlyauditandcompensationcommittees.

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  • Cross-membershipoftheauditcommitteeandrisk committeeisnowquitecommon,withsomefirmsinvolving(oratleastinviting)thechairoftheboard,eventhefullboard,ontotherisk committee.

  • Thetimecommitmentofindependentdirectorshasincreasedconsiderablyoverthepastseveralyears.

  • Upgradingtheskillsrequirementsofindependentdirectorsontheriskcommitteeandexpectingthesemembers to commitmoretime totheseendeavours.

  • Thecompositionofboardshaschangedconsiderablywithmany

  • non-executivedirectorsnowhavingfinancialindustryexperience;thedominanceofmembersfromindustrialcompaniesormajorshareholdersismuchlessthanadecadeago.

  • Changingtheattitudetowardtheownershipofriskacrossthefirmwiththebusinesslinenowbeingmuchmoreaccountablefortheriskscreated bytheir activitiesthanpreviously.

  • In additiontochangingthecompositionandimprovingthestrengthoftheboard,therehavebeenmajordevelopmentsinhowfirmsanalyserisksandtheassociatedtoolsutilisedsuchasRAFs,stress testsandreversestress testing.

  • Oneofthekeylessonsfromthecrisiswasthatreputationalriskwasseverelyunderestimated;hence,thereismorefocusonbusinessconductandthesuitabilityofproducts,e.g.,thetypeofproductssoldandwhotheyaresoldto.

  • Asthecrisisshowed,consumerproductssuchasresidentialmortgageloanscouldbecomeasourceoffinancialinstability.

  • Thenextfoursub-sectionssummarisethefindingsfromthesurveyedfirmsregardingthethreekeyrisk governancefunctionsandprovideasummaryofthesupervisoryevaluationsoffirms’progress.

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1.Theboardandits committees

Theboardisresponsibleforensuringthatthefirmhasanappropriateriskgovernanceframeworkthatiscommensuratewiththefirm’sstrategy,complexityandsize.

Theboard’sroleandresponsibilitiesforrisk governancearegenerallydefinedintheboard’scharterandincludeapprovalofthefirm’sstrategyandoverseeingitsimplementation,settingouttheguidelinesandpoliciesforriskmanagement,andensuringthefirm’sinternalcontrolsarerobust.

Theboardisalsoresponsibleforformulatingthemandateandresponsibilitiesofitscommitteessuchastherisk andauditcommittees.

Forinstance,auditcommitteesshouldensurebusinessunitshaveeffectiveremediationplans to addressanycontrolweaknessesnotedbyinternalaudit.

SomefirmshavedevelopedaCorporateGovernanceFrameworkor Codewhereallrulesregardingtheroles,responsibilitiesandoversightfunctionsoftheboardareassembled.

Establishinganenterpriseorfirm-widerisk managementframeworkcanhelptoprovideanoverviewofriskpolicyarchitectureandprocess.

Havingastand-alonerisk committeeisacommonpracticeeventhoughitisnotrequiredbyallnationalauthorities.

Firmsgenerallyensurethattherisk committee,whichisresponsibleforoverseeingseniormanagement’simplementationoftheriskstrategy,coversalltherisksfacedatthefirm-widelevel,includingfinancialrisksaswellasoperational,compliance,legalandregulatoryrisks.

RegularmeetingsareheldwithseniormanagementandtheCROtodiscussperformanceofthebusinessunitandcompliancewiththeRASandrisk limits.

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Materialrisksarepresentedanddiscussedonbothanaggregatebasisandbytypeofrisk.

Afewfirms,however,notedthechallengeofaggregatingrisksdue to thecomplexityoftheorganisation,underscoringtheimportanceofriskcommitteesaddressinginformationchallengesarisingfromthecomplexityoflargefirms.

Aneffectivegovernancestructurehasmeasures topreventconcentration ofpowerandresponsibility,suchasrequiringanumberofindependentdirectors,representationofcertainskillsandqualificationsontheboard,andtheboardregularlyevaluatingitseffectiveness.

Itiscommonforboardstohaveindependentdirectors;somefirmsestablishminimumquantitativerequirements,rangingfromaminimumofone-third tothree-quartersoftheboard.

Most firmsprovideadefinitionofindependence intheboard’scharter,whichisembeddedinthefirm’sgovernanceframework.

Therisk committeeoftencomprisesonlyindependentdirectors.

Thereisawiderangeofpracticeregardingthequalificationsformembersoftheboardandrisk committee;onefirmhighlightedthattheskillsrequiredbytheboardareevolving, in partreflectingtheriskstakenbythefirm.

Somefirmsperformamatrixanalysisoftheexperienceandexpertiseofeachdirectortoidentifyskillsneededfromincomingdirectors.

Thereisalsoawiderangeofpracticeinvolvinglimitationslinkedtoboardstructure,including:

Thepreclusionofthechairoftheboardfrombeingchairofeithertheriskorauditcommittee;

TheseparationoftherolesoftheCEOandchairoftheboard;and

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(iii)Limitedtenureonacommittee.

Periodicreviewsoftheperformanceoftheboardandriskcommitteeareacommonpractice.

Reviewsareconductedby theboardnominationorgovernancecommitteesorbytheentireboard.

In somecases,externalpartiesmaybeemployed.Suchreviewsmayincludeanassessmentoftrainingand skillsneededontheboard.

In somefirms,theboardconsidersthefunctioningofitsoverallcommitteestructure,includingthenumberandtypesofcommitteesandthehighestandbestuseofboardmembers’expertise.

Theyalsoevaluatethereportingbythecommitteestothefullboard.

Theboardandriskcommitteeareabletoreceiveinformation, bothformallyandinformally,directlyfromtheCROortherisk managementfunction.

ItisbecomingacommonpracticefortheCROtoreportinformationdirectly totheboard;therisk reportsareusuallystandardised in termsofformality,frequencyandcontent.

Boththeoverallrisklevelofthefirmandinformationforeachrisk typeare includedinthereportingtemplate(e.g.,aheatmapofidentifiedriskcategoriesacrossregions,globalbusiness,andareportwiththetopandemergingrisksfacedbythefirm).

Somefirmsexplicitlydefineanddocumenttheinformationthattheboardandrisk committeeshallreceive,settheagendaatthebeginningoftheyear,andcirculatetomembersinadvanceofmeetingstherelevantmaterialto supporttheagendaitem.

Somefirmsrequireinternalaudit,orathirdparty,toverifytheaccuracy,comprehensivenessandcompletenessofinformationprovided to theboardandrisk committee.

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Otherfirmssatisfythemselvesthroughdiscussionswithmanagementorconductself-assessmentsoftheeffectivenessoftheinformationprovidedtotheboard.

2.Theriskmanagementfunction

Sincethefinancialcrisis,manyfirmshaveimprovedriskmanagement.

Someofthemostobviouschangesrelateto thegovernanceprocessesaroundtheriskmanagementfunction;therealsohavebeenmajorchangesinhowrisksareanalysedandcommunicatedandtheassociatedtoolsthatareutilised.

2.1Governanceoftheriskmanagementfunction

Sincethefinancialcrisis,manyfirmshavestrengthenedhowtheirriskmanagementfunctionsarestructured,resourced,compensated,whothefunctionis accountable to aswellasitsoverallmandate.

In manyways,thesechangesarebringingthegovernancearrangementsfortheriskmanagementfunctionuptothestandardthathastypicallyappliedtotheinternalauditfunctionforseveralyears.

Firmsarethereforeencouraged to atleastconsiderthevalidityofany remainingdifferencesingovernanceprocessesthatsurroundthetwofunctions.

Oneofthemostcommonimprovementsmadebyfirmsoverthepastfiveyearshasbeentoconsolidateandraisetheprofileoftheriskmanagementfunctionthroughtheestablishmentofagroup-wideCRO.

TheCROandtherisk managementfunctiongenerallyhavebeengivenmorestature,authorityandindependencecompared to thepre-crisisperiod.

AlmostallfirmsreportedthattheynowhaveaCROwithfirm-wideresponsibilityforriskmanagementwhooperatesindependently.

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AssessmentoftheCRO’sstature,authorityandindependenceincludestheprocessforappointment,dismissalandperformanceevaluationoftheCROaswellasthestaffingrequirementsoftheriskmanagementfunctionmoregenerally.

Onlyafewfirmsnotedthatthechairoftherisk committeeisinvolvedintheperformanceassessmentoftheCRO.

Further,onlyafewfirmslinktheadequacyandqualificationsoftheriskmanagementstafftoanannualprocessthattakes intoconsiderationthestrategyofthefirmgoingforward.

MostfirmsnotedthattheCROhasadirectreportinglinetotheCEO(versus anotherbusinessunit)whichrepresentsamajorimprovementsincethecrisis.

However,therearestillexamplescitedatasmallnumberoffirmswheretheCROdoesnothaveadirectreportingline to theCEO.

AfewfirmsrequiretheCROtohaveadirectreportinglinetotheboard,whichhelpstoboostthestatureoftheCRO.

Alarge numberoffirmsalsonotedthattheirCROisable to“access”theboard,generallythroughtheriskcommittee,butitisunclearhow thisisdoneinpractice.

AlmostallfirmsoperatewithaCROwhoisseparatefromrevenue-generatingresponsibilitiesorotherexecutivefunctions(thatis,

“dual-hatting”oftheCRO’sresponsibilitiesisavoided).SuchastructureisessentialfortheCRO’sindependence.

Thisseparationofresponsibilitieshasbeenreinforcedbymanyfirms

re-structuringtheirriskmanagementfunctionsunderagroup-wideCRO,withregionalorbusinesslineCROshavingadirectreportingline to thegroupCRO,ratherthantotheregionalorbusinesslineheadsashadoccurredinthepast.

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  • Topreservetheindependenceintendedfromsuchstructures,

  • ‘dual-hatting’ofresponsibilitiesshouldalsobeavoidedforthoseseniorpositionsintheriskmanagementfunctionthatreporttothegroupCRO,particularlyatgloballyactive,complexfirms.

  • Atsomefirms,theCROreportstotheCFOor,inafewexceptionalcases,onepersonassumestheresponsibilitiesofboththeCROandCFO.

  • In addition,thereareinstancesatsomefirmswheretheCROisassignedotherfunctional,albeitnon-revenuegenerating,responsibilities.

  • Wherethisrelates totheoversightoffunctionssuchascomplianceandanti-moneylaundering,theconcernismoreabouttherisk of

  • over-burdeningtheCRO,particularlyinmorecomplex,global

  • institutions,thanthepotentialforconflictofinterestperse.

  • Indeed,muchprogresshasbeenmadetowardelevatingthestatureandindependenceoftheCRO.

  • WhiletheroleoftheCROhasbroadenedandincludesinvolvementin anumberofkeyprocessesandinternalcommitteesthatrequireinputsfromtherisk managementfunction,otherimportantprocesseswarrantgreaterparticipationoftheCRO,suchas:

  • Mergersandacquisitions.Whiletheanalysisofaproposedmergeroracquisitionwouldbesubmittedtotheboardoracommitteeforapproval, theCROgenerallytakes partintheprocessasamemberofthecommittee.

  • OnlyafewfirmsrequiretheCROtoprepareaformalriskopiniononplannedmergersand acquisitions.

  • Strategicplanningprocess.Traditionally,theCROisresponsiblefortheoversightoftheexistingriskprofileofthefirmandofthoserisksbeingtakenonaday-to-daybasisasaresultofpreviousbusinessdecisions.

  • However,asindicatedabove,theCROshouldalsobecomeincreasinglyinvolved, in amoreproactivemanner,intheactivitiesandplansthatdeal

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  • withprospectivebusinessrisk,includingthoseriskswhichmayarisefromtheexecutionofthefirm’sstrategicbusinessplan.

  • TheCRO shouldbeinvolvedinthisprocess,fromariskperspective,byinteractingwithseniormanagementandtheboard,understandingstrategicbusinessplans,andformallyopiningontheprospectiveriskprofileandwhetherornotthefirmhasthenecessaryresourcesandsystems to accommodatetheresultingexposures.

  • Ifsuchresourcesarenotavailable,thenspaceinthestrategicplanshould becreated to ensureproperriskcontrols.

  • Treasuryfunction.SomefirmshaveclearlydefinedtherolesandresponsibilitiesoftheCROregardingoversightofafirm’streasuryfunction.

  • However,thereisarangeofpracticesurroundingtheorganisationalrelationshipbetweenthesetwo functions:

  • Theindependentliquidityrisk controlfunctionhasresponsibilityforthemanagementandcontrolofliquidityrisk andthatfunctionreportsdirectly totheCRO;

  • TheCROparticipatesasavotingmemberoftherelevantmanagementcommittee(typicallytheassetandliabilitymanagementcommittee),withnospecific rolefortheCROdefined;or

  • TheCFOaloneisresponsibleforthetreasuryfunctionwithoutanyoversightfromtheCROintheriskmanagementprocess.

  • 2.2Riskmanagementtools

  • Two keyadditionstoriskmanagementtoolshavebeen(i)thedevelopmentofRAFsand(ii)morerobustandseverestresstestingpractices.

  • Relatedtothis,andgiventheunderestimationofreputationalrisk

pre-crisis,therenowismuchgreaterfocuswithinmanyfirmsonbusiness

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  • conductandthesuitabilityofproducts,e.g.,thetypeofproductssoldandtowhomtheyaresold.

  • TheRAFisanincreasinglyimportanttoolincentralisingthefocusonthefirm’sriskprofileandprovidingamoreintegratedpictureofthefirm’s risks.

  • Firmsindicatedagooddegreeofunderstandingthekeyelements,objectivesandusesofRAFswhicharegenerallyin linewithrecentstudiessuchasthe2010SSGreportondevelopmentsin risk appetiteframeworksandITinfrastructure.

  • Keyfeaturesofariskappetiteframework(RAF)

  • RAFshelpdrivestrategicdecisionsandright-sizeafirm’srisk profile.

  • RAFsestablishanexplicit,forward-lookingviewofafirm’sdesiredriskprofileinavarietyofscenariosandsetoutaprocessforachievingthatriskprofile.

  • RAFsincludeariskappetitestatementthatestablishesboundariesforthedesiredbusinessfocusandarticulatetheboard’sdesiredapproachtoavarietyofbusinesses,risk areas,andinsome cases,producttypes.

  • ThemoredevelopedRAFsareflexibleandresponsivetoenvironmentalchanges;however,risk appetiteisdefinitiveandconsistentenough tocontainstrategicdrift.

  • RAFssetexpectationsforbusinesslinestrategyreviewsandfacilitateregulardiscussionsabouthow tomanageunexpectedeconomicormarketeventsinparticulargeographiesorproducts.

  • Discussionswithfirms,however,revealthatthereissignificantvariationintheperceptionofhowmuchfirmshaveprogressedinthedevelopment,comprehensivenessandimplementationoftheirRAFs.

  • Oneofthekeychallengesisdifferentinterpretationsofessentialelements,includingrisk appetite,risklimits,andrisk capacity.

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  • Somefirmswereable to reportsignificantprogressandhavehadanRAF forseveralyears(insomecasessincebeforethecrisis).

  • Thesefirms’RAFswerelinkedtothefirm’sstrategyandintegratedwithmost otherrelevantinternalprocessessuchasbudgeting,compensation plans,mergersandacquisitionevaluations,newproductapproval,andstress testing.

  • Thesefirmswereable to reportthattheunderstandingoftheRAFwas widespreadbothacrossfunctionallinesandwithinmultiplelayersoftheirfirm.

  • Theywerealsoabletoidentifyclearexamplesofhowtheyhadusedtheir RAFinstrategicdecision-makingprocesses,suchasdecisionstoactivelyreducethecomplexityoftheiroperations.

  • Thatsaid,evenatthesefirms,itwasrecognisedthatoperationalisinganeffectiveRAFisacontinualjourneythatneedstoevolvewithchangesin internalprocessesandtheexternalenvironment.

  • AnumberoffirmsreportedthattheirimplementationofanRAF wasmorerecentandwhileithadbeenlinkedto thefirm’sstrategyandintegratedwithsomeofthekeyinternalprocesses,furtherworkisenvisaged,suchas:linkingtheRAF withalltherelevantinternalprocesses;ensuringthatqualitativeaswellasquantitativemetricsareappropriatelyincluded;andsomewhatrelatedly,broadeningtheRAFtocoverthosehardertoquantifyrisks,suchasoperational,complianceandreputationrisks.

  • Forotherfirms,theirRAFsareatanearlystageofdevelopment.

  • Whiletheymayhaveahigh-levelframeworkinplace,numerousgapsexist.

  • Forexample,thecoveragemaynotextendtoallrelevantsubsidiariesintheframeworkbecausetherisk appetiteisnotclearlyarticulatedatthebusinesslevelnorintegratedwithalltherelevantinternalprocesses.

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Further,someRAFsarelessdevelopedintermsofincludingallthematerialrisksthefirmfaces,particularlyreputationalandoperationalrisks.

Allfirmssurveyedconsideredrisk limitsto bethevehicleforoperationalisingtheRAF atthebusinesslinelevel.

Thecommunicationandescalationprocessforanybreachesseemedtobeverysimilaracross thefirmssurveyed:theriskmanagementfunctionwasresponsibleformonitoringrisk limits,metrics,andbreaches,andescalatinganyconcerns;businessunitshave toexplainbreachestotheriskmanagementcommitteeorboarddependingonthenatureandsizeoftheexposure;theauthorisationofexceptionswasdefined top-down;andactionplanswererequired.

However,thereweredifferencesbetweenfirmsintheirapproaches todeparturesfromtheRAF:somefirmsgrantflexibilityforabusinesslinetodepartfromtheRAFiftheglobalriskappetitewasnotbreached,whereasothersgivenoflexibilityfor individualbusinesslinesto deviatefromtheirbusinesslinerisk limits.

Embeddingthefirm’sagreedRASintothefirm’srisk cultureremainsachallengebutseveralapproacheshavebeentakenbyfirms.

Anumberoffirmshavedevelopedtrainingprogramsandmanuals(withonefirmrequiringrelevantemployeestocertifyeveryyearthattheyhaveattendedthetrainingprogramandreadthemanual),butonlyafewfirmsreportedthattheyhavelinkedcoreriskobjectivestostaffperformancemanagementprocesses.

Discussionswithfirmsrevealedthatakeytocreatingincentivesforabetterriskcultureinfirmsisto linkriskobjectiveswitheithercompensationorcareeradvancementprospects.

Stress testinghasbecomeacommontoolforfirms.

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Thegovernancearoundgroup-widestresstestingtypicallyinvolvesfirmsdevelopingtheir ownhistoricalandhypotheticalscenarios,though nationalauthoritiescan alsosetscenarios.

TheCROandriskmanagementfunctiongenerallyhaveacentralrole,actingasthe owneroftheprocessorparticipatinginthecommitteeleadingtheeffort.

The testingisconductedatleastannually,andinmany casesonaquarterlybasis.

Stress testsresultsareusuallypresentedtotherisk committeeandsometimestothenationalsupervisor.

TheseprocessesappeartobefurthestdevelopedinAEs,andsomealsoperformreversestresstestingandcounterpartystresstesting.

In contrast,somefirmsinEMDEshavenotperformedstresstestingonanintegratedbasisorarestillin theprocessofimplementingtheirstresstestingprocesses.

Mostfirmsusethestresstestingresultsfortheirbudgeting,RAF andICAAP processesand to setcontingencyplansagainststressedconditions.

3.Independentassessmentoffirms’riskgovernanceframework

3.1Internalaudit

Firmsprimarilyrelyontheirinternalauditfunctions to independentlyassesstheirrisk governanceframeworks.

Inalmostallcases,internalauditassessestheframeworkthroughaseriesofindividualassuranceaudits,combinedwithsomeproject-specificandotherongoingauditwork.

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  • Afewinternalauditfunctionsdemonstratethebetterpracticeof providinganoverallopinionoftherisk governanceframeworkonan annualbasis.

  • In linewithexpectationsestablishedbynationalauthorities,allofthefirms’internalauditfunctionsareorganisationallyseparatefrombusinesslinesandhaveunfettered accesstotheboard.

  • Almosteveryfirmreportedthattheyhavemadechangestostrengthentheir internalauditfunctionssince2008.

  • Majorchangesinclude:appointingaCAE;establishingmoreattractivecompensationplansandcareerpathsfor internalauditors; increasingboththenumberandskillsofinternalauditstaff;expandinginternalaudit’srole/responsibilities,includingparticipatingasanobserveratriskmanagementcommitteesanddecision-makingprocesses;andenhancingbusinessmonitoring.

  • Internalaudit’sroleandresponsibilitiesareprimarilyestablishedviaanauditcharter,withauditmanualsdetailingproceduresforplanning,executing,andreportingaudit’swork.

  • Atallsurveyedfirms,internalauditisresponsibleforassessingriskmanagementorriskgovernanceprocessesaswellasinternalcontrols.

  • Whilenationalauthorities’expectationsvary,mostinternalauditfunctionsalsoassess:

  • Theappropriatenessofassumptionsusedinscenarioanalysisandstresstesting,

  • Thedegreetowhichthefirm’srisk governanceiskeepingpacewithindustrytrendsandalignswithbestpractices,

  • Thequalityandadequacyofresourceswithintherisk managementfunction,

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  • Theoverallefficiencyandintegrityofrisk managementinformationsystems,and

  • Theeffectivenessoftherisk andissueescalationprocess.

  • MostfirmsindicatedthatinternalauditplaysaroleinmonitoringwhetherthebusinessandriskmanagementunitsareoperatingaccordingtotheRAF.

  • However,somefirmsrelyprimarilyontheindependentriskmanagementfunctionforthisassessment.

  • Internalaudit’sroleisgenerally totestthatpracticesalignwiththeprocessesandproceduresestablishedintheRAF,thoughafewfirmsexpectinternalauditto alsoopineontheappropriatenessofthelimitsandothertolerancesestablishedintheRAF.

  • GiventhatmanyRAFsare intheearlystagesofevolution,somefirmsnotedthat internalaudit’sroleandresponsibilitiesrelatedtotheRAF arestillbeingdefinedandimplemented.

  • Firmsreportedawiderangeofpracticeswithregardtotheformatandcontentofreportingto theboard.

  • Atseveralfirms,theCAEprovidesregularreportstotheboardorauditcommittee,summarisingtheresultsofinternalaudit’swork,includingoverallconclusionsorratings,keyfindings,materialrisks/issues,andfollow-upofmanagement’sresolutionofidentifiedissues.

  • Meanwhile,someinternalauditfunctionsonlyprovidetheboardorauditcommitteewithaperiodicsynthesisofinternalaudit activityora“reportonauditreports”,whichdoesnotseemsufficienttoensuretheboardcancarryoutitsresponsibilitieswithintherisk governanceframework.

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    • Thirdparties

  • Approximatelyhalfofthefirmsthatparticipatedinthepeerreviewindicatedthattheyhaveusedthirdparties to assesstheirfirm’sriskgovernanceframeworkorcomponentsoftheframework.

  • Therestofthefirmsindicatedthattheyusedthirdpartiestoprovideperspectivesandbenchmarksrelatedtoregulatoryexpectationsandindustrybestpracticesassociatedwithrisk governanceframeworks,orsignificantaspectsofthoseframeworks,withthisinformationbeingusedtopromoteupgradesin firmpractices.

  • Suchanapproachwasseenashelpfulinmeetingthecontinualchallengeofdevelopingandmaintainingrisk governanceframeworksthatkeepabreastofchanginglegislative/regulatoryenvironmentsalongwithanevolvingeconomicandcompetitivelandscape.

    • Escalationprocesses

  • Allfirmsreportedhavinginternalpolicies,procedures,and/orprocessestofacilitateemployeesreportingconcernsandissueswithinthefirm.

  • Theseareinaddition to externalcomplaintandwhistle-blowerprocessesestablishedbysupervisors.Somefirmsdescribedhavingprocessestailoredtodifferenttypesofissues(e.g.,issuesimpactingfinancialresultsandrelateddisclosuresversusgeneralissuesrelated to riskand/orcontrolbreakdowns).

  • Forsensitiveinformation,mostfirmshaveestablishedaninternal“whistle-blowing”hotlineandofferemployeesanonymityand otherprotectionsfromnegativeconsequencesto theextentpossibleundertherelevantlawsofthejurisdiction.

  • Fornon-sensitiveinformation,processesgenerallyinvolveemployeesreportingto adirectsupervisororseniormanagerwithinthebusinessunitand/ortoanindividualwithinanindependentrisk,compliance,and/orauditfunctionorlegaldepartment.

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  • 3.4Evaluationoftheeffectivenessoftheindependentassessment

  • Whilethereisnocommonpracticeforcomprehensivelyevaluatingtheeffectivenessoftheindependentassessmentoftherisk governanceframework,mostfirmshaveseveralprocessesinplaceforassessingtheworkoftheinternalauditfunction.

  • Someofthekeyprocessesand/orcriteriausedinclude:

  • Thenumberofinternalauditsthatcoverriskmanagementtopicsduringthecourseofanauditcycle,

  • Thenumberandtypesofriskmanagementissuesidentifiedbyinternalaudit,

  • Resultsofinternalaudit’squalityassurance activities,

  • Resultsofperiodicinternalaudit self-assessmentsand/orassessmentsperformedbyexternalparties,

  • Qualityofinformationprovided totheauditcommittee,and

  • CompliancewiththeInstituteofInternalAuditors’(IIA)professionalstandards.

  • 4.Supervisoryevaluationsofriskgovernancepractices

  • Thepeerreviewaskedsupervisorsofsurveyedfirms to evaluatefirms’progresstowardenhancedrisk governanceacrosssevenbroadareas.

  • Tohelp providesomeconsistencytothisexercise,high-levelevaluationcriteriaweredeveloped(seeAnnexA)andthesupervisoryevaluationswerereviewedforallsurveyedfirms;G-SIFIs;andbyregion.

  • Thecriteriaweredevelopedbydrawingfromacompilationofrelevantprinciples,recommendationsandsupervisoryguidance,andare

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consideredbythereviewteamasthefundamentalpreconditionsforeffectiverisk governanceframeworks.

In summary,surveyedfirmshavemadethemostprogressinstrengthening(ii)theroleandresponsibilitiesoftheboard,withnearly80percentofsurveyedfirmsevaluatedbynationalsupervisorsasmeetingorexceedingallofthecriteria.

Thisisanarea thatwarrantedsignificant changesbutisalsoviewedascomparativelyeasytoimplement.

Morework,however,isneededbysupervisors to assessthetrueeffectivenessoftheboard’soversightofthefirm.

Further,despitesignificantimprovementsin(i)firms’approaches to riskgovernanceand(vii)theindependentassessmentoftheriskmanagementfunction,significantgapsremain.

Roughly50percentofsurveyedfirmsfailedto meetallofthecriteriain

(iii)havingdefinedresponsibilitiesoftheriskcommitteeand(vi)theriskmanagementfunction.

Theseareasneedmuchgreaterattentiononthepartofbothsupervisorsandfirms.

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Thesupervisoryevaluationsindicate that, among theG-SIFIssurveyed,more progresshasbeenmadetowardenhancing riskgovernancepracticesrelativetoothersurveyed firms,

Oneofthekeyhindrances to effectiveriskmanagementatG-SIFIs hasbeenweaknesses infirms’ITinfrastructuresandtheinability toaggregaterisk dataefficiently.

Whileprogressisbeingmade,somesupervisorsnotedtheirfirmcould notcompletetheFSBDataGapscommondatatemplateforG-SIFIs.

Thiscommondatatemplateaimstoaddresskeyinformationgapsidentifiedduringthecrisisandprovideastrongframeworkforassessingpotentialsystemicrisks.

However,G-SIFIs identifiedinNovember2011andNovember2012areexpectedtomeethigherexpectationsforriskdataaggregationcapabilitiesandrisk reportingbeginning in January2016.

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Byregion,firmsthatresideinAEshavegenerallyprogressedfurtherthanthoseinEMDEsacrossallaspectsoftheareasevaluated,exceptfor(iii)riskcommitteeresponsibilities(seeChart5below).

Thisalignswiththefindingthatfirmsthatwerehardesthitduringthefinancialcrisishavemade themostprogressassuchfirmslargelyresideinadvancedeconomies.

Thesefirmsexperiencedasignificantturnoverinseniormanagementand directors, includingmorenon-executivedirectors,butboardoversightofriskthroughanestablishedrisk committeeisweakacrossregions.

ForEMDEs,riskgovernancepracticesneedtobesignificantlyenhanced;inparticularinthe(vi)riskmanagementfunctionasapproximately65percentofsurveyedfirmsdonotmeetallofthecriteria.

Otherareaswheremoreworkisneededisintheir(i)approachtoriskgovernanceand(iv)governanceoftheboardandrisk committeewheremorethan50percentoffirmsdonotmeetalloftheevaluationcriteria.Thesegapsneedimmediateattention.

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IV.Conclusionsandrecommendations

Muchprogresshasbeenmadetowardenhancingrisk governanceframeworksatsurveyedfirmssincethecrisis.

Nonetheless,thisprogresshasbeenunevenacrossthefunctionsthatcollectivelyformtherisk governanceframework– theboard,the

firm-widerisk managementfunction,andtheindependentassessmentof

riskgovernance.

Specifically,firmshavemademostprogressindefiningtheroleandresponsibilitiesoftheboard,butmuchmoreneedstobedone tostrengthentheroleoftherisk committeeandtheCROandriskmanagementfunction.

Continuedweaknessesinrisk managementwillunderminetheeffectivenessofthechangesmadeto boardoversightofthefirm’sriskgovernanceframework.

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Toensurethatprogresscontinuestoward achievingmoreeffectiveriskgovernanceframeworks,amore integratedandconsistentapproachacrossallaspectsoftherisk governanceframeworkhas tobedeveloped.

Suchanapproachwillrequireashiftinattitudeforbothfirmsandsupervisorsas thisrequirestakingaholisticviewofallaspectsoftheriskgovernanceframeworkratherthanlookingateachfacetinisolation.

DrawingfromthesurveyresponsesanddiscussionswithriskcommitteedirectorsandCROs,thisreportsetsoutalistofsoundrisk governancepracticesthatshouldhelpsupervisors toenhancetheiroversightofriskgovernanceatfinancialinstitutions,inparticularatSIFIs(seeSectionV).

Whilenoneofthesurveyedauthoritiesandfirmsexhibitedallofthesesoundpractices,manyfirms’practicestendedtobemoreadvancedthantheguidanceprovidedbynationalauthorities.

Recommendation1:Toensurethatfirms’riskgovernancepracticescontinuetoimprove,FSBmemberjurisdictionsshouldstrengthentheirregulatoryandsupervisoryguidanceforfinancialinstitutions,inparticularforSIFIs,anddevote adequateresources(bothinskillsandquantity)toassesstheeffectivenessofrisk governanceframeworks.

Inparticular,nationalauthoritiesshouldtakeintoconsiderationthesetofsoundrisk governancepracticesidentifiedduringthepeerreview.

Recommendation2:Therelevantstandardsettingbodies(e.g.,BCBS,IAIS,IOSCO, OECD)shouldreviewtheirprinciples,takingintoconsiderationthesoundpracticesforriskgovernancelistedinSectionV.

Recommendation3:Riskcultureplaysacriticalroleinensuringeffectiveriskgovernanceenduresthroughchangingenvironments.

TheFSBSupervisoryIntensityandEffectivenessgrouphasagreed toimplementtherecommendationfromthe2012FSBprogressreportonenhancedsupervision to explorewaystoformallyassessriskculture,particularlyatG-SIFIs.

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ThisworkshouldbecompletedbySeptember2013.

Asthesupervisoryevaluationsrevealed,bothnationalauthoritiesandfirmsneedtofocusonstrengtheningfirms’risk managementfunctions.

Effectiverisk governanceisbasedonawell-designedandarticulatedfirm-wideriskmanagementframework,whichreflectsthefirm’sriskculture,enumeratesthefirm’sriskprofile,andensuresthattherisklimitssetoutintheagreedRASarenotbreached.

Therisk limitshave to beproperlydefinedandcalibratedandalignwithcompensationaswellas escalationprocessesthatenableappropriateactiontobetakenifthefirmisoperatingoutsideitsriskappetiteandrisklimits.

DevelopinganeffectiveRAF,however,remainsachallengeformostfirms;firmsneed tomakefurtherprogressin linkingtheirRAFstobusinessstrategiessothatRAFsbecometrulyeffectiveandoperationaltools.

Recommendation4:To improvetheirabilitytoassessfirms’progresstowardmoreeffectiverisk management,nationalauthoritiesshould provideguidanceonthekeyelementsthatareincorporatedineffectiveriskappetiteframeworks.

To enablefirmstodefineframeworkswithaminimumamount ofcomparabilitydespitetheirfirm-specificnature,acommonnomenclaturefortermsusedin riskappetitestatements(e.g.,“riskappetite”,“riskcapacity”,“risklimits”)shouldbeestablished.

TheFSBSupervisoryIntensityandEffectivenessgroup,incollaborationwithrelevantstandardsetters,hasagreed to finalisethisworkbytheend of2013.

Effectiveinternalcontrolsystemsareakeyelementofsoundriskgovernance,andsupervisoryexpectationsfortheindependentassessmentofinternalcontrolsystemsbyinternalauditwerewellestablishedpriortothecrisis.

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ThisincludesguidanceissuedbytheBCBSasearlyas199849andbyalongerhistoryofregulatoryrequirementsforpublicly-tradedfinancialinstitutions,includingpermanentauditcommitteesandindependentCAEs.

Sincethecrisis,manysupervisorshaveappropriatelyelevatedtheirexpectationsofinternalauditfunctionstoincludemorequalitativeassessmentsofpolicies,procedures,risklimitsandrisk exposures.

Assuch,thisisanarea thatdemonstratedrelativelysoundpracticesacrosstheFSBmembershipforbothnationalauthoritiesandfinancialinstitutions.

NearlyallfirmshaveanindependentCAEwhoreportsadministrativelytotheCEOorauditcommitteechairandwho directlyreportsauditfindingstoapermanentauditcommittee.

Despitethewiderangeofsoundpractices,thereisstillroomforimprovingtheCAE’saccess todirectorsbeyondthoseontheauditcommittee.

Regulatorsalsoneed to elevateandconveyexpectationsfor internalaudit,and/orathirdparty,toperiodicallyprovideafirm-wideassessmentofriskmanagementorriskgovernanceprocesses.

Finally,topromotefurtherprogress towardeffectiveriskgovernance,thereportrecommendsthat anotherpeerreviewbeconducted.

Recommendation5:TheFSBshouldconsiderlaunchingafollow-upreviewonriskgovernanceafter2016(i.e.,aftertheG-SIFIpolicymeasuresbegintobephasedin),to assessnationalauthorities’implementationoftherecommendations to strengthentheirsupervisoryguidanceandoversightofrisk governance.

ThereviewalsoshouldincludetheG-SIFIs identifiedin2014bytheFSBincollaborationwiththeBCBSandIAIS.

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V.Soundriskgovernancepractices

Drawingfromthefindingsofthereview,includingdiscussionswithindustryorganisationsaswellasrisk committeedirectorsandCROsofseveralfirmsthatparticipatedinthereview,thereportsetsoutalistofsoundrisk governancepractices.

Thelistextractssomeofthebetterpracticesexemplifiedbynationalauthoritiesandfirms.

Thesoundpracticesalsobuildonsomeoftheprinciplesand recommendationspublishedby otherorganisationsandstandardsetters,drawingtogetherthosethatarerelevantforrisk governance.

Thisintegratedandcoherentlistofsoundpracticesaimstohelpnationalauthoritiesandfirmscontinuetoimprovetheirriskgovernance.

Theboardofdirectors

1.Theboard:

avoidsconflictsofinterestarisingfromtheconcentrationofpowerat theboard(e.g.,byhavingseparatepersonsasboardchairmanandCEOorhavingalead independentdirectorwheretheboardchairmanandCEO arethesameperson);

comprisesmemberswhocollectivelybringabalanceofexpertise(e.g.,riskmanagementandfinancialindustryexpertise),skills,experienceand perspectives;

compriseslargelyindependentdirectorsandthereisacleardefinition ofindependencethatdistinguishesbetweenindependentdirectorsand non-executivedirectors;

setsoutcleartermsofreferencesforitselfanditssub-committees(includingtenurelimitsforcommitteemembersandthechairs),andestablishesaregularandtransparentcommunicationmechanismto

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ensurecontinuousandrobustdialogueandinformationsharingbetweentheboardanditssub-committees;

conductsperiodicreviewsofperformanceoftheboardandits

sub-committees(bytheboardnominationorgovernancecommittee,theboardthemselves,oranexternalparty).

Thisincludesreviewing,ataminimumannually,thequalificationsofdirectorsandtheircollectiveskills(includingfinancialandriskexpertise),theirtimecommitmentandcapacitytoreviewinformationandunderstandthefirm’sbusinessmodel,andthespecialisedtrainingrequiredtoidentifydesiredskillsfortheboardorfordirectorrecruitmentorrenewal;

setsthe tonefromthetop,andseekstoeffectivelyinculcatean appropriaterisk culturethroughoutthefirm;

isresponsibleforoverseeingmanagement’seffectiveimplementationofafirm-wideriskmanagementframeworkandpolicieswithinthefirm;

approvestheriskappetiteframeworkandensuresitisdirectlylinkedtothebusinessstrategy,capitalplan,financialplanandcompensation;

hasaccesstoanyinformationrequestedandreceivesinformationfromitscommitteesatleastquarterly;

meetswithnationalauthorities,atleastquarterly,eitherindividuallyorasagroup.

2.Theriskcommittee:

isrequiredtobeastand-alonecommittee, distinctfromtheauditcommittee;

hasachairwhoisanindependentdirectorandavoids“dual-hatting”withthechairoftheboard,orany othercommittee;

includesmemberswhoareindependent;

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includesmemberswhohaveexperiencewithregardtoriskmanagementissuesandpractices;

discussesallriskstrategiesonbothanaggregatedbasisandbytypeofrisk;

isrequiredtoreviewandapprovethefirm’srisk policiesatleastannually;

overseesthatmanagementhasinplaceprocesses to ensurethefirm’sadherencetotheapprovedriskpolicies.

3.Theauditcommittee:

isrequiredtobeastand-alonecommittee, distinctfromtheriskcommittee;

has achairwhoisanindependentdirectorandavoids“dual-hatting”withthechairoftheboard,orany othercommittee;

includesmemberswhoareindependent;

includesmemberswhohaveexperiencewithregardtoauditpracticesandfinancialliteracyatafinancialinstitution;

reviewstheauditsofinternalcontrolsovertherisk governanceframeworkestablishedbymanagementtoconfirmthattheyoperateasintended;

reviewsthethirdpartyopinionofthedesignandeffectivenessoftheoverallrisk governanceframeworkonanannualbasis.

Theriskmanagementfunction

4.TheCRO

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hastheorganisationalstature,skillset,authority,andcharacterneededtooverseeandmonitorthefirm’srisk managementandrelatedprocessesandtoensurethatkeymanagementandboardconstituentsareapprisedofthefirm’sriskprofileandrelevantriskissuesonatimelyandregularbasis.

TheCRO shouldhaveadirectreportingline totheCEOandadistinctrolefrom otherexecutivefunctionsandbusinesslineresponsibilitiesaswellasadirectreportingline to theboardand/orriskcommittee;

meetsperiodicallywiththeboardandrisk committeewithoutexecutivedirectorsormanagementpresent;

isappointedanddismissedwithinputorapprovalfromtheriskcommitteeortheboardandsuchappointmentsanddismissalsaredisclosedpublicly;

isindependentofbusinesslinesandhas theappropriatestatureinthefirmashis/herperformance,compensationandbudgetisreviewedandapprovedby theriskcommittee;

isresponsibleforensuringthattheriskmanagementfunctionisadequatelyresourced,takingintoaccountthecomplexityandrisksofthefirmaswellasitsRAFandstrategicbusinessplans;

isactivelyinvolvedin keydecision-makingprocessesfromariskperspective(e.g.,thereviewofthebusinessstrategy/strategicplanning,newproductapprovals,stresstesting,recoveryandresolutionplanning,mergersand acquisitions,fundingandliquiditymanagementplanning)andcanchallengemanagement’sdecisionsandrecommendations;

isinvolvedinthesettingofrisk-relatedperformanceindicatorsforbusinessunits;

meets,ataminimumquarterly,withthefirm’ssupervisorto discussthescopeandcoverageoftheworkoftherisk managementfunction.

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5.Theriskmanagementfunction:

isindependentofbusinesslines(i.e.,isnotinvolvedinrevenuegeneration)andreportstotheCRO;

hasauthority to influencedecisionsthataffectthefirm’sriskexposures;

isresponsibleforestablishingandperiodicallyreviewingtheenterpriseriskgovernanceframeworkwhichincorporatestherisk appetiteframework(RAF),risk appetitestatement(RAS)andrisk limits.

TheRAF incorporatesanRASthatisforward-lookingaswellasinformationonthetypesofrisksthatthefirmiswillingornotwillingtoundertakeandunderwhatcircumstances.

Itcontainsanoutlineoftherolesandresponsibilitiesofthepartiesinvolved,therisk limitsestablished toensurethattheframeworkisadheredto,andtheescalationprocesswherebreachesoccur.

TheRASislinkedto thefirm’sstrategic,capital,andfinancialplansandincludesbothqualitativeandquantitativemeasuresthatcan beaggregatedanddisaggregatedsuchasmeasuresoflossornegativeevents(e.g.,earnings,capital,liquidity)thattheboardandseniormanagementarewillingto acceptinnormalandstressedscenarios.

Risk limitsarelinkedto thefirm’sRASandallocatedbyrisktypes,businessunits,businesslinesorproductlevel.

Risk limitsareusedbymanagementtocontroltheriskprofileandlinkedtocompensationprogrammesandassessment.

d)hasaccesstorelevantaffiliates,subsidiaries,andconciseandcompleteriskinformationonaconsolidatedbasis;risk-bearingaffiliatesandsubsidiariesarecapturedbythefirm-widerisk managementsystemandareapartoftheoverallrisk governanceframework;

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providesrisk informationtotheboardandseniormanagementthatisaccurateandreliableandperiodicallyreviewedbyathirdparty(internalaudit)to ensurecompletenessandintegrity;

conductsstresstests(includingreversestresstests)periodicallyandbydemand.

Stress testprogramsandresults(group-widestresstests,riskcategoriesandstresstestmetrics)areadequatelyreviewedandupdatedtotheboardorriskcommittee.

Wherestresslimitsarebreachedorunexpectedlossesare incurred,proposedmanagementactionsarediscussedattheboardorriskcommittee.

Resultsofstresstestsare incorporatedinthereviewofbudgets,RAF andICAAP processes,andintheestablishmentofcontingencyplansagainst stressedconditions.

Independentassessmentoftheriskgovernanceframework

Theboardrequiresaperiodicindependentassessmentofthefirm’soverallrisk governanceframeworkandprovidesdirectoversighttotheprocess.

TheboardorauditcommitteefullysupporttheCAEandinternalaudit functionbyensuringtheCAE:

isorganisationallyindependentfrombusinesslinesandsupportfunctionsandhasunfetteredaccesstotheauditcommittee;

meetsregularlywithauditcommitteemembersoutsideofmanagement’spresence;

isappointedanddismissedwiththeapprovaloftheauditcommittee(orchairofthatcommittee);

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hashis/herperformance,compensation,andbudgetreviewedandapprovedby theauditcommittee;

hastheorganisationalstature,talent,andcharacterneededtoprovideareliable independentassessmentofthefirm’sriskgovernanceframeworkandinternalcontrolsandnotbeundulyinfluencedbytheCEOandothermembersofmanagement;

has theresources(peopleandsystems)neededtoeffectivelycarry outtheresponsibilitiesofinternalaudit;

providesregularreports totheboardorauditcommitteewhichsummarisetheresultsofinternalaudit’swork,includingoverallconclusionsorratings,keyfindings,materialrisk/issues,andfollow-upofmanagement’sresolutionoridentifiedissues.

Theauditcommitteeandriskcommitteeperiodicallymeettoensureeffectiveexchangeofinformation,to ensureeffectivecoverageofallrisksincludeemergingriskissuesrelativetotheRAFandbusinessplans.

Internalauditmeetsitsobligationstotheboardandsupervisorsby:

reportingauditfindings,significantissues,andthestatusofremedialactiondirectlytotheboardorauditcommitteeonaregularbasis;

providinganoverallopinionofthedesignandeffectivenessoftheriskgovernanceframeworkto theauditcommitteeonanannualbasis;

providingqualitativeassessmentsofrisksandcontrolsasopposed toevaluatingcompliancewithpoliciesandprocedures;

assessingwhetherbusinessandriskmanagementunitsareoperatingaccordingtotheRAF;

providingfeedbackonhowthefirm’srisk governanceframeworkandRAF comparetoindustryguidanceandbetterpracticesasameansofinfluencingtheirevolution;

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providinginputtorisk assessmentsandfeedbackoninternalcontrolsduringthedesignandimplementationprocesses;

escalatingissuesandconcernsidentifiedinthecourseofauditworkorthroughinternalwhistle-blowing,complaint,orotherprocessesandsituationswhereappropriateremedialactionisnotbeingimplementedinatimelymanner;

beingawareofindustrytrendsandbestpractices;

i)meets,atleastquarterly,withthesupervisor.

10.Thirdparties

supplement(butdonotreplace) internalauditstafftoincreasecoverage;

complementinternalaudit’sskillsetswithdeeperexpertise inselectareasand/orbroadercontextofindustrypractices;

areeffectivelysupervisedbytheboardorinternalauditfunction toensureaccountabilityremainswithinthefirm.

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KeynoteLuncheonSpeech

By CommissionerElisseB.Walter

U.S. SecuritiesandExchangeCommission32ndAnnualSECand FinancialReportingInstituteConference,Pasadena,CA

Introduction

Goodafternoonandthankyou,Dean Bill(Holder)foryourkindintroduction,andthanks toRandy(Beatty)forinvitingmeto

sharemyviewsatthe32ndAnnualSECandFinancialReportingInstituteConferencehereatUSC.Iamdelightedto beherewithallofyoutoday.

Youmaynothearthistoooftenfrompeopleoutsideyourprofession,butIhavealwayshadapassionforaccountingandauditing.

IthinkthishasitsrootsinthetimeIspentwithmyfather,whowasaCPAandtheCFOofa

publicly-heldcompany;hehelpedmebegintounderstandjusthowimportantaccountingis tobusinessandthefinancialsystem.

Ofcourse,inmymorethantwodecadeswiththeSEC,whichincludedclosetoadecadeintheDivisionofCorporationFinance,Ihavedeveloped

adeeperandmorecompleteunderstandingofthecriticalroleaccounting

andauditingprofessionalsplayin ourcapitalmarkets.

And today,Iampleasedtoseethatweareworkingtoadaptandexpandthatroletoserveinvestorsandotherstakeholdersevenmoreeffectivelyintheyearsahead,byaddressingcriticalissuesatamomentofgreatchangeandimportantprogressintheworldsoffinanceand accounting.

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BeforeIgoon,Ihaveadisclosurerequirementofmy own.

IneedtoremindyouthattheviewsIexpresstodayaremyown,andnot thoseoftheCommission,myfellowCommissionersortheCommission’sstaff.

High-QualityFinancialReporting

Becausefinancialinformationisthestartingpointforaninvestor’sdecision-makingprocess,highquality accountingstandardsarecritical.

Accurateandusefulfinancialinformationcreatestheenvironmentinwhich capitalformationsprouts,growsand,sadly,sometimeswithers.

Thatiswhy,whendevelopingaccountingstandardsthatwillshapeanincreasinglycomplexfinancialenvironment,itiscriticalthattheyaccuratelyreflecttheunderlyingeconomicsofthetransactionstheydocument.

Ofcourse,asweknow fromthemanystandards-settingprocessesunderway,thereisoftenadiversityofviewsonhowtheeconomicsof businesstransactionsshouldbeconsideredwhendevelopingaccountinganddisclosurerequirements,andreconcilingthemisaprimarytaskofanygoodstandardsetter—thedevelopmentofhigh-qualityaccountingstandardsiscertainlydependentuponit.

ReconcilingdiverseviewsoncorporatefinanceissuesissomethingIhavespentalotoftimeonasaCommissionerandregulator.

Andfrommyperspective,themosteffectiveway to resolvethesedifferencesistosetastandardthatexpressesatransaction’seconomicsinafashionthatmeaningfullyinformsinvestorsandresonateswiththemastheystudyacompany’s disclosures.

FASB/IASBConvergenceProjects

WeareseeingthisdynamicplayoutintheFASBandIASBpriorityconvergenceprojects.

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Earliertoday,youdiscussedsignificantprogresstowardsanalignmentofaccountingstandardsin four keyareas—revenue,leases,financialinstruments,andinsurance.

Thisprogressisapositivedevelopment,withboththeFASBandtheIASBshowinggreatskillin workingtogethertocreatecommon standardsthatwilleffectivelyserveinvestorstheworldover.

However,asPaul[Beswick]notedthismorning,publicationofthestandardsisjustthestartingpoint.

Thechallengeyouface,asCPAs,istosuccessfullyimplementanynew accountingstandards,andtherebycollectivelyprotectinvestorsin thisevolvingfinancialmarket.

And,finishingtheconvergenceprojectsis,ofcourse,nottheendofthestoryfortheUnitedStatesandIFRS.

Icontinue to lookforward to adaywhenthereisonesetofglobalaccountingstandards,andwearetakinganumberofstepsinthatdirectionattheSEC,includingsolicitingviewsfromU.S.publiclyheldcompaniesregardingtheseissues.

AsPaulnotedearlier,theIFRSalreadyplaysanimportantroleintheU.S.capitalmarkets.

Forexample,todaywithUSforeignprivateissuersalreadyusingIFRS,wehaveasignificantpublicmarket—withapproximately450companieswithamarketcapitalizationinthetrillions—alreadytradingonthebasisoffinancialstatementspreparedin accordancewiththosestandards.

Ihopethat,asthesecommonstandardscomeonline,youwillworkwithaccountingcolleaguesandcorporatemanagers toensureasuccessfultransitionrestingonfourpillars.

Thefirstpillarofsuccessfulimplementationistraining,andtheseprojectswillrequiretrainingacrossallconstituentsatalllevelswithinthe

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organization—fromthestaffaccountantperformingthefilingreviewtotheseniormanagement.

In addition,weallneedtoconsiderhowwe canmakesurethatinvestorsunderstandthechangesthatareoccurring.

In orderforthattohappen,youandallofthe otheraffectedpersonnelattheentitiesyourepresentwillfirstneedtotakeasmuchtimeasnecessary tofullyunderstandthenewstandardsyourselves.

Thenextpillarisresources.

Itisimportantthatcompaniesdevotesufficienttimeandresourcestoupdatingtheirfinancialreportingsystemsinthewakeofthesechanges.

We canalreadyseethatthestandard-settersunderstandthesignificanceofthechangesandtheneedforasufficientlylongimplementationperiod.

Butcompaniesthemselvesmustalsobesuretoallotadequatetimetoamendingprocessesandsystems,andresourcesnecessarytorunparallelsystems,untiltheyfeelfullycomfortablereportingfinancialinformation usingthenewstandards.

Thethirdpillarisidentificationofinterpretativeissues.

Thestandard-settersarespendingagreatdealofeffortnowtoensurethat thenewstandardsareaspreciseaspossible.

Buttherewillalwaysbeareasthatdemandinterpretation.

Itwillbeimportanttoidentifyareaswherethereisdiversityinapplicationandaddressthemthroughinterpretativeguidancesothatinvestorsarenotharmedandfinancialstatementsaretransparent.

IexpecttheSECstaffwillbefairlyactivein thisspace.

In addition,IcommendtheFASBforproactivelyaddressingthisarea bybringingtogetherabroadspectrumofrepresentativeconstituentsintoan

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implementationgroupthatwillraisepracticeinterpretationissuesrelatedtotheproposedrevenuestandard.

Thisisabouttimelycommunicationthatallowsthoughtfuldeliberation,andthegoalistodothisinanopenandtransparentmanner.

IalsothinkisitapositivesignthattheIASBhasagreed toparticipateinthisinitiativeandthatwe,throughtheSEC staff,willbeanobserver.

Perhapsthiscouldserveasapilotforallofthenewstandardsindevelopmentandanewtoolfortheprofession.

Thefinalpillarisafocusoninvestorunderstanding.

Whenthereisan accountingpolicychoice,weshouldselecttheaccountingthatbestreflectsthebasiceconomicsofthetransaction.

Withmoreprinciples-basedstandards,itisoftheutmostimportancetoconsiderthesubstanceofthetransactionandtheeconomics.

Disclosurethatistransparentandcommunicatesthecriticaljudgmentswillallow theinvestortoseetransactionsthroughmanagements’eyes,allowingthemtobetterunderstandthemotivationsandthepotentialpitfallsorbenefitsofthetransaction,andto makemoreinformed decisions.

Dependinguponthetransaction,thismaymeangoingbeyondtheexplicitdisclosurerequirements.

Again,Iencourageyoutolookbeyondabstractaccountingstandardsand disclosurechecklistsandthinkaboutwhatwouldbemeaningfultoaninvestorseekingtounderstandatransaction’simportance.

Acheck-the-boxmentalitymaynotproducethebestfinancialinformation.

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IncreaseOutreachtoInvestorsRelatedtoFinancialReporting

Increasedinvestorunderstandingshouldalwaysbeaprimarygoalofnew standards.

Buttoendupwithstandardswhichsupportthatgoal,weneedtostartthestandard-settingprocesswithinvestoroutreach.Findingoutwhatisoninvestors’mindsisanecessarystepbecausethiswillimprovetheoverallqualityofthestandards.

Recently,wehaveseenanincreaseininvestoroutreach,inlargepartthanks toastrongeffortbyFASB,butIbelievethereisstillroomforimprovement.

Forexample,theFASB,initsdueprocess,shouldemphasizecollectingfeedbackfromusers.

Weneedtoaskourselves:“Dowereallyknowwhatmatterstoaninvestor?”

“Whatinformationis theinvestorlookingfor?”

And“havewereceivedfeedback fromacross-sectionofthedifferenttypesofinvestors?”

AstheSEC lookstoupdateitsguidanceasaresultoffinalnewaccountingstandards,we,too,willbeseekingtounderstandtheneedsofinvestorsinadvanceofanyamendments.

Disclosures

OneofthepartsofmyjobthatIenjoymostistheopportunity to interactwithindividualswhoaredevotedtoprovidinginvestorswithhigh-qualityfinancialreporting.

In theseinteractions,Igetto hearallofthewonderfulthingsthattheCommissionisdoingwelland,notsurprisingly,whattheCommissioncoulddobetter.

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Oneissuethathasbeenraisedinthesediscussionsisthelevelofrequireddisclosuresthatareincludedinacompany’sfilingswiththeCommission.

WhenIhearthissortofcomment,Ithinkthenaturalinclinationis tobesomewhatskepticalofacompanynotwantingtobeastransparentaspossiblewiththeirinvestors.

Butincreasingly,wehearthatthelevelofdisclosuresisinterferingwitharegistrant’sability tocommunicatewithinvestors.

Ofcourse,weneedtoinvestigateandevaluatethatassertion.

But,iffornow,Iacceptthisassumptiontobeafact,thenwhataretheappropriatenextsteps?

Inmyview,thereseemtobetwopotentialnextstepstoresearchtheissueandconsiderpotential improvements.

Onepathwouldbetorethinktheentireregime.

Whilethisroutemaysoundencouragingonfirstblush,itfailstoacknowledgethatourcurrentdisclosureregimehasservedinvestorswellfordecades.

And,becauseoftheenormityofthetask,itrunstheriskoftakingtoolongwhilenotbeingasimpactfulasitmightotherwisebe.

Amoretargetedreviewofsomeoftheareaswheretheinformationisnotperceived tobeasvaluablehastheadvantageofbeingcompletedmorequicklyandthereforehaveamoreimmediateimpact.

In additiontoimportantareasoflineitemdisclosure,IbelievethattheprimetargetforimprovementisManagement’sDiscussionandAnalysis(“MD&A”).

AsIhavesaidmanytimesbefore,thesedisclosuresaboutwhereacompany’sbeenandwhereit’sgoing“shouldbemadeinawaythat

communicates— trulyspeaks —toshareholders....[that]trulyenables

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theowners[ofthecompany],theshareholders,toviewthecompanyanditsprospectsthroughtheeyesofitsinsiders.”

SoIencourageyouallto giveusyourthoughtsondisclosurerequirements;wereallyneedtoworktogethertoensurethatdisclosuretrulyservestoinform.

RoleoftheAuditor

Steppingbackforamomentfromfront-line accounting,itisimportant that,asweshapethefinancialreportingstructureofthefuture,wecontinuetoemphasizeandenhancetheroleoftheauditorswhoserveasgatekeeperstothepublicsecuritiesmarkets.

TheintegrityandreliabilityofthefinancialreportingsystemreliesheavilyonauditorshavingsignificantresponsibilityforthelargevolumeoffinancialinformationthatsupportstheCommission'sfull disclosuresystem.

Congress,increatingoursystem,grantedtheaccountingprofessionanimportantpublictrust.

Thistrustinauditors,combinedwiththevigilanceofthePublicCompanyAccountingOversightBoard(“PCAOB”),helps toformthefoundationofthefinancialreportingprocess.

Welook to auditorsnotonly tohelpdetectproblems,but,mostimportantly,topreventproblemsfromoccurring in thefirstplace,bydeterringthosewhowouldfudgenumbers,takeshortcuts,or,moresubtly,tolerateinappropriatebiasesthathavetheeffectofmakinganotherwisereasonableestimateorjudgmentunreasonable.

RoleofthePCAOB

Experienceteachesusthatthereisvaluein auditingtheauditorsaswell,and,sinceitscreation10yearsago,thePCAOBhasgrownintoanimportantregulatorybodywithasignificantinvestorprotectionroleinthisarea.

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ThePCAOBisinauniqueandfortunatepositionofhavingitsstandardsetting, inspections,andenforcementallunderoneroof.

Thepotentialbenefitsofthisstructureareremarkablebecausetheyareallcriticalcomponentsofwhatsomehavecalledthe“auditperformancefeedbackloop”—theprocessesof,forexample,leveragingtheinformationgatheredduringinspectionsandenforcement actions todevelophighqualitystandards.

Morethan2,300accountingfirmsareregisteredwiththePCAOB,about 900ofthembasedoverseas.

Asyouknow,oneofthePCAOB’smostimportantmandatesis toconductinspectionsofaccountingfirmsregisteredwiththeBoard.

Andsince2002,ithasconductedinspectionsofthousandsofauditsof

U.S.publiccompaniesintheU.S.andabroad.

Onearea thathasbeennearestanddearesttomyheartinoverseeingthePCAOBisauditorperformancestandards.

AsIhaveoftensaid,IwouldliketoseethePCAOBdevotemoreattentiontoupdatingandmaintainingtheirperformancestandardsandqualitycontrol,whichhavethemostdirecteffectonhow auditsareperformed.

Highqualityauditstandardsthatsetclearexpectationsforauditorperformanceareabsolutelycriticaltoourfinancialsystem.

I’mencouragedthatstandardsregardingtheauditingofrelatedpartiesandsignificantunusualtransactions,aswellasauditingaccountingestimates, includingfairvaluemeasurements,areonthePCAOB’scurrentstandardsettingagenda.

However,Ithinkmore canbedonetoenhancethedevelopmentandmaintenanceofhighqualityauditingstandards.

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Therearealsoanumberofveryimportantauditingmattersunderconsiderationglobally,suchas theconsiderationsforchanges to theauditor’sreportingmodel.

ItisimportantthatthePCAOBbealeader inadvancingthecontinuingimprovementofauditquality,includingbysharingexperiences,knowledgeandviewsbetweenregulators.

Thisalsoincludesmonitoringtheactivitiesofotherregulators,standard setters,andlegislativebodiesastheyexplore changestothewayauditsareconductedorauditorsareoverseen.

AsecondpriorityisexpandingthePCAOB’sabilitytoperforminspectionsincertainjurisdictionsoutsidetheU.S.

TheBoardhasmaderemarkableprogressoverthepastyearinadvancingnewcooperativeagreementsanddevelopingrelationshipswithnon-U.S.regulators,enablingadvancementsofinspectionsofauditsaroundtheglobe.

Astrong,globalinspectionprogramiscriticaltoevaluatingauditperformanceandprovidesimportantinformationnecessaryforthePCAOBtoimprovetheirauditingandqualitycontrolstandardsaswellasforfirmstoimprovetheirownqualitycontrols.

AuditsofBrokerDealers

TheDodd-FrankActgavetheBoardexplicitauthorityovertheauditsandauditorsofbroker-dealers’financialstatements.

Currently,theBoardhas aninterimbroker/dealer inspectionprograminplace,anditissueditsfirstpublicprogressreportonthatprogramlast year.

Theinitialresultswereconcerning.

TheBoardplanstocontinueinspectionsundertheinterimprogramuntilrulesforapermanentprogramtakeeffect.

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Itsnextprogressreportisexpectedlaterthisyearandwillcoveramuchlargernumberoffirmsandaudits.

Iwillbeverymuchinterestedintheresults.

Inaddition,inJune2011,theCommissionproposedamendmentstoRule17a-5,therulethatcontains thefinancialreportingrequirementsforbrokersanddealers.

Amongotherthings,theproposedamendmentsareintendedto increasefocusoncertainfinancialandcustodialrequirementsandfacilitatethePCAOB’simplementationofitsoversightofbroker-dealeraudits.

InJuly2011,thePCAOBproposednewauditingandattestationstandardsthatwouldapplytotheauditsofbrokeranddealers.

IamhopefulthattheCommissionwillmoveforwardtofinalizeitsrulesinthenearfutureandthat,oncewedo,thePCAOBwilllikewisemoveforwardexpeditiously.

PCAOBInspectionReports—EnhancingInspectionReportContent

IunderstandthatoneofthePCAOB’snewneartermpriorityprojectsisdirectedatimprovingthecontentandreadabilityofinspectionreportsandthattheBoardisintheearlystagesofconductingoutreachaspartofthisefforts.

I’mencouragedbythisdevelopment—higherqualityinspectionreportswillpromotebetterunderstandingoftheissuesandhelptopreventsimilarproblemsgoingforward.

In particular,IbelievethatPCAOB inspectionreportsshouldincludecitationstoaspectsoftherelevantstandardsorrulesandanevaluationofhowtheauditor’sperformancecomparedto suchrequirements.

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Conclusion

Weareallchargedwithcreatingandimplementinganaccountingandauditfoundationthatwillallow investorsto makesenseoftherapidlychangingfinancialmarkets,andensurethattheresultsarenotonly timelyandaccurate,butalsocomprehensibleandusefulto investors.

Thenewstandardsthataredevelopedshouldbeinformedbythoughtfulandrobustanalyticalthinkingandwiththeneedsofinvestorsuppermostinourminds.

Thesenewstandardsneed tobeclear,appropriatelyandconsistentlyapplied,andtheneffectivelyenforced.Timelycommunicationbetweenallplayersleadingup to theeffectivedatewillbecriticaltohelppavetheroadto success.

Thankyouforyourtime,andIlookforwardtoansweringyourquestions.

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BackgroundonthePCAOB

StevenB.Harris,BoardMemberKennesawStateGraduateStudentMeetingWashington,DC

Manythanks Dr.EppsforprovidingmethisopportunitytotalktothegraduatestudentsofaccountingofKennesawState thismorning.

IknowyouhaveafullprogramandIhavebeenasked to startoffwithabriefoverviewandbackgroundofthePublicCompanyAccountingOversightBoard.

BeforeIcontinue,ourBoardpolicy requiresthatItellyouthattheviewsIexpress todayaremyown,anddonotnecessarilyreflecttheviewsoftheotherBoardMembersorthestaffoftheBoard.

Ialsowillleavetimeandamhappy to take questionsattheend.

RESPONSIBILITYOFAUDITORS

AsIthinkyouknow,thePCAOBoverseestheauditorsandauditsof publiccompaniestrading in theUnitedStates,aswellasthoseof broker-dealers.

Ourjobisinvestorprotection—andthatistheauditor'sjobaswell.

Theaccountingandauditingprofessionsserveavitalroleinourcapitalmarketsandoureconomy,andIcongratulateyouforchoosingthislineofstudy.

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Thefederalsecuritieslawsgrantauditorsauniquefranchiseinthateverypubliccompanythatraisesmoneythroughour capitalmarketsorhasasecuritylistedonanexchangemusthireanindependentpublicaccountant to audititsfinancialstatements.

Thisroleplacesauditorsattheveryheartofourfinancialregulatorysystem—aconceptthatwasupheldbytheU.S.SupremeCourtin1984.

InUnitedStatesv.ArthurYoung,theCourtstressedtheimportanceoftheauditprocesstotheintegrityofourmarketsandtheconfidenceofinvestors.

Itdescribedtheauditasa"publicwatchdog"functionthat"demandsthattheaccountantmaintain total independencefromtheclientatalltimesandrequirescompletefidelitytothepublictrust."

Without accurateandreliablecorporatedisclosuresandfinancialstatements—andcompetentauditorstoauditthem--ourcompetitivefreemarketsystemcannotfunctionproperly.

Thatiswhy,asIstatedearlier,yourchosenarea ofstudyisvitalto oursystemofcapitalism.

In theUnitedStates,overhalfofallhouseholdsinvestinpubliclytradedcompanies,whetherthroughdirectinvestmentsin companies'securitiesorthroughotherinvestmentvehicles.

Theseinvestmentsinmanyinstancesprovideforcollegefundingandretirement.

Investorsrelyontheassurancesprovidedbyindependentauditorsthatfinancialstatementsfairlypresentthefinancialpositionsofpubliccompanies.

Alossofinvestorconfidenceintheintegrityofthefinancialstatementortheauditorwouldreducetheefficiencyofourmarketsandadd unnecessarycoststothe capitalformationprocessusedbythousandsof

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American companies to raise thefundsneededtobuildtheirbusinessesandcreatemorejobs.

BACKGROUNDOFTHEPCAOB

ThelossofthatinvestorconfidenceiswhatCongressfacedin2002afterthefinancialcrisisthatculminatedinthefailuresofWorldComandEnron.

Whiletherehadbeen othersignificantfinancialreportingfraudsbefore,nonehadreachedthemagnitudeofwhatwewerefacing intheearly 2000s.

LiterallybillionsinearningsandassetswererestatedduetoaccountingerrorsandirregularitiesatEnronandWorldCom.

ThefallofEnronalonecostalmost20,000jobsandmorethan$2.1billioninretirementassetstoitsemployees,aswellasabout$67billiontoitsshareholders.

WorldComcostitsshareholdersabout$180billion.

Asaresultofthoseandotherfinancialreportingfraudsandtheassociatedauditfailures,theSarbanes-OxleyAct,whichcreatedthePCAOB,waspassedwithoverwhelmingsupportfrombothpartiesin July2002.

ThestatedpurposeoftheActis"toprotectinvestorsbyimprovingtheaccuracyandreliabilityofcorporatedisclosures."

ThePCAOBwasestablishedbecausetheaccountingprofession'sframeworkofself-regulationhadfailed.

ThePCAOB'sstatedpurposeis"toprotecttheinterestofinvestors... inthepreparationofinformative,accurateandindependentauditreports."

Thisyear,thePCAOBiscelebratingits10thanniversaryandIbelieveithas achievedanimpressiverecordofaccomplishmentsinresponsetothatdirectivefromCongress.

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PCAOBRESPONSIBILITIESANDACCOMPLISHMENTS

TheSarbanes-OxleyActdirectsus to:

Registerauditfirms;Writeauditingstandards;Inspectauditfirms;and,

Investigate,conductdisciplinaryproceedings,andimposesanctionsonauditorsandauditfirms,asneeded.

Essentially,thePCAOBauditstheauditors.

Presently,thereareabout2,300auditingfirmsregisteredwiththePCAOB,includingmorethan900internationalfirmsin about84countries.

Lastyear,theBoardconductedinspectionsofabout300auditfirms,includingnearly80internationalfirmsinclose to 30countries.

Nineofthelargerfirmsarecurrentlysubjectto annual inspections,includingDeloitte&Touche,Ernst&Young,KPMG,andPricewaterhouseCoopers,whichareoftenreferredtoasthe"BigFour."

ThesefourfirmscollectivelyauditU.S.publiccompaniesrepresenting98%ofthetotalU.S.marketcapitalization.

Therestoftheauditfirmswithpubliccompanyclientsareinspectedonatriennialcycle.

Todate,wehaveconductedover1,700inspections,andhaveissuedover1,500inspectionreports.

Sinceitsfoundinginearly2003,thePCAOBhasissued16auditingstandards,coveringinternalcontroloverfinancialreporting,andasetofeightfoundationalrisk-assessmentstandards.

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LastAugusttheBoardapprovedourlateststandard,CommunicationswithAuditCommittees,to improvetherelevance,timeliness,andqualityofcommunicationsbetweenauditorsandauditcommitteesofpubliccompanies.

ThestaffoftheChiefAuditor'sofficealsohas issuedseveralauditpracticealerts toprovideguidanceoncurrentauditingissues,suchasauditrisksin emergingmarketsandauditconsiderationsduringtheeconomiccrisis.

Thelatest,issuedinDecember,callsattentiontothefundamentalimportanceofprofessionalskepticism.Itoutlinesstepsthatauditorscantake toensurethattheyremainskepticalthroughouttheaudit.

In theenforcementarea,theBoardsettledeightenforcementcasesin2012.

ThoughtheSarbanes-OxleyActpreventsusfrompublicizingourongoingenforcementproceedings,Icantellyouthatourproceedingssofarhaveaddressedabroadrangeofauditissues,includingafirm'sfailuretoassurethatauditsarestaffedappropriately,anauditor'sfailureto actwhenconfrontedwithevidenceofillegalactsbyaclient,andanauditor'sfailure to beindependentfromhisauditclient.

CountriesaroundtheworldhavetakennoticeofthePCAOBanditswork.Morethan40countrieshaveestablishedsimilarindependentauditoversightregimessincethePCAOBwascreated.

Mostofthosecountriesarenow membersoftheInternationalForumofIndependentAuditRegulators,orIFIAR,acoalitionof46jurisdictionsofindependentauditoversightbodiesfromaroundtheworld.

So,thatisaverybriefoverviewofthePCAOB.

Now,Iwant totouchonsomeofthethingsthattheBoardisworkingoncurrently.

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Theseinclude(1)requiringgreaterdisclosureintheauditor'sreport,(2)enhancingauditorindependence,and(3)fosteringgreateraccountabilityintheprofession.

GreaterDisclosureintheAuditor'sReport

Theauditor'sreport,asIthinkmostofyouknow,hasnotbeenupdatedsignificantlysincethe1980s.

Whilethecurrentpass/failmodelishelpful,wearehearingfromavarietyofinvestorrepresentativesthatthereportneeds toconveymoreinformation,especiallyin lightoftherecentfinancialcrisiswheresomanyissuersreceivedclean opinionspriortofilingforbankruptcyorreceivinggovernmentassistance.

Theauditor'sreportprovidesanopportunityforauditors to demonstratetheirrelevancetoinvestorsandthepublicgenerally.

JimTurley,ChairmanandCEOofErnst&Young, hassaidthat,"Themostimportantissuefacingourprofessionistherelevancyofourauditservice/productandmakingsurethatwecommunicatewithstakeholdersinwaysthatareofimportancetothem."

TheBoardiscurrentlylookingatvariouspossiblechangestotheauditor'sreport.

Weissuedaconceptrelease in 2011askingforcommentsonhowimprovementscouldbemade,suchasbyaddingmoreinformationaboutsignificantrisksidentifiedbytheauditor.

EnhancingAuditorIndependence

Amajorreasonauditorsaresovitaltoourmarketsisbecausetheyprovideanindependentcheck onacompany'sfinancialstatements.Theindependenceoftheauditorfromitsclientiscritical.

BeforepassageoftheSarbanes-OxleyActin 2002,firmswereprovidingbothconsultingandauditservicestothesameclient.

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TheauditfailuresleadinguptothepassageofSarbanes-Oxley,however,revealedthatinanissuer-paymodel, whenafirmderivesasubstantialamountofconsultingrevenuefromanauditclient,itsindependenceandobjectivitymaybecompromised.

Sarbanes-Oxleyaddressedthisconcernbyprohibitingfirmsfromprovidingcertain"non-audit"servicestoauditclientsintheU.S.

TheBoardhasundertakenvariousinitiativestoaddressitsongoingconcernsthatsomeauditorsmaynotbeapproachingcertainaspectsoftheirauditworkwiththeindependence,objectivityandprofessionalskepticismenvisionedbytheSarbanes-OxleyActandPCAOBstandards,andweareconcernedaboutsomeofthemarketingandbusinessdevelopment activitiesofsomeofthefirmsweinspect.

FosteringGreaterAccountability

ThetwoitemsthatIhavejustmentionedarerelated to oneofthebasicunderlyingprinciplesoftheSarbanes-OxleyAct—increasingthe"accountability"ofallmarketparticipantstoinvestors.

Forexample,theActrequiredthattheprincipalexecutiveofficerandtheprincipalfinancialofficerpersonallycertify,in part,thatthedisclosureandfinancialstatementsarefairlyrepresentedinallmaterialrespects.

Anumberofusbelievethatnothingfocuses themindquitelike puttingone'snameorsignatureonadocument.

TheBoardislookingatvariousmeanstoaddressaccountabilityintheprofession.

Someofthethingsweareconsideringincludewhethertorequire theengagementpartner,thepersonwhoisresponsibleforsupervisingtheaudit,tosigntheauditreportorhavetheengagementpartnerspecificallynamedinthereport.

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Boardconsiderationto addresstheseand otherpendingissuesmust,however,bebalancedagainsttheunintendedresultofcreatingtoomanyrequirements,andoverlycomplexstandards.

Inmyopinion,sucharesultwouldnotbeinthebestinterestofinvestors.

Mygoalasaregulatoroftheauditingprofessionistooverseeatargeted,effective,cost-efficient,regulatoryprocesswitheachproposedstandardjustifiedinadvancebytheBoard'sclearlystatingwhattheproblemisthatneedstobeaddressed.

ByhavingstraightforwardandstreamlinedstandardsandreportswritteninplainEnglish,andbyavoidingcomplexity totheextentpossible,Ibelievewecanendupwithmoreeffectivestandardsandreports,moreeffectiveaudits,andmoreinvestorconfidenceintheauditandfinancialreportingprocess.

CONCLUSION

In conclusion,IbelievethatthepassageoftheSarbanes-OxleyAct,whichcreatedthePCAOB,institutedfundamentalchangesintheoversightoftheauditingprofessionandhelpedrestoreinvestorconfidenceintheauditors'workandopinion.

Letmerepeat,Icommendyouforchoosingsuchanintellectuallyrigorousandrobustfieldofstudy.

Yourfuturechosenprofessionisvitaltotheintegrityofourcapitalmarketsand totheinfrastructureofourentirefinancialsystemwhichsoeffectivelypromotescompetitionandwhichIbelieveremainstheenvyoftheworld.

Iamhappytoansweranyquestionsyoumayhave.

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  • FinancialConglomeratesDirective

  • TechnicalReview

  • ThisPrudentialRegulationAuthority(PRA)policystatementpublishesthefinalrulesimplementingtheFinancialConglomeratesDirectiveTechnicalReview(2011/89/EC)(FICOD1)whichamendstheFinancialConglomeratesDirective(2002/87/EC)andcertainotherDirectivesinsofarastheyapplytofinancialconglomerates.

  • Thisstatementisrelevanttofinancialconglomeratesandfinancialgroupswhichcarry outactivitiesinbothbanking/investmentandinsurancesectors.

  • In CP12/40(1)theFinancialServicesAuthority(FSA)consulted,onbehalfofthePRAandtheFinancialConductAuthority(FCA)andinconjunctionwithHMTreasury,onproposalsforimplementingFICOD1.

  • Considerationoftheresponsesreceivedhasresultedinsomeadjustmentstotheinstrumentintheappendix,andadescriptionoftheseissetoutinthisstatement.

  • Summaryofproposals

  • FICOD1introducedtechnicalamendmentsaimedatcorrectingunintendedconsequencesandimprovinginefficienciesoftheoriginaldirective.

  • TheFICOD1changesrelateto:

  • theapplicationofconglomeratesupervisiontoensurethatitsupplements,butdoesnotsubstitute,sectoralsupervisionwhenagroupisheadedbyafinancialorinsuranceholdingcompany;

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  • theconglomeratecapitalcalculationmethodology;

  • inclusionofassetmanagementcompaniesandalternativeinvestmentfundmanagerswithintheconglomerateidentificationprocess;

  • conglomerate identificationthresholdtriggers;and

  • requirementsforconglomeratestresstesting.

  • Consultationresponses

  • In totaltherewerethreerespondents.

  • Allexpressedsupportfortheproposed‘copy-out’approachwhichimplementsdirective textintothehandbookwithoutsupplementaryprovisionsorguidance.

  • However,respondentssoughtclarificationoftheproposedchangesincertainareas.

  • Ourresponsetothisissetoutbelow.

  • Onerespondentnotedthattheintroductionofthenewthresholdtestinthefinancialconglomeratedecisiontree(GENPRU3Annex4)impliesanautomaticexemptionfromconglomeratestatus.

  • Asindicatedintheconsultationpaper,anexemptionunderFICOD1Article3(3A)isavailableonlyatthediscretionoftheco-ordinator,inconsultationwithothercompetentauthorities,inthesamewayasiscurrentlythe caseforanexemptionunderthresholdtest3(FICOD1,Article3(3)).

  • WherethePRAortheFCAistheco-ordinator,itisintendedthatfirmswouldbeable to apply to theappropriateregulatorforawaiverorrulemodificationwhichwouldprovideanexemptiononthebasisofFICOD1Articles3(3)or3(3A).

  • Thedecisiontreewillthereforeremainascurrentlyinforce.

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Toallaycertainconcernsraisedaboutpotentialdoublecountingandinternalinconsistenciesfor insuranceentities,thePRAconfirmsthatsectoralrequirementsareintendedtobespecificallyappliedatthemixedfinancialholdingcompany(MFHC)leveltocounterthesituationwhereaholdingcompanytowhichsectoralruleswouldhaveappliedbecomesanMFHC,potentiallydisplacingthosesectoralrules.

However,where theapplicationofrequirementsatthelevelofboththeultimateEuropeanEconomicArea(EEA)MFHCandtheultimateEEAinsuranceholdingcompanyresultsinduplication,itisourintentiontoconsiderwaivingrequirementsattheleveloftheMFHC.

Wehavedecidednot to includeMFHCinthedefinitionofinsuranceparentundertakingandwehaveamendedthehandbooktexttoclarifythelevelatwhichINSPRU6.1andcertainreportinganddisclosurerequirementsinSUP 15.9andIPRU(INS)9.40apply to conglomerates.

OnerespondentaskedforclarificationonconglomeratestresstestingandqueriedfutureconsultationonEuropeanSupervisoryAuthority(ESA)conglomeratestress-testingguidance.

Forfinancialconglomerates,thePRA’sintentionistostresstesteachsectoratthesametimesothatcross-sectorconsiderationscanmoreeasilybetakenintoaccount.

Suchtestingwillbecasespecific,tobeagreedbetweentheconglomerateanditssupervisor,butwedonotenvisagesignificantchanges to existingarrangements.

WewillconsultonanyproposalsforEU-widestresstestingwhichentailchangestoourrulebook.

Allrespondentssupportedtheproposedapproachthatthefinancialconglomerate,havingconsultedthePRA,shouldchoosewhichcapitalcalculationmethoditwillapply.

However,twospecificissueswereraised.

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First,theadditionofMFHCto thedefinitionofinsuranceparentundertakingappearsto takeawaytheapparentchoiceforMFHCconglomerates to choosetheircalculationmethodbyapplyingtherequirementsofINSPRU6.1(whichimplementsthedeductionandaggregationmethod)unlessthoserequirementsarewaived.

Second,INSPRU6.1.62R–64Rcontinues to implementcalculationmethod3forancillaryservicesundertakingsalthoughthatmethodisnolongeravailableunderFICOD1.

Afirmwhichnowbecomessubject tosectoralreportingunderINSPRU6.1inrespectofanMFHCconglomeratebutwhichwishestoelecttousemethod1(accountingconsolidation)(asavailable toconglomeratesunderGENPRU3.1)in calculatinggroupcapitalresourcesratherthanthedefaultmethod2(deductionandaggregation)asappliedbyINSPRU6.1toinsurancegroups,maybepermittedtodosototheextentthatsectoralrequirementsarewaived.

Aprovisionspecificallydealingwiththistypeofwaiverhasbeenaddedto INSPRU6.1.Theavailabilityofmethod1underGENPRU3.1forinsuranceconglomeratesisunchangedasisthescopeoftheapplication ofsectoralrulesinINSPRU6.1toinsuranceconglomeratesincalculatingconglomerate capitalresources.

Withregardtothetreatmentofancillaryservicesundertaking,INSPRU6.1.62R–64R(whichapplyforinsurancegroupsthehigherofbook valueandcapitalrequirementdeductionmethodwhichnolongerapplies toconglomerates)havebeenamendedtoexcludeapplicationtoconglomerates.

OnerespondentqueriedtheapplicationofPartVofChapter9ofIPRU(INS)toconglomerates.

ThePRAconfirmsthattheintentionistoprovideflexibilityforMFHCconglomerates toagreereportingarrangements(includingrequirementsforauditorverification)withtheirsupervisor.

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Theexistingapproach,wherebyconglomeratesusingdiscretecalculationmethodsmayagreereportingarrangementswiththeirsupervisor, hasbeenextendedtoconglomeratesusingacombinationmethod(withthemandatoryuseoftheformsinAppendix9.1ofIPRU(INS)/Form95andrelatedrequirementsforanauditor’sreportnowbeingdisapplied).

Theintentionis to applyPartVofChapter9ofIPRU(INS)(andtherelatedrequirementforanauditor’sreportthatthecapitaladequacy calculationhasbeenproperlycompiled)toMFHCconglomeratesonafullsectoralbasisonlyin thecasewhereaninsuranceholdingcompanybecomesanMFHCandthesectoralreportingrulesatthatlevelwouldotherwisefallaway.

However,where adequatereportingatMFHCconglomeratelevelhasbeenagreedwiththefirm’ssupervisor,itisintendedthatthissupplementarysectoralrequirementonanMFHCconglomerateshould bewaivedinfavourofapplicableconglomeratereporting.

Wehaveamendedthetext to reflectthat.Toread more:

http://www.bankofengland.co.uk/pra/Documents/publications/policy

/2013/ficodps3-13.pdf

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CommitteeontheGlobalFinancialSystemCGFSPapersNo49

Assetencumbrance,financialreformand thedemandforcollateral assets

ReportsubmittedbyaWorkingGroupestablishedbytheCommitteeontheGlobalFinancialSystem

TheGroupwaschairedbyAerdtHouben,NetherlandsBank

Preface

Giventhatthedemandforcollateralassetsisincreasing,theCommitteeontheGlobalFinancialSystem(CGFS) in May2012establishedaWorkingGroup(chairedbyAerdtHouben,NetherlandsBank)toexploretheimplicationsofthistrendformarketsandpolicy.

ThisreportpresentstheGroup’sfindingsfromasystem-wideperspectiveanddrawsbroadconclusionsforpolicymakers.

Thereportpresentsevidenceofincreasedreliancebybanksoncollateralisedfundingmarketsinrecentyearsforsomeregions,withtheincreasebeingmostpronouncedinEurope.

Regulatoryreformsandtheshift towardscentralclearingofderivativestransactionswillalsoaddtothedemandforcollateralassets.

Butthereisnoevidenceorexpectationofanylastingorwidespreadscarcityofsuchassetsinglobalfinancialmarkets.

Temporarysupply-demandimbalances,however,mayariseinsome cases,asthesupplyofcollateralassetsvarieswidelyacrossjurisdictionsandinstitutions.

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Endogenousprivatesectorresponses,suchascollateraltransformationactivities,will helptoaddressthesesupply-demandimbalancesifandwhentheyemerge.

Whilethiswillmitigatecollateralscarcity,theseactivitiesarelikelytocomeatthecostofincreasedinterconnectedness,procyclicalityandfinancialsystemopacityaswellashigheroperational,fundingandrolloverrisks.

Hence,monitoringthesedevelopmentsanddesigningmeasuresthatlimitanyresultingadversemarketimplicationsforfinancialmarketstabilityshouldbeanimportantfocusofpolicy.

Theconceptsandpolicyimplicationsdescribedinthisreportareatimelycontributiononanimportant topic.

Ihopethattheywillinformongoingdiscussionsamong policymakersonsomeofthekeyissuesrelated to increaseddemandforcollateralassets.

WilliamCDudley

Chairman,CommitteeontheGlobalFinancialSystemPresident,FederalReserveBankofNewYork

Executivesummary

Theuseofcollateralin financialtransactionshasriseninmanyjurisdictionsintheaftermathofthefinancialcrisis,andislikelytoincreasefurther.

Thisisdrivenbybothmarketforces andregulatorychanges,andhastriggeredconcernsaboutrealorperceivedcollateralscarcityandexcessiveassetencumbrance.

Takingasystemwideperspective,thisreportexamineshowgreatercollateraluseandassetencumbrancemayimpactthefunctioningofthefinancialsystemanddrawslessonsforpolicymakers.

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  • Thekeyfindingsaresummarisedbelow.

  • Increasingcollateralisedfundingandassetencumbrance

  • Thereisevidenceofincreasingbankrelianceoncollateralisedmarketfunding,particularlyin Europe.

  • Akeydriverofthisdevelopmentisperceptionsofhighercounterpartycreditrisk amongstinvestors,whodemandmore collateralorchargehigherrisk premiaonunsecureddebt.

  • However,theshareofcollateralisedfundingdifferssignificantlyamongbanksandbetweenjurisdictions.

  • Indeed,differentbusinessmodels,marketstructuresandregulatoryframeworkswilltendtogenerate–andsupport–structurallydifferentlevelsofcollateralisedfunding inbankbalancesheets.

  • Greaterrelianceoncollateralisedfundingraisestheshareofbankassetsthatareencumbered.

  • Assetencumbranceisalsorisingon accountofinitialmarginrequirementsofcentralandbilateralcounterpartiestocoverderivativesexposuresandotheraspectsofregulatoryreform.

  • Noaggregatecollateralshortages,butdifferencesamongstJurisdictions

  • Thedemandforhigh-qualityassets(HQA)that canbeusedascollateralwillincreaseduetoanumberofkeyregulatoryreforms.

  • Examplesarestricterstandardsfor initialmarginrequirementsonover-the-counter(OTC)derivativestransactions,bothforcentralandforbilateralclearingarrangements,andtheintroductionoftheliquiditycoverageratiounderBaselIII.

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  • Thiscomesontopofgreaterdemandforcollateralassetsinsecured bankfunding.

  • -CurrentestimatessuggestthatthecombinedimpactofliquidityregulationandOTCderivativesreformscouldgenerateadditionalcollateraldemand tothetuneof$4trillion.

  • Atthesametime,thesupplyofcollateralassetsisknowntohaverisensignificantlysinceend-2007.

  • OutstandingamountsofAAA-andAaratedgovernmentsecuritiesalone–basedonthemarketcapitalisationofwidelyusedbenchmarkindices– increasedby$10.8trillionbetween2007and2012.

  • Othermeasuressuggestevengreaterincreasesinsupply.

  • Hence,concernsaboutanabsoluteshortageofHQAappearunjustified.

  • Yetasthesituationvariesmarkedlyacrossjurisdictions,temporaryHQAshortagesmayarisein somecountries,forexamplewhenthelevelofgovernmentbondsoutstandingislow orwhengovernmentbondsareperceivedriskybymarketparticipants.

  • Implicationsformarketsandfinancialstability

  • Privatesectoradjustments canmitigateshortagesofHQA.

  • Suchadjustmentsincludebroadereligibilitycriteriaforcollateralassetsinprivatetransactions,moreefficiententity-levelcollateralmanagementandincreasedcollateralreuseandcollateraltransformation.

  • Yetwhilelesseninganycollateralshortage,suchendogenousresponseswillcomeatthecostofgreaterinterconnectednessinthefinancialsystem,forexampleintheformofmoresecuritieslendingorcollateraltransformationservices.

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  • Theymayalsoincreaseconcentration,iftheseresponsesrelyontheservicesofonlyasmallnumberofintermediaries,andwilladd tofinancialsystemopacity,includingviashadowbankingactivities,andincreaseoperational,fundingandrolloverrisks.

  • Increasedcollateralisationofbankbalancesheetsmitigatescounterpartycreditrisk,butaddstotheprocyclicalityofthefinancialsystem.

  • Thechannelsthroughwhichthisoccurs, in timesoffinancialstress,aretheexclusionofcertainassetsfromthepoolofeligiblecollateral,higherhaircutsoncollateralassets,increasedmarginrequirementsoncentrallyclearedandnon-centrallyclearedderivativestradesandmarking-to-marketofbankassetsincollateralpools.

  • Greaterencumbranceofbankbalancesheetscanadverselyaffect theresidualclaimsofunsecuredcreditorsduringbankresolution,increaserisks todepositinsuranceschemesandreducetheeffectivenessofpoliciesaimedatbail-in.

  • Givenlimiteddisclosuresonencumberedassets,theabilityofmarkets to accuratelypriceunsecureddebt canalsobeimpaired.

  • Implicationsforpolicy

  • Marketdiscipline canbeenhancedbyrequiringbankstoprovideregular,standardisedpublicdisclosuresonassetencumbrance.

  • Transparency abouttheextent towhichbankassetsareencumberedorareavailableforencumbrancewillallow unsecuredcreditors tobetterassesstheriskstheyface.

  • Suchdisclosureswouldincludeinformationonunencumberedassetsrelativetounsecuredliabilities,onovercollateralisationlevels,andon receivedcollateralthat canberehypothecated.

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  • Developmentofsuchstandardswouldbenefitfromoutreachtomarketparticipantsandcouldinvolvethereportingoflagged,averagevalues to limitadversedynamicsincrisisperiods.

  • Supervisors,inturn,shouldreceivemoredetailed andgranulardata,asrequired,includingtheamountsandtypesofunencumbered assets.

  • -Includingassetencumbranceinthepricingofdepositguaranteeschemesdeservesconsiderationin jurisdictionswhereencumbranceisofconcern.

  • Sincedepositorswillnotthemselvesfactor intherisksposedbyincreasedassetencumbrance– astheirdepositsareguaranteed– risk-sensitivedepositguaranteepremiacouldservetodisciplinebanks.

  • Thiswouldinternalisetheeffectofassetencumbranceonresidualrisksforsuchschemes,aswellasforthegovernmentastheultimatesafetynet.

  • Furtheranalysisisneededtomakethisoperational,taking intoaccountdifferencesinbusinessmodels.

  • Tointernalisetherisks ofrisingassetencumbrance,prudentiallimitscanserveasabackstoptootherpolicymeasures,aspractisedinsomejurisdictions.

  • Incaseswhereencumbrancecouldbecomeamaterialconcern,banksshouldbe asked toperformregularstressteststhatevaluateencumbrancelevelsunderadversemarketconditions.

  • Centralbanksandprudentialauthoritiesneed to closelymonitorandoverseemarketresponses to increasedcollateraldemandandtheireffectsoninterconnectedness.

  • Thisprovidessupportforworkonbestpracticestandardsinsecuritiesfinancingmarketsandforshadow bankingactivitiesmoregenerally,

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aswellasforsupervisoryreviewsoffinancialinstitutions’riskandcollateralmanagementarrangements.

-Concernsoverprocyclicaldemandforcollateralassetslendsupporttoeffortstargetingstrictstandardsforcollateralvaluationpracticesandthrough-thecyclehaircuts.

1.Introduction

Theuseofcollateralin financialtransactionshasriseninmanyjurisdictionsintheaftermathofthefinancialcrisis,drivenbybothmarketforcesandregulatorychanges.

Marketparticipantshaveshownincreasedappetiteforsecuredlong-termbankbonds,suchascoveredbonds.

Likewise,relianceonrepomarkets,asopposedtoshort-termunsecuredlending, has risenforsomeregionssuchas theeuroareaortheUnitedStates.

Manybanks,especiallyin Europe,havebecomeincreasinglydependentoncollateralisedborrowing,leadingto risingbankassetencumbrancelevels.

Addingtothedemandforcollateralassetswillbemorestringentcollateralisationrequirements,akeyelementofover-the-counter(OTC)derivativesmarketsreform,andthenewPrinciplesforFinancialMarketInfrastructures(PFMIs)issuedjointlybytheCommitteeonPaymentandSettlementSystems(CPSS)andtheInternationalOrganizationofSecuritiesCommissions(IOSCO).

NewliquidityregulationunderBaselIIIwillrequirebanks tomaintainlargerbuffersofhighqualityliquidassets(HQLA).

Finally,Europeaninsurancefirmsarelikelytoadd to thedemandforhigh-qualityassets(HQA),drivenbythenewcapitalrequirementsunderSolvencyII.

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Thesedevelopmentshaveraisedconcerns abouttheimplicationsofincreased collateralisationoffinancialtransactionsandbankasset encumbranceforthefunctioningandstabilityofthefinancialsystem.

Againstthisbackdrop, in May2012,theCommitteeontheGlobalFinancialSystem (CGFS)setupaworkinggroup,undertheChairmanshipofAerdtHoubenoftheNetherlandsBank,withthemandateto:

engagein astocktakingexercise,includingconsultationswithmarketparticipants,tounderstandthefactorscontributingto theincreasedrelianceoncollateralisedfundingmarkets,andhow thismayaffect assetencumbranceonbanks’balancesheets;

toassesstheeffectsofongoingregulatoryreforminitiativesoncollateraldemand,andhowtheseinfluencethesupplyofcollateralassets;and

to assessthesystem-wideimplicationsofthesedevelopmentsformarketsandpolicy.

Thereport,whichdocumentsthefindingsoftheWorkingGroup,isorganisedasfollows.

Section2discussesthefactorsthatinfluencetheshareofcollateralised bankfundingandthendocumentsbankfundingpatternsindifferentjurisdictions.

Challengesthatarisewhenmeasuringbankassetencumbrancelevelsarealsohighlighted.

Section3providesanassessmentofthestructuraldemandforHQAfromvariousregulatoryreforms.EstimatesofHQAsupplyandwaysinwhichrealorperceivedshortagesofHQAcouldbemetthrough behaviouralresponsesarepresentedinSection4.

Section5examinestheimplicationsformarketfunctioningandfinancialstability,andthoseforpolicy arediscussedinSection6.

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2.Bankfundingand assetencumbrance

Thearrangementsthroughwhichbanksfundtheirbusinessactivitieshaveimportanteffectsonthedemandforcollateralassets.

Forexample,ashiftfromunsecured to securedfundingsourcescreatesadditionaldemandforcollateralassetstobacktheclaimsofsecuredcreditors.

Pledgingcollateraltosecuredcreditors,however,leads toencumbranceofbanks’assets.

Thatis,assets pledgedascollateralinsecuredtransactionsbecomeunavailableforotheruses,suchasformeetingtheclaimsofunsecuredcreditorsincaseofbankruptcy.

Thisimpliesthatsecuredfundingcontributestolowerrecoveryvaluesforunsecuredcreditors.

Thedegreeofrelianceonsecuredfundingvariessubstantiallyacross differentbankingsystems,jurisdictionsandbankbusinessmodels.

Fundingcostsalsoinfluencethedecisiononwhethertoissuesecuredorunsecureddebt.

Greaterrelianceonsecuredfundinginstruments,therefore,doesnotnecessarilyreflectthe(in)abilityofbanksto accessunsecuredfundingmarkets,butdependsonamixtureofstructuraland cyclicalfactorsaswellasthedesiretoreducefundingcosts.

Asaresult,abank’sbusinessmodel,thequalityofitsassets,thelevelofbankcapital,legalframeworks,existingfundingpatterns,andsovereignrisk in thebank’shomejurisdictionareallfactorsthatinfluenceitsfundingmix.

This,inturn,leadstodifferentlevelsofassetencumbrance,suggestingthat changes,notlevels,arelikelytobemorerelevantforassessingthe

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implicationsoffundingpatternsandassetencumbranceforthefunctioningoffinancialmarkets.

Tofurtherexploretheseissues,thissectionfirstdiscussesthefactorsthatinfluencetheshareofcollateralisedbankfunding,andthendocumentshowtheshareofbankfunding,categorisedbyinstrumenttypes,variesacrossjurisdictionsandbanks.

Thesectionconcludeswithadiscussionofthemechanicsofhowdifferentsecuredfundinginstrumentscontributetoassetencumbrance,andwhatchallengesarisewhenmeasuringbankassetencumbrancelevels.

2.1Factorsinfluencingtheshareofcollateralisedfunding

Financialinstitutionsfundthemselvesusingavarietyofinstrumentsthatdiffer in termsofattributessuchasmaturity,priorityincaseofbankruptcy,and easeofsubstitutabilityacrosssourcesoffunding.

Marketliquidity,relativecostsoffunding instruments,assetcomposition ofbalancesheets,andregulatoryrulesarekeyfactorsinfluencingthecompositionofbankfundingpatterns.

In addition,thefundingmixismanagedonadynamicbasisin responsetochangesinmarketconditionsandcompetitivepressures.

Asuddenretrenchmentinmarketliquidity,forexample,couldexposebanks to rolloverriskontheirshort-termliabilities.

In suchperiods,thereisusuallyashift towardsgreaterrelianceonsecuredfundinginstruments,astheytendtobelesspronetorolloverrisk.

Thissectionhighlightsanumberoffactorsthatinfluenceabank’sdecision to raise collateralisedfunding.

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Bankbusinessmodels

Banksthatspecialisein mortgagelendingactivitytypicallyhaveahighershareofsecuredfunding,andtheirliabilitiesgenerallyhavealongermaturityprofile.

Thisispartlydrivenbyregulatorycriteriafavouringmortgageassetsforuseas collateralinlong-termfundingtransactionscomparedwithothertypesofbankassets(suchasbankloans).

In addition,thelevelsofovercollateralisationrequiredbyratingagenciesandinvestorstoissuecollateraliseddebtbackedbymortgageassetsaregenerallylowerthanforothersecuritisedassets,enablingbanks toraisemorefundsforagivenamountofassets.

Two formsofcollateralisedmortgagedebtarecommon:coveredbonds,whichremainontheissuingbank’sbalancesheet;andresidentialmortgage-backedsecurities(RMBS),whichareoff-balancesheetinstruments.

TherelianceoncoveredbondsorRMBStofundmortgagelendingtendstobeinfluencedbylocalmarketpracticesandlegislation.

Forexample,Denmark,GermanyandSpainhavealonghistoryofcoveredbondlegislationthathassupportedfundingofmortgagelendingthroughtheseinstruments(Table1).

In theUnitedStates,bycontrast,mortgagelendingisprimarilybasedontheissuanceofRMBS,whichreliesontheoriginate-to-distributebusinessmodel.

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Differentbusinessmodelsandcorrespondingbankfundingpatternsgeneratedifferentencumbrancelevels.

In generalterms,onlythoseliabilitiesthatareretainedonbankbalancesheetsaddtoassetencumbrance(eginthecaseofcoveredbonds),whereasoff-balancesheetliabilities(egRMBSandothersecuritisations)affectencumbranceonly totheextentthatissuingbanksprovideimplicitorexplicitguarantees to securitisationstructures.

Investmentbankstypicallyfundtheirtradingactivitiesthrough

short-termrepomarketsandthusrelyheavilyonsecuredfundingaswell.

Theserepopositionsareoftenoffsetthroughreverserepos,limitingtheirimpactonassetencumbrancelevels.

Atthesametime,bothpositionswilltendtobedifferentin termsofmaturityandqualityofcollateralassets,sothattheoffsetprovidedby reservereposisimperfect inrisk terms.

Cyclicalfactors

Theshareofsecuredfundingonbankbalancesheets canalso changeasriskappetite,investorpreferencesandthenetsupplyofHQAchange.

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Thecapacitytopooleligiblecollateralassetstoraisesecuredfundingcan beviewedasaliquiditybuffertobeusedintimesoffinancialmarketstress.

Thisprovidesanincentiveforbanks to issueunsecureddebtinnormaltimes.

In periodsoffinancialstress,whenrisk appetitefallssharplyduetoincreasedcounterpartyrisk,adjustmentsintherelativepricingofsecuredandunsecureddebtwillinfluencehow banksusetheirbalancesheets toobtainfunding.

This canleadtoariseintheshareofcollateralisedfundingonbankbalancesheets,asunsecuredfundingbecomesmorecostlyorevenunavailableowingtoinvestoruncertaintyaboutthetruelevelofrisk.

Similarly,accesstosecuredfundingmarkets canbeadverselyaffectedifcollateralisedinstrumentshavecomplexstructuresthatcallstandardvaluationmethodologiesintoquestion.

ThesedynamicswereobservedduringthesubprimemortgagecrisisintheUnitedStates,resulting inthecollapseoflargepartsofthesecuritisationmarket.

Sovereignrisk isanotherimportantchannelaffectingbanks’relianceonsecuredfunding.

Ashighlightedbytherecenteuroareacrisis,concernsoversovereignriskinconjunctionwithdeclinesinthequalityofbankassets canadverselyaffect accesstounsecuredfundingmarketsforbanks exposed to sovereignrisk.

Forsomebanks,unsecuredmarketsmaybeclosedentirely,forcingrecourse to securedmarketsorthecentralbank,asseen,forexample,inthecontextoftherecentincreaseincentralbankcreditintheeuroarea.

In therecentcrisis,somecentralbanksdecided tobroadentheeligiblepoolofcollateralassetstoeasefundingstressandtoensurethatthe

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bankingsectorholdssufficient amountsofunencumberedassets– asimpliedbythedifferencebetweenoutstandingcreditandusablecollateral(Graph1)– that canbeusedtoraiseadditionalcollateralisedfundingifneeded.

Athirdcyclicalfactorthatcaninfluencetheshareofsecuredfundingischangesinliquidityrisk,whichaffectthedemandforandsupplyofHQA.

Duringtherecentfinancialcrisis,liquiditypreferencecontributed to anincreaseddemandforinstrumentssuchascoveredbonds,whichcouldbeusedascollateralforcentralbankfunding in theeuroarea.

In part,increasedbankissuanceofcoveredbondsinthecurrentenvironmentmaythussimplyrepresentasupplyresponsetostrongdemandforHQA,withsecuredfundingbecomingcheaperrelative tounsecuredfundingevenforthoseissuersthatretainaccesstobothmarkets.

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Regulatoryframeworks

Someshiftsinbankfundingpatterns towardscollateraliseddebtareregulationdriven.

Specifically,theintroductionofBaselIII,SolvencyIIandpossiblenewresolutionframeworksislikelytoincreasethedemandforbankdebtthatisbackedbycollateral.

TheliquiditycoverageratiounderBaselIIIalsofavourssecuredfundingtounsecuredshort-terminterbankfunding.

Coveredbonds,whicharepopularasafundinginstrumentinEurope,areoneofthesecuredfundinginstrumentsthathavebenefitedfromtheregulatoryreformagendamentionedabove.

Forexample,regulatoryreformsunderSolvencyIIwillrequire insurancecompaniestoholdlesscapitalforexposuretocoveredbondsascomparedwithunsecuredorsecuritiseddebt.

Thiswillmostlikelycreategreaterdemandforcoveredbonds amonginsurancecompanies.

Moreover,coveredbondsareexcludedfromwritedownsinmanyresolutionframeworks,whileunsecureddebtisnot.

Thesefactorsarelikelytocontributetoincreasedissuanceofcovered bondsinjurisdictionswheretheyarealreadyapopularfundinginstrument,andcanbeahurdleforefforts torestartthemarketsforothertypesofsecuritisations.

2.2Bankfundingpatternsindifferentbankingsystems

Comprehensivedataonbanks’recoursetosecuredandunsecuredfundinginstrumentsarenotconsistentlyavailableacross jurisdictions.

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  • Tocomparefundingpatternsfordifferentbankingsystems,membersoftheWorkingGroupusedthefollowingbroadcategorisationofbankfundingforwhichcomparabledatawereknown toexist:

  • retaildeposits:depositsfromnon-banks(non-monetaryfinancialinstitutionsforeuroareacountries)irrespectiveofmaturity;

  • short-termfunding:short-termborrowings(excludingrepos)withmaturitiesoflessthanoneyearandallinterbankdeposits;

  • long-termfunding:long-termdebtinstruments(withmaturitiesexceedingoneyear),excludingdeposits;and

  • netrepos:thebankingsystem’snetrepobalance.

  • Whiletheabove categorisationdoesnotprovideabreakdownoffundingsourcesintosecuredandunsecured,somebroadpatterns canbediscernedfromthedata(Graph2).

  • Inaddition,someindicationofthetrendsinbankfundingpatternscanbeobservedbyexaminingthechangesinfundingsharesovertheperiod2006–11.

  • Thefirstobservation,corroboratedbytheGroup’sinterviewswithmarketpractitioners,isthatfundingpatternsvarywidelyacrossandalsowithinjurisdictions.

  • Evenwhencomparingfundingpatternswithingroupsofemergingordevelopedeconomies,therearesignificantdifferences.

  • Thesecondobservationisthatfundingshareschangedconsiderablyinalmostallbankingsectors,withsomeindicationofgreaterrelianceonsecuredfundingobservable,inparticular,forEurope.

  • Third,thereisashifttowardsgreaterretaildepositsinthemajorityofcountriesinthesamplebetween2006and2011.

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BanksinChinaandIndiaareprimarilyfundedbyretaildepositswithashareofmorethan70%ofbankliabilities,implyinglimitedrecoursetosecuredfundinginstruments.

Bycontrast,theshareofretailfundingisonlyabout40%in KoreaandMexico.

TheMexicanbankingsystem’srelianceonrepofunding,in turn,issubstantial,withnetrepos accountingforabout18%ofliabilitiesin2011,reflectingregulatoryincentivesbut,perhaps,alsodifferencesinhowfundingdataarecategorisedin individualbankingsystems.

ForbothKoreaandMexico,aggregatedatapoint to areplacementovertimeofrepofundingwithretailfunding,implyinglessrelianceonsecuredfundingoverall.

Differencesinbankfundingpatternsareequallypronouncedacrossadvancedeconomies.

CountriessuchasCanada,JapanandSwitzerlandshowstrongreliance onretaildepositfundingsimilartothatinChinaandIndia,withashareofabouttwo thirdsoftotalliabilities.

Relianceonlonger-termfundingislessthan2%forCanadaandJapan,but amountstoabout10%forSwitzerland.

WhereasfundingsharesremainedbasicallyunchangedinJapanbetween2006and2011,theobservedreductioninshort-termborrowing in CanadaandSwitzerlandwasoffsetbyanincreasingshareofretailfunding.

Whiletheobservedsubstitutionoffundingsourcesgenerallyleaves theoverallshareofunsecuredfundingunchanged,coveredbondissuancedatasuggestthatasmallbutincreasingshareoflong-termfundinghasbeencollateralised.

SimilardevelopmentsareobservedfortheAustralianbankingsector.

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TheUnitedKingdomhasthelowestshareofretailfunding intheavailablesample,accountingforabout25%ofthebankingsector’sliabilitiesin2011.

DeleveragingatsomeUKbanks in2012,incombinationwithincreasedretailfundingandlowerrelianceonshort-termdebt,meansthatthesector’sstructuralfundingpositionhasimprovednoticeably.

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In theUnitedStates,banksreducedtheirrelianceonunsecured short-termborrowings,offsetbyretailfundingandhigherrepos.

USbanks raisedtheirlongtermunsecuredfundingshares,aidedbygovernment-guaranteeddebtthathassincematured,afterthecollapseofmajorsecuritisationmarkets.

Bankingsectorsintheeuroareaarecharacterisedbyintermediatelevelsofretailfunding,rangingfromasmuchas50%inSpaintoaround37%inFranceandGermany.

Whiletherelianceonshort-termfundingisbroadlysimilaracrosstheeuroarea(15–20%),nationalbankingsectorsdiffermorestronglyregardingtheshareoflong-termfunding,rangingfrom about10%inSpain10toaround22%inItaly.

Overallchangesin fundingsharesintheeuroarea suggestgreater relianceon collateralisedfunding,including bothshort-andlong-termfundingmarkets.

Forshort-termborrowings,interviewswithmarketparticipantshighlightedapronouncedshiftfromunsecuredborrowingsinshort-termmoneymarketstorepofunding.

Forlonger-termfunding,bankbondissuancedatasuggestgreaterrecourse to coveredbondfundingwiththeexceptionofGermany(seeGraphA3.1inAnnex3)and,asdiscussed in Section2.1,significantretentionofsecuredbondstogeneratecollateralforcentralbankfunding.

2.3Assetencumbrancepatterns

Pledgingbankassetsascollateraltobackcoveredbondsorothertypesofsecuredfundinginstrumentsresultsinthoseassetsbecomingencumbered.

Thatis,theybecomeunavailable to repayunsecuredcreditorsin theeventofthebank’sdefault.

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Encumbranceofbankassetscanalsoarisefrompostingofinitialmarginswithcentralcounterparties(CCPs)orbilateralcounterpartiesto coverOTCderivativesexposures(formoredetail,seeSection3).

Whyassetencumbrancelevelscanmatter

Higherlevelsofbankassetencumbrancecancreatechallengesforbanks’ability to fundinunsecuredmarkets.

Thisstemsfromfourpossibleissues.

First,eligibilityrequirementsmayresultinbetter-qualityassetsbeingpooled tobackcoveredbondsandothercollateralisedfundinginstruments,thuserodingtheaveragequalityoftheassetsbackingclaimsonunsecuredcredit(“cherry-picking”).

Second,overcollateralisationrequirements(ietheamount ofassetspledgedinexcessofthenominalvalueofthebonds)increaseassetencumbrance,furtherloweringtherecoveryvaluesonunsecureddebt.

Third,asovercollateralisationrequirementshavetobemetdynamically,theresidualassetsavailabletomeetclaimsofunsecuredcreditors can declinequickly,particularlyunderstressedmarketconditions.

Fourth,limitedtransparencyofactualassetencumbrancelevels canimpedetheabilityofmarketparticipantstoappropriatelypriceunsecureddebt,challengingtheviabilityoftheunsecureddebtmarket.

Risinglevelsofassetencumbrancewilltendtobeviewednegativelybyunsecuredcreditors,particularlywhentheycoincidewithanincreaseintheprobabilityofbankdefault,giventhepotentiallylowerrecoveryvaluesforunsecureddebt.

Yetsecuredfundingarrangementsaregenerallymoreresilientduringperiodsofmarketstress,sothatincreasedrelianceonsecuredfunding(and,hence,higherassetencumbrance)tendstoreducefundingliquidityrisk.

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In contrast,whenmarketsconsiderbanks’assetqualitytobestrongandbanksareseenasadequatelycapitalised,access toandcostoffundingin unsecuredmarketsmaynotbeadverselyaffectedevenifasignificantshareofbankassetsisencumbered.

Indeed,thisisatpresentthecaseformanyNordicbanks.

Assessingassetencumbrancelevels

Toassesswhetherassetencumbrancelevelshavethepotentialto affecttheviabilityof,orborrowers’accessto,unsecuredfundingmarkets,an appropriatemeasureofassetencumbrancehastobecomputed.

Onemeasurethatwould capturethisistheratioofunencumberedassetstounsecuredliabilities.

Thismeasureprovidesanindicationoftheamountofassetsonthebank’sbalancesheetthatwouldbeavailabletocoverunsecuredcreditors’claimsintheeventofdefault.

Themajorchallengesthatmayariseincomputingsuchameasurearelimiteddisclosurebybanksofencumberedassetsandsecuredliabilitiesandalackofharmoniseddefinitionsthatmakescomparabilityofdataacrossbanksdifficult.

Reflectingtheselimitations,twodifferentmeasuresofassetencumbrancetendtobecitedbymarketpractitionersonthebasisofavailabledata:onethatisbasedontheproportionofsecuredborrowinginbankliabilities(liabilities-sideapproach);andonebasedontheproportionofbalancesheetassets pledged(assets-sideapproach).

Neitherofthesemeasuresisentirelyadequate.

Ontheliabilitiesside,issuancevolumesdonotrevealtheamountofovercollateralisationthatunderpinsthesecuredfundingliabilities,andwillmissoutalsoonanyderivatives-relatedliabilities.

Thiswilllead toadownwardbiasinestimatedassetencumbranceratios

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underthisapproach.

Ontheotherhand,ifrepo-basedfunding in wholesalemarketsisasignificantpartofthebankbalancesheet,liability-basedmeasures canoverestimateactualencumbrancelevelsifoffsettingreverserepotransactionsarenotproperlytakenintoaccount.

Ontheassetsside,akeychallengeisthelackofcomparableandpubliclyavailabledataonpledgedassets,includingthosepostedasinitialmarginsforderivativestransactions.

Thelackofinformationoncontingentencumbrance,egadditionalencumbranceofassetsresultingfrompotentialmargincalls,addsafurtherchallenge.

In addition,theratioofencumberedassets tototalassetsmaybehighasaresultofabankbusinessmodelthatinvolvesastructurallyhigh proportionofsecuredfunding.

Hence,thisratiodoesnotallow assessmentoftheamountof unencumberedassetsrelative to theamountofunsecuredclaims.

Keepingthesecaveatsinmind,Graph3reportsdifferentassetencumbranceratiosforasampleof60largeEuropeanbanks.

Liabilities-sideratios,asmeasuredbytheshareofsecuredfunding inbanks’fundedassets,areshownintheleft-handpanel.

Althoughthemedianencumbranceratiois22.5%andsomebankshaveratiosoflessthan10%,encumbranceratiosgreaterthan50%arereportedinindividualcases.

Whilesuchhighencumbrancelevelsareexplainedinpartbydifferentbusinessmodels,theyare inlinewithinformationobtainedthroughinterviewswithmarketparticipantswhichsuggeststhat,forsomeinstitutions,sovereignriskconcernshaveresultedinlevelsofencumbrancethatcouldaffecttheirabilitytorespond to futurefundingshocks.

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Asnotedearlier,asecondapproachtomeasuringassetencumbranceistocomputetheproportionofbalancesheetassetspledged.

Broad patternsunderthisalternativemeasurearesimilartothoseobservedforliabilities-sidedata,althoughthemedianratioissomewhathigherat28.5%(Graph3,centrepanel).

Bankswithhigherencumbranceratiosusingtheassets-sideapproacharetypicallyspecialistmortgagebanks,suchasthoseintheNordiccountries.

Anotherissueinthecomputationofassetencumbrancelevelsisthetreatmentofdeposits.

Strictly,depositsdonotencumberabank’sassets,astheyarenotsecured byanyspecificcollateral.

Butdepositorpreferencerulescanchangethepriorityofclaimsrelatedtodepositsand canthussubordinateunsecuredcreditorsin caseof bankruptcy.

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Aroughestimateoftheinfluenceofdepositorpreferenceonassetencumbrancelevels canbeobtainedbyaddingretaildepositsto theliabilities-sidemeasure.

Assumingallretaildepositsweretoreceivedepositorpreference,thiswouldraisethemedianassetencumbranceratioforEuropeanbanks toabout69.5%(Graph3,right-handpanel).

Overcollateralisationrequirementswouldtendto further increase encumbranceforsomecountries.

Forexample,theSwissdepositinsuranceschemerequiresbanks toholdassetsinSwitzerlandequivalent to 125%oftheirinsureddeposits.

Ontheotherhand,notalljurisdictionsassignpreferredcreditorstatus toclaimsrelatedtothedepositguaranteescheme.

3.Demandforhigh-qualityassets

TheevolvingtrendsinbankfundingexaminedinSection2suggestthat,duetoacombinationofcyclicalandstructuralfactors,therelianceonbothshort-andlongtermcollateralisedfunding has increasedin recentyears– eventhoughtherearelargedifferencesacrossjurisdictions.

Owingto concernsoversovereignandbankcreditrisk aswellastheircombinedimpactonbankfunding,theshifttowardscollateralisedfundingisparticularlyevidentinthoseeuroareacountriesthataremostaffectedbytherecentfinancialandeconomiccrisis.

Oneconsequenceofthisdevelopmentisincreasingcollateralisationof bankbalancesheetsandrisingdemandforcollateralto back securedfunding,atleastinEurope.

Atthesametime,anumberofkeyregulatoryreformswillcontributetoastructuralincreaseinthedemandforassetsusedascollateralgoingforward.

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Theyinclude:theintroductionoftheliquiditycoverageratio(LCR)aspartoftheBaselIIIpackageofliquidityreforms;reformoftheOTC derivativesmarketthroughtheintroductionofmarginingrequirements,forbothcentrally(standardised)andbilaterallycleared

(non-standardised)derivatives;andtheintroductionofthenewPrinciplesforFinancialMarketInfrastructures,whichwillsethigher international

standardsfortheresourcesthatCCPsmusthold.

Beforeassessingthedemandforcollateralassets,akeyfirststepistodevelopaconsistentassetdefinition.

Thisiscomplicatedbythefactthatthereisnoclearstandard,anddifferentdefinitionsofcollateralassetsexist amongregulators,centralbanksandmarketparticipants.

Moreover,thedefinitionofacollateralassetdiffersdependingon thepurposeandtheriskprofileoftheinstitutionacceptingtheunderlyingasset,eitheras collateralorfor investmentpurposes(seeBox1).

3.1Liquiditycoverageratio

Duringtheglobalfinancialcrisis,manyfinancialinstitutionssawarapid depletionofliquiditythatseverelyrestrictedtheirabilitytoperformcreditintermediationactivities.

Strengtheningbanks’liquidityrisk managementstandardshasthereforebeenoneofthekeyobjectivesofglobalfinancialregulatoryreformsunderBaselIII.

Inthiscontext,theBaselCommitteeonBankingSupervision(BCBS)hasintroducedtwonewglobalstandardsforliquidityregulation:theLCRandthenetstablefundingratio(NSFR).

TheLCRisaimedatensuringthatbanksholdsufficientamountsofHQLAthat canbeusedwithoutanyrestraints(unencumbered)sothatbanks cansurviveasignificantstressscenariolastingforonemonth,promotingtheirshort-termresilience to liquidityshocks.

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In thisregime,bankswillberequiredtoholdan amountofHQLAequaltoorgreaterthantheirnetcashoutflowinastressscenarioovera30-dayperiod.

TheBCBSconductedaglobalquantitativeimpactstudy(QIS)toanalysetheimpacttheLCRregulationwillhaveonstructuraldemandforcollateral.

AccordingtotheQISresultsbasedon2011data,the209banksstudiedwouldhavehadanHQLAshortfallof€1.8trillion($2.3trillion)undertheLCRminimumrequirement(100%),whichisapproximately3%oftheir

totalassets(€61.4trillion).

AlthoughtheQISfails to coverallbanksaffectedbytheLCRandbanksarelikelytoholdacertainlevelofbuffer inaddition totheminimumrequirement,actualHQLAshortfallsareneverthelesslikelytobesignificantlylowerthanthe2011estimate.

Thisisforavarietyofreasons.

First,theQISdidnotaccountforanyredistributionofliquidassetsacrossbanks,whichwouldresultfromthebankingsystem’sadjustment tothenewregulations.

Aspartofthisadjustment,atleastsomeHQLAwillbebidawayfrom surplusbanksbydeficitbanks,eliminatingpartsoftheestimatedaggregateshortfall.

Second,bankswilltakefurthermitigatingactions to addresstheremainingshortfall,includinglendingmoreshort-termto increasenetcashinflowsintheLCRcalculationandengagingincollateralupgradetransactions.

Butbanksmayalsostartborrowingmorelong-termtoreducetheircashoutflowsin astressedscenario.

Third,currentestimatesarebasedonthe2010formulationoftheLCR.

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RevisionstotheLCRdeterminationrule,asannouncedin

January2013,arelikelytosubstantiallyreducetheaggregateshortfall.

Categorisationofcollateral assets

Aprerequisiteforassessingthedemandforcollateralis to agreeonadefinitionoftheassetsthatareeligibleascollateral.

While,inprinciple,anyassetcanbeused to collateraliseagivenclaim,theapproachtakenforthisreportseekstodefinecollateralassetsaccordingtotwodimensions.

Oneisregulatory,andgivesrise tonarrow definitionsofcollateralassetsthatareunlikelytochangemuchovertime.

The otherdimensionismarketpractice.

Here,thedefinitionofcollateralassetswilldependontherequirementsandpreferencesofmarketparticipants.

Onthisbasis,threeoverlappingdefinitionsarebeingconsidered.

ThenarrowestoneisbasedonregulatoryconsiderationsandfollowstheBaselCommitteeonBankingSupervisioninincludingonlyhigh-qualityliquidassets(HQLA)undertheLevel1andLevel2definitionsoftheliquiditycoverageratio(LCR).

AssetsthatqualifyfortheLCRareexpectedtohavelowcreditandmarket riskandbeeasytovalue,exchange-listed,tradedinactivemarkets,unencumbered,liquidduringtimesofstressandideallycentral

bank-eligible.

Abroaderdefinition,termedhigh-qualityassets(HQA),takesamoremarket-basedstance,includingallassetsthatmarketparticipantscanusetomeetcollateraldemandfromderivativestransactions.

Thisdefinitionwillbetherelevantoneforassessingtheimpactofover-the-counterderivativesreforms.

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Thebroadestdefinition,termedcollateralassets(CA),targetsthepoolofassetsthatqualifiesforuseincollateralisedfundingtransactions(suchasincoveredbonds,agencyandprivate-labelmortgage-backedandassetbackedsecurities).

Notably,thecategorisationofanyparticularassetundertheselasttwodefinitionsmayvarywithtimeandacrossdifferentmarketsandcounterparties.

Centralbanks tendtopublishtheir ownlistofassetswithapplicablehaircutsthatareeligibleascollateralfortheirmonetarypolicyoperationsandtoprovideintradaycredit to qualifyingfinancialinstitutions.

ThedefinitionofHQAusedbycentralbanksandbankingsupervisorscan alsoinfluencethetypeofcollateralacceptedbybanks inrepotransactions,astheycansubsequentlybeusedtoobtaincentralbankliquidityortocomplywithBaselIIIliquidityregulation.

Rehypothecationandreuseofcollateral assets

Rehypothecationreferstotherightoffinancialintermediaries to sell,pledge,investorperformtransactionswithclientassetstheyhold;anditallowsprimebrokersandotherfinancialintermediariestoobtainfundingusingtheirclientcollateral.

Collateralreuse,inturn,usuallycoversabroadercontextwheresecuritiesdeliveredinonetransactionareusedtocollateraliseanothertransaction,includingtheabilitytoreuse collateralthroughchangein(temporary)ownership.

Yetthetermsrehypothecationandreuseofsecuritiesareoftenusedinterchangeably;theydonothavedistinctlegalinterpretations.

Certaintypesofcollateralrehypothecation(andreuse)canplayanimportantroleinfinancialmarketfunctioning,increasingcollateralvelocityandpotentiallyreducingtransactionandliquiditycosts.

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Rehypothecationdecreases the(net)demandforcollateralandthefundingliquidityrequirementsoftraders,sinceagivenpoolofcollateralassets canbereusedto supportmorethanonetransaction.

Thislowersthecostoftrading,whichisbeneficialformarketliquidity.

Securitieslending-typetransactions(includingcollateralswaps),whichhavebeenstructuredascollateralisedloans,wouldnotexistwithout rehypothecation.

Intherepomarket,participantswouldnotbeabletocovershortpositionswithouttheabilitytoreusecollateral.

However,reposdonotdirectlyrehypothecatecollateralbecausetheyarestructuredasasaleandrepurchasetransaction.

Whilecertaintypesofrehypothecationcanbebeneficialtomarketfunctioning,ifcollateralcollectedtoprotectagainsttherisk ofcounterpartydefaulthas beenrehypothecated,thenitmaynotbereadilyavailableintheeventofadefault.

This,inturn,mayincreasesysteminterconnectednessandprocyclicality, andcouldamplifymarketstresses.

Therefore,whencollateralisrehypothecated,itisimportanttounderstandunderwhatcircumstancesandtheextenttowhichtherehypothecationhasoccurred;or in otherwords,howlongthecollateralchainis.

Tocontinuereading:http://www.bis.org/publ/cgfs49.pdf

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PeerReviewofSwitzerlandReviewReport

FSBcountrypeerreviews

TheFSBhasestablishedaregularprogrammeofcountrypeerreviewsofitsmemberjurisdictions.

The objectiveofthereviewsistoexaminethestepstakenorplannedbynationalauthoritiestoaddressInternationalMonetaryFund(IMF)-WorldBankFSAP recommendationsconcerningfinancialregulationandsupervisionaswellasinstitutionalandmarketinfrastructure.

FSBmemberjurisdictionshavecommittedtoundergoanFSAPassessmentevery5years,andpeerreviewstakingplacetypicallyaround2-3yearsfollowinganFSAPwillcomplementthatcycle.

AcountrypeerreviewevaluatestheprogressmadebythejurisdictioninimplementingFSAPrecommendationsagainstthebackgroundofsubsequentdevelopmentsthatmayhaveinfluencedthepolicyreformagenda.

ItprovidesanopportunityforFSBmemberstoengageindialoguewiththeirpeersand to sharelessonsandexperiences.

Unlike theFSAP,apeerreviewdoesnotcomprehensivelyanalyseajurisdiction'sfinancialsystemstructureorpolicies,nordoesitprovideanassessmentofitsconjuncturalvulnerabilitiesoritscompliancewithinternationalfinancialstandards.

Foreword

ThepeerreviewofSwitzerlandisthefifthcountrypeerreviewundertheFinancialStabilityBoard’s(FSB)FrameworkforStrengtheningAdherencetoInternationalStandards.

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FSBmemberjurisdictionshavecommittedtoundergoperiodicpeerreviewsfocusedontheimplementationoffinancialsectorstandardsand policiesagreedwithintheFSB,aswellastheireffectivenessin achievingthedesiredoutcomes.

Aspartofthiscommitment,Switzerlandvolunteered toundertakeacountrypeerreviewin 2011.

Thisreportdescribes thefindingsandconclusionsoftheSwitzerlandpeerreview,includingthekeyelementsofthediscussionintheFSB’sStandingCommitteeonStandardsImplementation(SCSI)on13-14December2011.

ThedraftreportfordiscussionwaspreparedbyateamchairedbyPaulRochon(CanadaDepartmentofFinance)andcomprisingAlexandriaLuk(UnitedStatesOfficeoftheComptrolleroftheCurrency),LimChengKhai(MonetaryAuthorityofSingapore),Caio Ferreira(CentralBankofBrazil),JonathanGriffiths(UnitedKingdomFinancialServicesAuthority)andJuanYermo(OrganisationforEconomicCooperationandDevelopment).

JasonGeorgeandCostasStephanou(bothFSBSecretariat)providedsupport totheteamandcontributedtothepreparationofthepeerreviewreport.

TheanalysisandconclusionsofthepeerreviewarelargelybasedontheSwissfinancialauthorities’responsestoaquestionnairedesignedtogatherinformationaboutthe actionstakeninresponsetotherelevantrecommendationsofthemostrecentFinancialSectorAssessmentProgram(FSAP)assessmentforSwitzerland.

ThereviewhasbenefitedfromdialoguewiththeSwissauthoritiesaswellasdiscussionintheFSBSCSI.

Executivesummary

SwitzerlandunderwentanassessmentupdateundertheFinancialSectorAssessmentProgram(FSAP) in 2006–07.

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TheFSAPteamconcludedthatthemacroeconomicandfinancialsectorenvironmentatthetimewasfavourableandthattheSwissbankingsectorappearedresilienttoshocks.

Italsonotedthatimpressiveprogresshadbeenmade to strengthenthefinancialsupervisoryframeworksincethe2001FSAP,butthatfurtherattentionshouldbedevotedtothe capitalandliquidityrequirementsofUBS andCreditSuisse,thetwo largeandsystemicallyimportantbanks(SIBs);strongerindependence,morefunding,anddeeperstaffresourcestothenewregulatoryandsupervisoryauthority;inspectionsandcapitaladequacyofhighrisk insurers;andsupervisionofoccupationalpensionschemes.

Themainpurposeofthisreportis to assessSwitzerland’sprogress inaddressingtheseissues.

Togivesomecontext,section1providesabriefoverviewofmarketandregulatorydevelopmentssincetheFSAPwaspublished.

Sections2to5examinethemainareasidentifiedbytheFSAP.

Background

TheresponseoftheSwissauthoritiestotheproblemsofoneofthetwo SIBs duringthefinancialcrisiswasswiftandeffective(seesection1).

Theiractions,incombinationwithstrongmacroeconomicfundamentals,allowedtheeconomy to recoverfairlyquicklywithverylimitedfiscalstimulus.

Thesuccessfulresponsewas achievedwithonlylimitedformalinstitutionalarrangementsforcooperation amongthedifferentagencies.

However,thecrisisdidrevealtheconsiderablemacroeconomicandfinancialsystemrisksarisingfromaSIB’sfailure,anddemonstratedthatlargelossesbytheseinstitutionswerenotmerelyatheoreticalpossibility.

Asaresult,strengtheningtheirresiliencehasbecomeakey

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priorityfortheauthorities.

Thelynchpinoftheirresponseisthe too-big-to-fail(TBTF)package,whichwasapprovedbytheSwissParliamentinSeptember2011andisduetocomeintoforceon1March2012.

Thecoreelementsofthepackageinclude capitalandliquidityrequirements,organisationalstructure,risk diversificationandresolutionmeasures.

Thepackageisparticularlydemandingintermsofcapitalrequirements-infact,the10%commonequitytier1capitalrequirementunderthepackageexceedsbothBaselIIIandanyinternationallyagreed capitalsurchargeforglobalSIBs.

TheFSBcommendstheSwissauthoritiesfordevelopingthispackage,particularlyintheabsenceofaninternationallyagreedframeworkatthetimeonhow todealwithsystemicallyimportantfirms.

Thepackagegoesbeyondinternationalminimumstandardsin termsofregulatorycapitalrequirementsandhasbeeninfluentialintheinternationalpolicydebateonthisissue.

ImplementationissueswillbeimportantforthesuccessoftheTBTFpackage.

First,Switzerland’sexperiencewiththeuseofcontingentcapitalinstruments(CoCos),whicharearelativelynewinstrumentandrepresentalargeportionoftheadditionalcapitalrequirements,willbeusefulin determiningthebroaderuseoftheseinstrumentsattheinternationallevel.

Theinitialmarketreaction totheissuanceofCoCosbyoneofthetwo SIBs hasbeenfavourable.

Second,itwillbeimportanttomaintaintheintegrityoftheTBTFframeworkbylimitingthesizeofanyregulatorycapital“rebates”thatare

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envisagediffirmsareable todemonstrateresolvabilityandresolutionbeyondminimumrequirements.

Finally,atleastasimportantashighercapitallevelsandliquiditybuffersisensuring:

arigorouscorporategovernanceframework inSIBs toensurethattheirrisksarewell-understoodandadequatelymanagedinternally;and

arobustsupervisoryframeworkinFINMAwithsufficientresourcesandintensivesupervision.

Thesetwofactorsareparticularlyrelevantgiventhesize,globalreachand businessmodelsofthetwo largebanks.

Theregulatoryreformsunderway,bothatnationalandinternationallevels,havealreadybegun to impactthebusinessmodelsofthetwobigbanks.

BothSIBs haveshrunktheirbalancesheetssincethefinancialcrisisand haverecentlyannouncedadjustmentsintheirstrategytoreducetheimportanceofinvestmentbankingactivities.

AnotherimportantissueistherecentintroductionoftheCHF-EURflooranditspotentialimpactonthefinancialsystem.

Thecombinationofthefloorwithaprotractedlow interestrateenvironmentcouldpotentiallyresultinexcessivecreditcreationandcontribute to thebuild-upofimbalancesinthedomesticrealestateandmortgagemarkets.

Itisthereforeessentialthattheauthoritiesremainvigilantinmonitoringtrendsandmaintainingsoundunderwritingandcreditrisk managementinthissector.

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FSAPrecommendations

Theprudentialauthority’s(FINMA)operationalindependencefromthefederalgovernmenthas beenenhancedcomparedtoitspredecessorauthoritiesinareassuchashiringandbudgetsetting.

However,theconcernsexpressedintheFSAPwithrespecttoArticle7oftheFINMAAct(thecompetitivenessclause)remainunresolvedsincetherelevantprovisionshavenotbeenrevised(seesection2).

TheauthoritiesbelievethatArticle5oftheActclearlystatestheprimacyofFINMA’sprudentialobjectives,withtheoutcomescontributingto thereputationandcompetitivenessoftheSwissfinancialcentre.

Article7isintendedtoreflecttheneedforcost-benefitanalysisasoneofthebasicprinciplesofregulation.

However,theseArticlesdonotaddresssituationswheretherearetensionsordirectconflictsbetweenprudentialobjectivesandcompetitiveness.

TheFINMAActhasalsonotbeenrevised(asrecommendedbytheFSAP)tograntFINMAthepowerstoimposecivilmoneypenaltiestoenhanceitsprudential powers.

Progressonaddressingtheseissueswouldbedesirable.

FINMAhasmadegoodprogressinstrengtheningitsresourcesand headcountasrecommendedby theFSAP, in spiteofdifficultiesinrecruitingspecialists.

Whileresourceshavegenerallyincreasedin response to thecrisis,theneedandexpectationsfor increasedsupervisoryintensityandeffectivenesshavealsocorrespondinglyincreased.

FINMAshouldcontinue to increaseitsresources-bothonthebankingandontheinsuranceside-andenhanceitsin-houseexpertisetokeeppacewithmarketandregulatorydevelopments.

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FINMAismakinganumberofimprovementstoitssupervisoryframework,includinganewrisk-basedsupervisoryapproach(seesection3).

However,relianceonthesethirdpartiesremainsstrong.

Whiletheoutsourcingofsupervisoryfunctionstothirdpartiesisappropriateincertaincases(e.g.to tapadditionalexpertiseand resources),FSBmembersencouragetheSwissauthoritiestocontinueto

enhanceFINMA’ssupervisorycapacityanditsability toperformmore

on-siteexaminationsitself,includingwithrespecttobankriskmanagementpracticesandinternalcontrols.

Oneimportantconcernwithrespecttooutsourcingistheindependenceoftheworkcarriedoutbythirdparties.

In thatrespect,FINMAisencouragedtocontinuetoimproveitsoversightofbanks’externalauditors,asenvisagedinitscurrentplans.

In particular,FINMAshouldassumeprimaryresponsibilityfordevelopingthetermsofreferenceforregulatoryauditwork,selectingtheauditfirmthatisgoingtoundertakethiswork(whichshouldbedifferent thantheoneemployedforthefinancialaudit),andpayingthatfirmbasedonperformancebychargingsupervisedfinancialinstitutionsaccordingly.

Cantonalbanksweatheredthecrisisfairlywellandwereabletogainmarketshareattheexpenseofthetwolargebanks;theyarealsogenerallywellcapitalizedandhaveahigherqualityofcapitalthanthetwoSIBs.

Cantonalbanks aresubjecttosupervisionbyFINMAandoperateunderthesamecorporategovernanceregulationthatappliestoprivatebanks,including in termsofboardmemberrequirements.

However,someofthesebanks havetheirliabilitiesfullyguaranteedby theirrespectivecantons(oftenforafee).

In ordertopromotealevelplayingfield,theSwissauthoritiesshouldconsidereliminatingtheseguarantees.

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Significantprogresshasbeenmadeinimplementing insurancesector reformssincetheFSAP(seesection4).

TheSwissSolvencyTest(SST)cameintofulleffect in2011;FINMAhasexpandeditssupervisoryresourcesandundertakesfocusedinspectionsof highriskinsurers;thereisenhanceddatacollectionfor intra-grouptransactions(IGTs);aninternalauditfunctionwithinFINMAhasbeenestablished;andquarterlyreportingofselectedkeyindicatorsforinsurancecompanieshasbeenimplemented.

Lookingahead,FINMAneedstoensuretheproperoperationoftheSSTforallrelevant(re)insurers,anddataqualityand othermodellingissuesshouldberesolvedforfirmsthatarenotyetfullycompliant.

AlthoughtheSSTincludesanassessmentofgrouprisk,itcanbedifficult tofullyunderstandthewebofconstantlychangingandnumerousIGTsofcomplexgroups.

Accordingly,furtherdevelopment(suchas theplanneddatawarehouse)isnecessarytosupportin-depthanalysisoftheuseofIGTs.

FINMAisalsoencouragedtotakeadditionalstepstoexpandpublicdisclosure,anissuethatitiscurrentlyconsidering.

Theimpendingchangeinthesupervisorystructureforpensionfunds,whilefallingshortoftheFSAP’smainrecommendation(i.e.toestablishasingle,centralisedsupervisoryauthorityforthewholecountry),stillrepresentsamajorimprovementcomparedtothecurrentsituation(seesection5).

Thenewlaw,adoptedby theSwissparliamentinMarch2010,addressestheindependence,resourcesandpowersofthe cantonalsupervisorsandestablishesacentralsupervisorycommission(OAK)to overseethemandtoensuretheapplicationofcommonsupervisorystandardsforpensionfundsacrossSwitzerland,particularlyovergovernance,investmentandsolvency.

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However,itisunclearthatthecurrentresourcesallocatedtoOAKwillbesufficient to ensurethatgoal.

ItisalsoessentialtoensureaclearlineofcommunicationandcooperationwithFINMA,viaaMemorandumofUnderstanding,giventheroleofinsurancecompaniesintheprivatepensionsystem.

Significantprogresshasbeen achievedinstrengtheninggovernanceprovisionsofpensionfundsfollowingtheFSAP.

Thenewprovisionsarewelcomeandshouldhelpcontaintheproblemsoffraudandmismanagementthathadbeenobservedin somepensionfundsinrecentyears.

Ontheotherhand,thenewlegislationdoesnotspecificallyaddressotheraspectsofrisk management.

Thedevelopmentofsupervisoryguidelinesonrisk management,shouldthereforebeoneofthefirstprioritiesoftheOAK.

TheFSAPrecommendationonarisk-basedsolvencytestalsoremainstobeimplemented.

In particular,thevaluationstandardsforpensionassetsandliabilitieswouldneedtobereformedtobetterreflectmarketconditions.

However,fullytransferringmarketvolatility to solvencyvaluationsmaynotmakesensegivenverylong-termcontractswherethereislittlerisk ofmembersleavingthefundandwherebenefitpromises canbeadjusted.

Somepensionfundsarealsobackedbythesponsoringemployer,whilethereisaguaranteefundinthecaseofinsolvency.

Anynewfundingregulationswouldneed to takeallofthesefactorsintoaccount.

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RecentmarketdevelopmentsandregulatoryissuesFinancialsystemstructure

TheSwissfinancialsystemislargebyinternationalstandardsandplaysanimportantrolebothdomesticallyandinternationally.

It makesakeycontribution totheSwisseconomy,accountingfor10.7%ofvalueadded,5.7%oftheworkforceandroughly12-15%ofannualtaxreceipts.

Itstwolargestbanks(UBS andCreditSuisse)andinsurancecompanies(SwissReandZurich FinancialServices)arerankedamongthelargestglobalfinancialinstitutions.

Althoughthesizeofthebankingsectorhasdeclinedsince2006fromover9timesGrossDomesticProduct(GDP)to6.6times GDP in2010,its

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relativesizeandconcentrationremain amongthehighestintheG10countries(seeFigure1).

Withoperationsin over40countries,UBSandCreditSuissecomprisealargepartofthesector.

The totalassetsofeachbankaremorethantwiceSwitzerland’sGDP (alargepartofwhichcomesfromforeignoperations),andtogetherthesetwobanksaccountedfor38%ofthedomesticcreditmarketatend-2010.

Althoughtheyoperateasuniversalbanksprovidingawiderangeoffinancialservices,theirmainbusinesslinesareasset/wealth managementandinvestmentbanking.

In additiontothesetwolargebanks,theSwissbankingsectorcomprisescantonalbanks(whicharecontrolledandmostofwhichareguaranteed bySwitzerland's cantons),regionalandotherbanksaswellastheRaiffeisenGroup(acooperativewith328independentmembers),mostofwhichhaveadomesticclientfocusedbusinessmodel(seeTable1).

TheSwissinsurancesectoraccountsforaround3%ofGDP,whileitsinvestmentsrepresentapproximately100%ofGDP.

Itstwolargeinstitutions-ZurichFinancialServicesranks 13thinsizeamongstglobalinsurers,whileSwiss Reisthesecondlargestglobal

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reinsurer-dominatein overallsizebutareoflesssignificancein termsofmarketsharedomestically.

Thesectorremainsdualisticinnature,withafewlargeinternationalgroupsandnumeroussmaller insurancecompaniesdedicatedsolelytotheSwissinsurancemarket.

PensionfundsarethelargestinstitutionalinvestorsinSwitzerlandwithassetsundermanagementrepresentingover110%ofGDP.

Theindustryishighlydispersed,withover2,800pensionfundsaroundthecountry,someofthelargestbeingthoseestablishedforthegovernmentemployeesofthelargestcantons.

Theyoperateprimarilydefinedcontributionplans(overthreequartersofthetotal).

TheSIXGroupoperatesSwitzerland’sfinancialmarketinfrastructureandofferssecuritiestrading,clearingandsettlementservices,payment transactionsandfinancialinformation.

TheSIXSwissExchangeoffersawideproductrange,andrankedfourthinmarket capitalisation(USD1.2trillion)atend-2010amongregulatedEuropeanstockmarkets.

Regulatoryframework

TheSwissFinancialMarketSupervisoryAuthority(FINMA)istheregulatoryandsupervisoryauthorityresponsibleforthesupervisionof banks,insurancecompanies,stockexchanges,securitiesdealers,andotherfinancialintermediaries(exceptpensionfunds-seesection5).

Itwascreatedin June2007bytheFinancialMarketSupervisoryAct(FINMASA)andwasgivenfull poweron1January2009.

TheSwissNationalBank(SNB)andtheFederalDepartmentofFinance(FDF)areFINMA’smostimportantdomesticpartneragencies.

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CooperationbetweentheSNB,FINMAandtheFDFisgovernedbytwoMemorandaofUnderstanding(MOU).

TheSNBandtheSFBChadaMOUinplacesince2007thatwascontinuedafterthecreationofFINMA.

ThisbilateralMOUwasrevisedinFebruary2010 to focusonfinancialstabilitybasedonlessonsfromthefinancialcrisis.

Itprovidesacleardivisionbetweentherespectivetasksofeachofthetwoinstitutions,describestheircommonareasofinterestandgovernstheircollaborationintheseareas.

In addition,thereisatrilateralMOUbetweentheFDF,FINMAandtheSNBthatwassignedin January2011.

Itgoverns collaborationbetweenthethreeauthorities,includingtheexchangeofinformationonfinancialstabilityandfinancialmarketregulationissues,aswellascoordinationintheeventofacrisisthatcouldthreatenthefinancialsystem'sstability.

Thethreeauthorities’statutoryresponsibilitiesanddecision-makingpowersremainunchangedunderbothMOUs.

Two maincommitteesareinplacetoeffect inter-agencycoordination:theSteeringCommitteeandtheCommitteeonFinancialCrises(CFC).

TheSteeringCommittee-comprisingtheFDF head(Committeechair),theSNBGoverningBoardChairandtheFINMAChairmancoordinatesanypolicy responsesin theeventofacrisis.

TheCFC-comprisingtheFINMAChiefExecutiveOfficer(Committeechair),FDF StateSecretary,theSNBGoverningBoard ViceChairman,andtheDirectoroftheFederalFinanceAdministration-meetsatleasttwiceayear.

In theeventofacrisis,itcoordinatespreparatoryworkfor

decision-makingoncrisisresponsesonbehalfoftheSteeringCommittee.

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FINMAhasalsosignedbilateralandmultilateralMOUswithanumberofforeignsupervisoryauthorities8,andithascreatedsupervisorycollegeswithimportanthostregulatorsforthelargestSwissbanks andinsurancecompanies.

Crisisresponse

TherecentglobalfinancialcrisishighlightedthevulnerabilityoftheSwisseconomyandthefinancialsystemtothetwo largebanks.

Priortothecrisis(2006),whenthecombined totalassetsofUBS andCreditSuisserepresentedover7timesSwitzerland’sGDP,bothbankshadlargeproprietarytradingportfoliosinUSasset-backedsecuritiesandincomplexstructuredproducts.

Thecollapseinthemarketpricesofthoseproductsgeneratedsubstantiallosses,particularlyfor UBS thathadsubstantialinvestmentsin USsubprimemortgage-backedsecurities.

Theselosseswerecompoundedbythefactthatthetwobankswerehighlyleveraged,hadinadequate capitalbuffersandtheirprofitabilityandfundingwereheavilydependentonglobalcapitalmarkets.

Bycontrast to the2bigbanks,smallandmedium-sizedSwissbanksweatheredthecrisisfairlywellandwereable to gainmarketshareattheexpenseofthetwo largebanks.

Inaddition,mostSwissinsurancecompanies(withtheexceptionofsomelargeones)didnothavesignificantexposurestoUSasset-backedsecuritiesorsimilarinvestmentsand, inspiteoftheirlargeinvestmentportfolios,werenotsignificantlyimpactedandwereabletomeetsolvencyandtied/pledgedassetsrequirements.

Theproblemsofthetwobigbanks threatenedtospillover totherestofthefinancialsystemandtotheeconomy.

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In response,theSNBtookanumberofextraordinarypolicymeasurestosecurethesupplyofliquidity tobanks andto easeprivateborrowers’access to capital,includingmoneymarketandforeignexchangeswapoperationsandthetemporarypurchase(untilyear-end2009)of

CHF-denominatedbondsbyprivatesectorissuers.

Depositorprotectionwasalsoraised toCHF 100,000inDecember2008, an amountthatiscomparable tothelevelofprotection adoptedinEuropeanUnion(EU)countriesfollowingthecrisis11–althoughotherfeaturesofthedepositinsurancesysteminSwitzerlandraisesome concerns.

Measures tostabilizeUBS:TheSwissauthoritiesapprovedapackageofmeasuresinOctober2008 to restoreconfidenceinthefinancialsystem.

TheSNBcreatedtheStabilisationFund,aspecialpurposevehicledesignedto receiveuptoUSD60 billionin illiquidassetsfromUBS’sbalancesheet,primarilyUSandEuropeanresidentialandcommercialrealestatemortgages,fororderlyliquidation.

UBS wasrequiredtoprovidethisvehiclewithequitycapitalof10%oftheassetspurchased,whiletheSNBgrantedaloan(securedbytheFund’sassetsandawarrantfor100millionUBSshares)fortheremaining90%.

Withprivate capitalmarketsdisruptedbythecrisis,theSwissauthoritieswereforced to injecttheequitycapital intoUBSbysubscribingtomandatoryconvertiblenotesinthe amountofCHF6billion.

Sinceitwasestablished,theStabilisationFundhasmanagedtoreduceitsportfolioofassetsfromUSD34.7billiontoUSD11billionthroughinterestpayments,repayments,assetsales,andtheclosingofderivativepositions.

Asof30June2011,equityhadincreasedtoUSD3.4billionwithayear-to-datesixmonthprofitofUSD1.3billion.

ThemainobjectiveremainsthefullrepaymentoftheSNB’sloanwhilemaximizingtheproceedsfromtheportfolio.

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PrudentialmeasuresforSystemicallyImportantBanks(SIBs):In2008,FINMAdevelopedanewcapitaladequacyregimeinclosecooperationwiththeSNB to increasetheresilienceofSwitzerland’stwo largebanks.

Thehighercapitaladequacytargetsweredefinedandcommunicatedtothetwo largebanksviaaformaldecree on20November2008,andtheymustbecompliedwithby2013subjecttofutureprofitability.

Theregimecallsforanincreasein risk-weightedcapitalforthelargebanksbetween50%and100%abovetheminimuminternationalrequirementsunderPillar1ofBaselII.

ThisadditionalcapitalrequirementisbeingimplementedunderPillar2ofBaselII.

Ingoodperiods,thebanksshouldbuilduptheircapitaltoatargetlevelof200%.

Thisbufferwillthenbeavailabletothebanksduringperiodsofcrisisandcan berundowntoaninterventionlevelof150%.

In addition,aleverageratiowasintroducedsothattheminimumproportionofTier1capitalto totalassetsforbothbanks is3%atgroupleveland4%for individual institutions.

FINMAandtheSNBalsosubstantiallyrevisedtheliquidityregimeforthetwo largebanks(seesection3).

Thenewregime,whichcameintoforceon30June2010,involvesastringentstressscenariocoveringageneralcrisisin financialmarketscoupledwithcreditors’lossoftrustinthebank.

Thenewregulations,originallyintroducedwiththeagreementofthetwobanks,nowhavealegal basissince thetoo-bigto-fail(TBTF) packagehasrecentlybeenapproved.

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Theyrequirethatthesebanks,byholdingan adequatereserveof

first-classliquidassets,areabletocoverestimatedoutflowsoveraperiodofatleast30days.

Recentdevelopments:TheSwisseconomyrecoveredfairlyquicklyfromthefinancialcrisis,withabroad-basedrecoverydrivenbyrobustdomesticdemandandareboundin exports.

Morerecently,however,extremerisk aversionpromptedbyproblemsintheEurozoneledtoa‘flighttosafety’byinternationalinvestors,resultinginasteepappreciationoftheCHF that-togetherwiththeworseningglobaleconomicenvironment-hasadverselyaffectedSwissexportsandtheoveralleconomy.

InSeptember2011,theSNBannouncedaminimumCHF-Euroexchangerateof1.20.

Accordingto theSNB,themassiveovervaluationoftheCHFatthetimeoftheannouncementposedan acutethreat totheSwisseconomyandcarriedtheriskofadeflationarydevelopment.

Tomaintainthisminimumexchangeratelevel,theSNBstatedthatitispreparedtobuyforeigncurrencyinunlimitedquantities.

TheSwissauthoritieshaveevaluatedthepotentialimplicationsoftheCHF-Euroexchangeratefloorandofaprotractedlow interestrateenvironment,includingtherisk thatitwouldresultinsubstantialdomesticcreditcreation.

Theauthoritieshaveconsequentlysteppeduptheircommunicationwiththebanks regardingthepotentialbuild-upofrisk inthefinancialsystem,includingtheresidentialmortgagemarket.

TheSNBhasalsobeenmonitoringthebanksandconductingsurveystoassesstheirexposuretotherealestatesector.

FINMAhasincreaseditssupervisoryfocusonthedomesticmortgagemarketbyworkingwiththeSwissBankers’Associationto tighten

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self-regulationandtorequiretheuniformapplicationofresidentialmortgageunderwritingstandards.

In additiontothesequalitativeparameters,theFederalCouncilhasdecided to introducehigherriskweightsformortgagelendingandacountercyclicalbufferthataresupposedto comeintoeffectinearly2012.

Majorregulatoryinitiatives

TBTF package:Giventhelessonsfromthefinancialcrisis,theSwissauthoritieshaveconcludedthatitiscrucialtostrengthentheresilienceofthetwoSIBsinordertoreducethepossibilityoffuturebailoutsandemergencyassistancemeasuresforthem.

On20April2011,theFederalCouncilsubmittedaproposedpackage toParliamentdetailingmeasuresdesignedtostrengthenthestabilityofthefinancialsystemandto preventpublicbail-outofSIBs.

ThecoreelementsoftheTBTF packageaddresscapitalandliquidityrequirements,organisationalstructure,riskdiversificationandresolution.

Undertheproposedcapitalframeworkandgiventhecurrentsituationofthetwolargebanks,thetotalminimumcapitaladequacyrequirementforeachofthemwillbearound19%ofrisk-weightedassets(RWAs).

TheFederalCouncil’sbill,baseduponrecommendationsfromacommissionofappointedexperts,wasapprovedbytheSwissParliamenton30September2011andisdue to comein BaselIII:TheBaselIIIframeworkisexpectedtobeadoptedintolawforallSwissbanks witheffectfromJanuary2013,andtofollowthetransitionperiodupto2019asagreedbytheBCBS.

BaselIIIisexpectedto haveahigherimpactonlargebanks,particularlywithregardtoeligiblecapitalaswellascapitalrequirementsfor

over-the-counterderivatives(seeFigure2foracomparisonofrisk-based

capitalrequirementsundertheBaselIIIframeworkandtheSwissTBTFregulation).

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Box1: TheTBTFpackage

UndertheSwissTBTF regime,systemicallyimportantfinancialinstitutions(SIFIs)aredefinedas“banks,financialgroupsandbank-dominatedfinancialconglomerateswhosefailurewoulddo

considerableharmtotheSwisseconomyandtheSwissfinancialsystem.”

DeterminationofSIFIstatusisdelegated to theSNBbasedoncriteriasuchasmarketshareandinterconnectedness,deposits,sizecomparedtoGDP andriskprofile.

Capitalrequirements:Theminimumcapitalrequirementsforthetwolargebanks arethree-foldinnatureandapplytoboththerisk-weightedcapitalratioandtotheleverageratio.

Partofthem canbeheldintheformofcontingent capital instruments(CoCos),i.e.bondsthatconvertintocommonequityorwrittenoffonceacontractuallydefinedtriggerisreached.

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Thebasicrequirementisaregulatoryminimum-4.5%CoreTier1ratiotoRWAs,asin BaselIII-mustbemetonanon-goingbasis.

The capitalbuffer(8.5%ofRWAs,comprisingbothcommonequityand high-triggerCoCos)allowsbankstoabsorblosseswithoutfallingshortofthebasicrequirementandwithouthavingto suspendnormalbusinessactivities.

Theprogressivecomponent(1-6%ofRWAs,madeupoflow-triggerCoCos)isasystemicsurchargethatincreaseswiththebank’ssizeanddomesticmarketshare.

TheSwissauthoritiesbelievethatbanksthatissueCoCoswillhaveanincentive to lowertheirrisk andthatsuchinstruments canprovidethebankwithadditionalcapital whenitmaybedifficulttoraiseitfromthemarket.

TheyarerevisingthetaxframeworktoensuretheattractivenessoftheseinstrumentstoinvestorsandtopromoteissuanceinSwitzerland.

Liquidityrequirements:TheTBTF amendmentsprovidealegalbasisforintroducingdifferentiatedliquidityrequirementsforSIBs.BasedontheregimeintroducedinJune2010,theywillcomplementtheBaselIIIrequirementsoncethelatterbecomeeffective.

Riskdiversification:Themainobjectiveofthesemeasuresistoreduceinterconnectednessinthebankingsectorbyreducingthedependenceofotherbanks ontheSIBs.

TheSwissCapitalAdequacyOrdinancewasrevisedasof1January2011toimplementthemorestringentBCBSprovisionsformarketrisksandsecuritisationaswellasrisk diversificationstandards.

Organisationalstructure:TheTBTF frameworkplacesresponsibilityforthecontinuationofsystemicallyimportantfunctions(payment transactions,depositandlendingbusiness)ontheSIB.

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It mustdemonstratebymeansofanemergencyplan(whichgetstriggeredifitscapitalratiofallsbelow5%)thatsuchfunctions canbemaintained.

TheFederalCouncilwillsetoutin anordinancethecriteriaandstandardsforassessingtheemergencyplan(ResolutionEffectivenessTest)andrecoveryarrangements,andwillprovideFINMAwiththeauthority to applycorrective actions.

In addition,theBankingActhasbeenamended toprovideFINMAwiththenecessarytoolstoreorganisedistressedbanks.

Macroprudentialsupervision:InApril2011,theFDF establishedaworkinggroup(withhigh-levelparticipationfromFINMAandtheSNB)onfinancialstabilityto evaluateSwitzerland'smacroprudentialframeworkandtoproposeimprovementsasneeded.

TheworkinggroupconcludedinNovember2011thatthefollowingtwomacroprudentialinstrumentsshouldbeconsideredforenforcementasofMarch2012:

-acountercyclicalbufferofupto 2.5%ofRWAsmadeupofCommonEquityTier1capital, in accordancewiththeBaselIIIframework.

Accordingtotheproposal,thebuffercouldbelimitedtoassetsinspecificmarketsegments(e.g.abank’sdomesticmortgagebusiness)thatmaygiverisk tosystemicrisks.

UpontheSNB'srequest, in consultationwithFINMA,theFederalCouncil wouldbeinchargeofactivatingthebuffer.

Sincecurrentandexpecteddevelopments intheSwissbanks’lendingactivitiesmayjustifyactivationofthebufferpriortoSwitzerland’sintroductionofBaselIII,theworkinggroup’sproposalincludesanamendmentofthecurrentordinancetoallowactivationbefore2013basedoncurrent capitaldefinitionsasneeded.

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-animprovementintheclassificationofrisk-weightsforexposuresrelatedtomortgage-backedrealestatefinancing.

In particular,the workinggroupisfollowingupontheFederalCouncil’sAugust2011proposalto improvetheclassificationofrisk-weightsforbanks’exposuresrelatedtosuchfinancing.

Thenewclassificationwillbemorerisk-oriented,takingaccountofthedebtor'sriskprofileandassigninga100%risk-weighttohigh-riskexposures.

PublicconsultationforbothregulatoryinstrumentshascommencedinNovember2011andwillendinmid-January2012.

Thistimeschedulewouldallowtherespectiveamendmentsintheordinance to enterintoforceon1March2012,conditionalongovernmentalapproval.

Theworkinggroupconsiderstheseamendmentskeytocompletingtheauthorities'macroprudentialtoolkit.

In linewithitsmandate,theworkinggroupwillalsopublishitsassessmentofSwitzerland’smacroprudentialframeworkinearly2012.

SwissSolvencyTest(SST):InsurancecompanieshadbeenpreparingfortheSSTsince2006.Asof1January2011,FINMArequiresallinsurancecompaniesandconglomerates to conductthistestbaseduponanextensivesetofparameterssetbythesupervisor.

TheSSTenablesamarket-consistentassessmentofthefirm’srisks(market, insuranceandcredit)andbalancesheet,includingrisksfromnon-insuranceandcapital-market-relatedtransactionstobecaptured(seesection4).

TheSSTalsoincludesscenariotestingagainsttheimpactonthetarget capitalto beestimated.

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AcomprehensivereportdetailingtheresultsofthetestissenttoFINMAannually.

Lessonsandissuesgoingforward

TheresponseoftheSwissauthoritiestotheproblemsofoneofthetwo SIBs duringthefinancialcrisiswasswiftandeffective.

Theiractions,incombinationwithstrongmacroeconomicfundamentals,allowedtheeconomy to recoverfairlyquicklywithverylimitedfiscalstimulus.

Thesuccessfulresponsewas achievedwithonlylimitedformalinstitutionalarrangementsforcooperation amongthedifferentagencies.

However,thecrisisdidrevealtheconsiderablemacroeconomicandfinancialsystemrisksarisingfromaSIB’sfailure,anddemonstratedthatlargelossesbytheseinstitutionswerenotmerelyatheoreticalpossibility.

Asaresult,strengtheningtheresilienceoftheSIBsandensuringthat taxpayersdonotassumefinancialriskstosavethemhasbecomeakeypriorityfortheauthorities.

Fromasupervisoryperspective,FINMAconcludedthatthelessonsfromthecrisiscentredaroundinadequate capitaladequacyrequirementsandliquiditystandards,insufficientattentionpaidtoexcessivegrowth,insufficientindependenttestingofinformation(includingoverreliancetointernalandexternalauditors),andalessthanadequaterangeofbankingcommissionpowersincludingsanctions.

ThelynchpinoftheSwissauthorities’responsetothecrisisis therecently-approvedTBTF package,whichhasbeendevelopedasawaytostrengthentheresilienceofSIBs.

Theframeworkismulti-facetedandparticularlydemandingintermsofcapitalrequirements,andtheSwissauthoritiesaretobecommendedfordevelopingthispackagein theabsenceofaninternationallyagreedframeworkatthetimeonhowtodealwithSIFIs.

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Thepackagehasbeeninfluentialintheinternational policydebateonthisissueandismoreambitiousincertainrespectsthanthepolicymeasuressubsequentlydevelopedbytheFSBonglobalSIFIsbecauseofthespecificchallengesinvolvedinthe caseofthetwobigSwissbanks.

Infact,the10%commonequitytier1capitalrequirementunderthepackageexceedsbothBaselIIIandanyinternationallyagreed capitalsurchargeforglobalSIBs.

TheTBTF packageisexpected to contributesignificantlytothestabilityoftheSwissfinancialsystembyreducingthevulnerabilityofthelargebanks to externalshocksandtheprobabilityofcontagioninafinancial crisis.

ImplementationissueswillbeimportantforthesuccessoftheTBTFpackage.

First,Switzerland’sexperiencewiththeuseofCoCos,whicharearelativelynewinstrumentandrepresentalargeportionoftheadditionalcapitalrequirements,willbeuseful in determiningthebroaderuseoftheseinstrumentsattheinternationallevel.

Second,acrucialfeatureoftheTBTF packageisthe capitalbuffers.

Althoughitmaybereasonabletograntsomekindofrebates– asiscurrentlyenvisaged–totheprogressivecapitalcomponentrequirementiffirmsareabletodemonstrateresolvabilityandresolutionbeyondminimumrequirements(suchasthecontinuationofsystemicallyrelevantfunctions),itwillbeimportanttomaintaintheintegrityoftheframeworkbylimitingthesizeofsuchrebates.

Finally,atleastasimportantashighercapitallevelsandliquiditybuffersisensuring:

arigorouscorporategovernanceframeworkinSIBs toensurethattheirrisksarewell-understoodandadequatelymanagedinternally;and

arobustsupervisoryframeworkinFINMAwithsufficientresourcesandintensivesupervision.

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Thesetwofactorsareparticularlyrelevantgiventhesize,globalreachand businessmodelsofthetwo largebanks.

FINMAhasmadesomeprogressinbuildingitssupervisoryresourcesandexpertisebutcontinuestorelyheavilyonauditorsand tooutsourceasignificant amountofsupervisorywork.

Theregulatoryreformsunderway,bothatnationalandinternationallevels,havealreadybegun to impactthebusinessmodelsofthetwobigbanks,whicharebasedonwealthmanagementaswellasonvolatiletrading incomeandinvestmentbankingactivities.

BothSIBs haveshrunktheirbalancesheetssincethefinancialcrisisand haverecentlyannouncedadjustmentsintheirstrategytoreducetheimportanceofinvestmentbankingactivities.

Partofthewealthmanagementsectorhasalsoseenanumberoftaxissuesthatimpactedbusinessstrategies.

ThechangingregulatorylandscapeisanimportantchallengefortheSwissbankingsector,whichtheSwissauthoritiesandthebankingindustryareactivelyaddressing.

AnotherimportantissueistherecentintroductionoftheCHF-EURflooranditspotentialimpactonthefinancialsystem.

TheSNBhastakenaboldstanceagainstanovervaluationofthecurrencyandthenegativeimpactitmayhaveontheeconomy.

However,thecombinationofthefloorwithaprotractedlow interestrateenvironmentcouldpotentiallyresultinexcessivecreditcreationandcontribute to thebuild-upofimbalancesinthedomesticrealestateandmortgagemarkets.

Itisthereforeessentialthattheauthoritiesremainvigilantinmonitoringtrendsandmaintainingsoundunderwritingandcreditrisk managementinthissector.

Inter-agencycooperationisessentialandtheauthoritieshavemadegood progressrecentlyinestablishingacooperationframeworktoimprovemacroprudentialoversight-notwithstandingthefactthattheframeworkdoesnotprovideaformaldesignationofsafetynetresponsibilitiesandobligations,anditleavessomeoperationalaspectsunclear.

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  • Bankingandsupervisoryframework

  • TheFSAPnotedthatSwitzerlandhadbeenactivelyupgradingitsregulatoryandsupervisoryarrangementsandstrengtheningcooperationandinformationexchangewithforeignregulators.

  • ItnotedtheneedforeffectivesupervisionofthemajorSwissfinancialinstitutionsviaastrong, independentregulator.

  • In thatcontext,itrecommendedareviewoftheprovisionsofthedraftFINMASAtoensurethatFINMAisprovidedwithsufficientoperationalindependenceandprudentialpowers.

  • TheFSAPalsorecommendedfurtherstrengtheningtheresourcesandexpertiseofthebankingandinsurancesupervisors.Inparticular,theSwissauthoritieswereadvised to:

  • reviewtheprovisionsofthedraftFINMASAtoavoidprovisionsthatmightlimitFINMA’soperationalindependenceandprudentialpowers;

  • provideFINMAwiththepowerstoimposecivilmoneypenalties;and

  • strengthentheresourcesandexpertiseofthesupervisors.

  • StepsTakenandActionsPlanned

  • OperationalindependenceandpowersofFINMA:FINMA’sindependencefromthefederalgovernmenthasbeenenhancedsinceitscreationinareassuchashiringandbudgetsetting.

  • Inparticular,FINMAstaffarenotemployedundertheFederalPersonnelOrdinancebutundertheFINMAPersonnelOrdinancethatwasenactedbyFINMA’sBoardofDirectorsandaccordsitwithgreaterflexibilityinhiringandretainingstaff.

  • ThisisincontrasttotheSFBC,wherethecreationofnewpositionsanda correspondingsalaryclasswererequired tobeapprovedbytheFDF.

  • Furthermore,FINMAkeepsits ownaccountsandisfinanciallyindependentfromthefederalbudget.ItsbudgetisapprovedbyitsBoard ofDirectorsandisnotsubject to furtherapprovalbythegovernmentorparliament.

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TheFINMAFeesandChargesOrdinanceempowersFINMAtochargesupervisedfinancialinstitutions to coveritsgeneralcosts,and to levyadditionalchargesincaseswheretheusualfeesareinsufficienttocoveritscosts.

ThisOrdinancedoesnotrestrictthesizeofFINMA’sbudgetortheapplicationoffunds.

FINMASAincludesprovisionsregardingFINMA’s accountabilityvis-à-visthepublic,theparliamentandtheFederalCouncil.

Article7(thecompetitivenessclause)requiresFINMAtotake intoaccountthecompetivenessoftheSwissfinancialcentrewhenregulatingfinancialinstitutionsandmarkets.

Althoughthisarticlecouldpotentiallygiveindustryrepresentativessomeleveragein opposingregulation,noFINMAregulationhasbeenchallengedincourtduetothecompetitivenessclausesincetheenactmentoftheAct.

FINMAemphasisesthatitdoesnotacceptorpromoteinadequateorineffectiveregulationin favourofcompetitionandthat,infact,itconsiderstheproposedTBTF regulationsforthetwo SIBsasacompetitiveadvantagefortheSwissfinancialcentre.

Furthermore,theSwissauthoritiesnotethat,whilethecostofregulationandcompetitionaretakenintoaccountinpolicyformulation,theprimacyofFINMA’sresponsibilitiesareprudentialandsupervisoryinnature.

Powerstoimposecivilmoneypenalties:TheFINMASAhasnotbeenrevisedtograntFINMAthepowerstoimposecivilmoneypenalties.

Somewhatmitigatingthispoint, incomparison toitsantecedents,FINMA’ssanctioningpowershavebeenstrengthenedbyenablingittoconfiscateillegalprofitsaswellto removebankingofficialsfromtheirpositionandprohibitthemfromemploymentinthebankingsector.

FINMAalsosupportstheworkofcriminalauthoritiesandfilescriminalcomplaintsagainstpartiesincaseswherereasonablegroundsexisttosuspectoffensesagainstthecriminalprovisionsoffinancialmarketsacts.

Strengtheningresourcesandexpertiseofsupervisors:ThestrengtheningofFINMA’sworkforcebyhiringstaffwithexperience inseniorroleswithinthefinanceandriskmanagementsectorhasbeenastrategic

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objective -particularlygiventhehighstaffturnoverexperiencedatthetimeofitscreation.

FINMAhasmadeprogressintermsofresources,asthenumberoffulltimeequivalentshasincreasedfromapproximately330in2009 to 380currently.

Thisincludesanumberofsenior-levelhiresfromtheprivatesector.

Thecurrentexceptionalmarketcircumstanceshavefacilitatedtherecruitmentofstaffwiththerequiredcredentialsandexperiencewhencomparedtothepast.

However,FINMAiswellawarethatthecurrentsituationmaynotcontinueand,asaconsequence,istakingsteps to improveitsability toattractandretainqualifiedstaff.

Tothisend,ithasintroducedinApril2011atechnicalspecialistscareerpaththatparallelsthetraditionalmanagementcareerpath.

FINMAalsohasplans to furtherimproveitstalentmanagement,leadershipdevelopmentandemployeebrandingaspartofits2012goals.ResponsibilityforfleshingouttheseinitiativeshasbeenassignedtoanewlycreatedOperationsDepartment.

Asapilotphase,FINMArecentlystartedamentoringprogramintheBankingDivisionandarotationprogramforyounghiresintheMarketsDivision.

Lessonsandissuesgoingforward

OperationalindependenceandpowersofFINMA:FINMA’soperationalindependencefromthefederalgovernmenthasbeenenhancedcomparedtoitspredecessorauthoritiesin areassuchashiringandbudgetsetting.

However,theconcernsexpressedintheFSAPsurroundingFINMA’soperational independence,particularlywithrespect to thecompetitivenessclause,remainunresolvedsincetherelevantprovisionsintheFINMAActhavenotbeenrevised.

TheauthoritiesbelievethatArticle5oftheActclearlystatestheprimacyofFINMA’sprudentialobjectives,withtheoutcomescontributingto thereputationandcompetitivenessoftheSwissfinancialcentre.

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Article7isintendedtoreflecttheneedforcost-benefitanalysisasoneofthebasicprinciplesofregulation.

However,theseArticlesdonotaddresssituationswheretherearetensionsordirectconflictsbetweenprudentialobjectivesandcompetitiveness.

FINMAhasnothaditsregulationschallengedin courtongroundsofcompetitivenesssinceitsformation.

Goingforward,theSwissauthoritiesshouldcontinue toensurethattheirfinancialregulationsandsupervisorystandardsarenotcompromisedonthegroundsofpromotingcompetitiveness.

In addition,FINMAshouldarticulateclearlyin otherformsofcommunicationthat, in instanceswhereprudentialobjectivesandthecompetitivenessoftheSwissfinancialcentreareindirectconflict,theprimacyofprudentialobjectiveswillprevail.

Powerstoimposecivilmoneypenalties:FINMAbelievesthatitsability totakemeasuressuchastheconfiscationofprofitsandtheremovalof bankexecutives canbemoreeffectivethanimposingcivilmoney penalties.

Acivilmoneypenaltyhastobesufficientlylargein ordertoachieveasimilardeterrenteffect, inwhichcaseitislikelythatacriminalchargemightalsobewarranted.

However,powers topursuecivilpenaltiesprovidemoresupervisoryoptionsthat canbepursuedforoffencesofmoderateseverity.

Thealternative,whichistakingactionundercriminalstatutes,maybelesseffectivegiventhelongerlegalprocessandresourcesrequiredtoexamineadditionalaspectssuchascriminal intent.

Itisalsonotuncommoninternationallyforregulatoryagenciestohavepowers to imposecivilmoneypenalties.

In fact,achievingfullcompliancewithBCP23(Correctiveand RemedialPowersofSupervisors)requiressupervisors to havepowerstoimposesuchpenaltiesattheirdisposal.

Strengtheningresourcesandexpertiseofsupervisors:FINMAhasmadegoodprogressinthestrengtheningofitsresourcesandheadcount.

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The adequacyofresourcesisachallengethatisacommonthemeacrosssupervisors.

Whileresourceshavegenerallyincreasedin response to thelessonsfromthecrisis,theneedandexpectationsfor increasedintensityandeffectivenessofsupervisionhavealsocorrespondinglyincreased.

FINMAacknowledgesthatindividualswithmorespecialisedexpertise,suchasactuariesandrisk managers,arehardertorecruit.

Demandforsuchskillswillalsocontinue to increaseasFINMAmovestowardrelyinglessonexternalauditorsandperformingmoreofitsownon-siteexaminations.

FINMAispreparedtoincreaseitsstafffurtherifitsresponsibilitiesareextendedformallyinitsstatutes.

However,thedemandforsupervisoryresources canincreaseevenwithoutadditionallegislativeresponsibilities.

Thismaybetosupportamoreintrusiveandintensivesupervisionthatiscommensuratewiththescaleandcomplexityofthebanksunderitssupervision(especiallythetwo SIBs).

In thisregard,FINMAshouldcontinueto increaseitsresourcesandenhanceitsin-houseexpertisetokeeppacewithmarketandregulatorydevelopments.

Bankingsupervision

The2007FSAPUpdateacknowledgedthatSwitzerlandhadmade“impressiveprogress...to strengthenthefinancialsectorsupervisoryframeworksincethe2001FSAP”.

Nevertheless,ithighlightedthreeareaspresentingkeychallengesthatshouldbeaddressed:

supervisoryissuesregardingthetwo largestSwissbanks;

theuseofexternalauditors;and

theoperationofthe cantonalbanks.

Giventhecomplexnatureofthetwo largebanksandtheirsystemicimportance,theFSAP madethefollowingrecommendations:

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anin-depthreviewoftheircapitaladequacyaspartofBaselIIimplementation,focusingparticularlyonPillar2 capitalrequirementsandadditionalon-sitesupervisorywork;

strengthenedsupervisionoftheirliquidityrisks;and

focusedauditstoevaluatetheirrisk managementvis-à-vishedgefunds.

Withregardtoexternalauditors,theFSAPrecommended:

strengtheningtheoversightofbanks’externalauditors;

consideringtheuseofarangeof internationalexpertsandauditfirmsforthespecialaudits;and

consideringtheperiodicrotationofauditfirms.

Finally,withrespectto thecantonalbanks,theFSAP recommendedthattheirgovernancestructuresshouldbestrengthenedandthattheycould begiventheoverridinggoalofprofitmaximizationwhilededicatingpartoftheirprofitsthroughthefiscalprocessto achievetheirsocialfunction.

Stepstakenandactionsplanned

Supervisionofthetwolargebanks:Followingtheweaknesseshighlighted bythefinancialcrisis,anewcapitaladequacyregimeforthetwo largebankswasintroducedinNovember2008.

This actionaddressedsomeoftheissuesidentifiedbytheFSAP- inparticular,abank-specificamount ofadditionalcapitalwasrequiredasaPillar2measure.

In addition,inApril2011,theFederalCouncilsubmittedaproposedpackageofmeasuresdesigned tostrengthenthestabilityofthefinancialsystemandtopreventthegovernmentfromhavingtousetaxrevenuesinthefuturetobailoutSIBs.

ThedeadlineformeetingthenewtargetforCoreEquitytier1capitalrequirementsis1January2013anda“glidingpath”tocomplywiththefinalrequirementsby1January2019wasagreedwiththebanks.

Thecurrentcapitaladequacyratiosofthe2bigbanks comparefavorably

withpeers,althoughthebanksremainrelativelymoreleveraged.

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Inaddition,theimplementationofastricterdefinitionofcapitalunderBaselIIIislikelytoreducesignificantlytheircapitalratios.

TheSwissauthoritiesholdregularcapitalplanningmeetingswiththebanks todiscussprogressinachievingtheagreedSIBrequirements.

Oneofthemaintoolsforassessingtheadequacyofthebanks’ capital withinthecontextofsupervisoryreviewprocess(Pillar2)issupervisorystress tests.

In lightofthelessonslearnedfromthefinancialcrisis,supervisoryexpectationssurroundingsoundstresstestingpracticesforbankshavebeenenhanced.

In theSwisscontext,since thebeginningof2008,FINMAhasmandatedstress testingexercises(so-called“BuildingBlockAnalysis”orBBA).

Thedesignofthestresstestandscenarios to beevaluatedaredevelopedjointlybyFINMAandtheSNB.

ResultsfromthesequarterlyrunexercisesarediscussedbyFINMA,theSNBandthebanks inordertounderstandtheevolutionofriskordetectreconciliationissueswithinternalriskreports.

Sincethebeginningof2009,theBBAhasbeencomplementedbyasemi-annual“LossPotentialAnalysis”(LPA),whoseobjectiveisto

identifysignificantsourcesofriskwithinthetwolargebanks,to estimate

losspotentialonastand-alonebasis,andto estimate eachbank’spotentialcumulativelossin caseofsubstantialfinancialmarketdeterioration.

Theimpactofsuchalossonthebanks’capitalpositionisassessedagainstsupervisoryexpectationswithrespecttotheirshockabsorptioncapacity,takingintoaccounttheirsystemicrelevance.

TheresultsoftheLPAformanimportantpartofassessingtheadequacyofabank’sinternalcapitalplanningprocess.

Therearenohardtriggersthatleadinamechanicalmannertoadditionalcapitalrequirements,althoughsuchrequirementsmayresultfromtheoverallsupervisoryreviewprocess.

FINMAhasrecentlydevelopedanewsupervisoryapproachunderwhichallsupervisedinstitutionsareallocatedtooneofsixcategoriesaccording

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totheirrisk impactoncreditors, investors, policy holdersandthesystem asawhole,aswellasthereputationoftheSwissfinancialsystem.

In addition,eachinstitutionreceivesaratingcorrespondingtoFINMA’sassessmentofitscurrentstate.

Onthebasisofthesetwoparameters,FINMAdeterminestheintensityofsupervision,suchastheuseofon-sitevisitstocomplementtheregulatoryaudit.

Directreviewsarecurrentlybeingcarriedoutonaregularbasisatthe2largeSIBs(theonlytwoinstitutionscurrentlyallocatedtocategory1),andselectivelyat otherbanks andinsurancecompanies.

FINMA’shighlevelassessmentisformalizedinanannualassessmentlettertotheboardofthebankwhereanoverallsupervisoryratingand necessaryremediation actions toclosesignificantgapsarecommunicated.

FINMAhasalsoestablishedexpertteamstoconducton-siteexaminationsandhorizontalreviewsatthe2largebanks,particularlyfortheir investmentbanking divisions.

Thesemeasureswereaccompaniedbyselectivehiringofseniormanagersandexpertswithlongstandingexperiencein bankingandaudit(seesection2).

Approximately20supervisoryreviewshavebeenscheduledin2011(comparedtotworeviewsin2007and2008)inareassuchasinterestraterisk in thebankingbook,compensationsystems,informationtechnologyrisk,marketrisksnot capturedbyvalue-at-riskmodels,collateralmanagement,riskprofit-and-lossandstop-losstriggers,andfixedincomeemergingmarkets.

Thereviewscontainrecommendationstowhichthebanksarerequiredtorespond.

Sincethetwo bankshaveasubstantialpartoftheiroperationsoverseas,muchoftheon-sitesupervisoryworkhasbeenconductedabroad incollaborationwithrelevanthostauthorities.

FINMAandtheSNBhavesubstantiallyrevisedtheliquidityregimeforthetwo largebanks.

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Thenewliquidityregime cameintoforceon30June2010andresemblesthedesignofBaselIII’sLiquidityCoverageRatio(LCR).

In addition,FINMAestablishedanewmonitoringapproachforliquidityrisksofthetwo largebanksbasedonamixofthenewliquidity requirements,bankinternalreports,monthlyupdatecallsandtheBCBSQuantitativeImpactStudyresultsoftheLCRandtheNetStableFundingRatio(NSFR)-animportantissueinlightoftherelativelystrongrelianceofthesebanks onexternalwholesalefunding.

Theauthoritieshavealsointroducedregularliquidityplanningmeetingswiththetwo largebanks.

FINMAhasalsoassessedthebanks’riskmanagementpractices,inparticularmarginingpractices,hedgefundexposuremeasuresandreporting.

Theresultsofthoseassessmentsweredeemed tobesatisfactoryoverall.

Thebanks’riskmanagementpracticeswereputtothetestduring2008-09whenthehedgefundindustrywasheavilyhitbythefinancialcrisis,whichledtotheliquidationofsomefundsasaresultofseverelossesincurred.

Thesupervisedbanksdidnotsuffersignificantlossesontheirhedgefundexposures,which canbeattributedin largeparttothehighdegreeofcollateralisationandclosemonitoringoftheseexposures.

Useofexternalauditors:Switzerlandusesadualisticapproachunderwhich, in additiontosupervisors,approvedauditfirmsplayasignificantrolein thesupervisoryprocess.

Theso-calledregulatoryauditessentiallylooksintocompliancewithlicensingregulationsandotherrequirementsimposedundersupervisorylaw.

Auditfirmsarehiredbythebanksdirectly(subjecttoFINMA’sapproval)andundertaketheregulatoryauditwork,particularlyresource-intensiveandstandardisedwork processes,onthebasisofariskanalysis/auditstrategythatisupdatedyearly.

ThisstrategyisdevelopedbytheauditcompanyitselfandmustbediscussedwithFINMA.

AcopyofallauditreportsofbanksmustbesenttoFINMA.

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In additiontotheregulatoryauditwork,FINMAstaffreviewspecialissuesdirectlywiththebanks (on-sitesupervisoryreviews).

FINMA,in closecooperationwiththeFederalAuditSupervisoryAuthority,assessesthequalityofauditfirms’workonanongoingbasistoensurethattheymeettheconditionsforrecognitionandcomplywithregulatoryprovisionsandrelevantprofessionalcodesofconduct.

FINMAverifiesthattheauditmethodologiesdefinedintheauditfirms’manualsandcodesofconductareapplied.

Italsoperformstargetedqualitycontroltestsontheorganisationalstructuresandmandateproceduresofauditfirmsandanalysestheirauditexpendituresandfees.

Ifnoweaknessesorproblemsareidentified,FINMAwill“approve”theauditfirmandplaceitonalistoffirmsthatmaybeusedbythebank.

WhileFINMAdoesnotprescribeperiodicrotationsforauditfirms,itdoesmandatetheperiodicrotationofleadauditors.

In addition,auditfirmsmustnormallyusetwoseparateteamsforthefinancialandtheregulatoryaudit,eachwithits ownmandateandleadauditor-althoughthecompositionofthetwoteamsmayoverlap,especiallyforsmallandmedium-sizedbanks.

FINMAreservestherighttodemandthattwodifferentauditfirmsbeusedinindividualcases,oreventhatanauditfirmbereplaced.

Thereareplanstofurtherimprovetheoversightofbanks’externalauditors.

In particular,astrictdistinctionwillbedrawnbetweentheauditoftheannualaccountsandtheregulatoryauditinthefuture,whilethepotentialforformulatingstandardised,regularauditmandatesversussupplementaryexceptionalorcase-specific auditmandateswillbeexplored.

Theauditfirm’sfreedomtodecidetheauditdepthforcertaintopicswillberestrictedandtherewillbeclearerreportingrulesaimedatproducingunambiguous,preciseandcomparableresults.

Additionalmeasuresincludenewrulesgoverningvariousaspectsofauditfirms’independencefromsupervisedinstitutions,tobe introducedviacircularscoming intoforcein 2013withprovisionfortransitionperiods.

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CantonalBanks:Cantonalbanks aresubjectto supervisionbyFINMAandoperateunderthesamecorporategovernanceregulationthatappliestoprivatebanks, including in termsofboardmemberrequirements.

In particular,theymustcomplywithFINMAcircular2008/24on“Supervisionandinternalcontrolwithinthebankingsector”.

Thecorporategovernancerequirements-whichrelatetothecomposition ofgoverningbodies,theirorganisationand activitiesaswellasthesegregationofdutyandguaranteeofproperbusinessconduct-forcantonalbanksareexaminedeveryyearbyexternalauditorsandreportedtoFINMA.

Theinfluenceofthecantonsontheday-to-daybusinessactivitiesofsuch banksisminimal-infact,thegeneraltrendsincetheSwissbankingcrisisofthe1990shasbeen todepoliticisetheirboards.

However,cantonalbanks’progressintermsofthereductionofpoliticalinfluenceintheirboardsdoesnotappearuniformsinceboardmemberscontinuetobeappointedbythegovernmentorparliamentonthesuggestionofpoliticalpartiesin somecantons.

Bycontrast,somecantonsorcantonalbanks haveadoptedmoreformalqualificationcriteriathantheonesfoundin theFINMACircular.

Nevertheless,sincethe cantonsaretreatedsimilarly to privateownerswithregardtosupervisoryrequirements,theyalsohavethesamerightstodefinethestrategyofthosebanks.

In additiontoowningthebanks,somecantonsprovidefullguaranteestotheirbanks’liabilities.

Lessonslearnedandissuesgoingforward

TheSwissauthoritiesappeartohaveheededthelessonsfromthefinancialcrisisandaredrawinguponthemtomakeimprovementstotheirsupervisoryframework.

EnhancementstotheframeworkalsoincludetheimplementationofBaselIIIwithintheinternationallyagreedtimeframeandthemonitoringofliquiditygapsbycurrencyasawaytoremainvigilantonliquidityrisks.

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TheTBTF packagewillfurtherstrengthencapitalrequirements,althoughtheCoCosproposedforinclusioninthepackagearelargelyuntestedinstruments.

FINMAalsocontinuestoregularlydiscusswiththetwo bigbanksanyinfrastructuredevelopmentsincollateralmanagement,particularlyasitrelatestohedgefunds.

Relianceonthirdpartiesforsupervisorypurposesremainsstrong.

Forexample,FINMAcurrentlyemploysalmost400staffwhiletotaloutsourcedactivitiesaccountforroughly800full-timeequivalents.

Whiletheoutsourcingofsupervisoryfunctions tothirdpartiesisappropriateincertaincases(e.g.to tapadditionalexpertiseand resources),experienceshowsthatitisgenerallyapoorsubstituteforworkdonein-housebythesupervisoryauthorities.

Supervisoryresponsibility,whichrestswithFINMA,cannotandshould notbedelegated.

ThesupervisionofSIFIsdemandsaminimumacceptableamount ofworkthatshouldbeconductedbythesupervisoryauthority.

Despiteimprovementsobservedinthelastcoupleofyears,theratioofownsupervisoryworkperformedbyFINMAin relationtotheworkoutsourcedtoauditingfirmsappearslowandwellbelowpeersupervisorsofglobalSIBs.

Toughregulation,althoughhighlydesiredandveryimportant,isalsonotasubstituteforthoroughsupervisionandon-siteanalysis.

FINMAshouldthereforecontinuetoenhanceits ownsupervisorycapacityandperformmoreon-siteexaminationsitself.

Oneimportantconcernwithrespecttooutsourcingistheindependenceoftheworkcarriedoutbythirdparties.

Theabilityofexternalauditorstocompetentlyidentifyrisksandtochallengefinancialinstitutionshasalsobeenraisedinpastbankfailures.

In thatrespect,FINMAisencouragedtocontinuetoimproveitsoversightofbanks’externalauditors,asenvisagedinitscurrentplans.

In particular,itshouldassumeprimaryresponsibilityfordevelopingthetermsofreferencefortheregulatoryauditwork,selectingtheauditfirm

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thatisgoingto undertakethiswork(whichshouldbedifferentthantheoneemployedforthefinancialaudit),andpayingthatfirmbasedon performancebychargingsupervisedfinancialinstitutionsaccordingly.

Theregulationandoversightofriskmanagementandinternalcontrolsat thelargestbankshasassumedevengreaterimportancegiventhevariousproblemsthathavesurfacedinthisareaoverthepastfewyears.

Itisthesupervisors’responsibility toensurethatbankshaveappropriateriskmanagementpracticesandstronginternalcontrols.

ThemostrecentUBStradingscandalsuggeststhattheremaybeareaswheremoresupervisoryattentionmayberequired.

FINMAshouldanalyzecarefullytheresultoftheindependentinvestigationintothisissue(whichwillincludeanassessmentofinternalcontrols inUBS’sinvestmentbank)andtakeappropriateactions.

Cantonalbanksweatheredthecrisisfairlywellandwereabletogainmarketshareattheexpenseofthetwolargebanks;theyarealsogenerallywellcapitalizedandhaveahigherqualityofcapitalthanthetwo SIBs.

In ordertopromotealevelplayingfield,theSwissauthoritiesshouldconsidereliminatingtheunlimitedguaranteecurrentlyprovidedtosomecantonalbanks.

(Re)insuranceregulationandsupervision

TheFSAPnotedthatreformssince2003hadupdatedtheregulationandsupervisionoftheinsuranceindustry,withthenewly-introducedSSTbeingattheforefrontofrisk-basedmeasurement.

WhiletheupdatedframeworkhadahighlevelofobservancewiththeInsuranceCorePrinciples(ICPs)issuedbytheInternationalAssociationofInsuranceSupervisors(IAIS),thereformprocesswasnotyetcompleteandtheFSAPrecommendedthatadequatesupervisoryresourcesbedevotedtoimplementationandthatfocusedinspectionsofhigh-riskinsurerstakeplaceinordertostrengthentheirriskmanagementpracticesandtoreducetheirvulnerability to marketrisks.

In ordertominimisecontagionrisk withingroupentities,italsorecommendedthattheauthoritiescontinue toworkcloselywithrelevant

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(re)insurers tobringdownintra-groupbalances(intheformoflendingandequityinvestments)thatwererelativelyhigh.

Withregardtothereinsuranceindustry,thedetailedICPassessmentrecommendedthattheauthoritiestakeactionstoenhancesupervisoryindependenceandaccountability,expandsupervisoryresources,andstrengthenongoingsupervision(particularlywithrespecttoon-siteinspections).

Severalofthoserecommendationsarealsoapplicabletotheregulationoftheinsurancesectorasawhole.

Stepstakenandaction planned

Inspectionsofhighrisk insurers:Due toresourceconstraints,therewerenoinspectionsofreinsurersduring2006,whileon-sitevisitsto otherinsurersweregenerallynotrisk-based.

FINMAnowconductson-siteinspectionsofreinsurersandhasgenerallyincreasedthenumberofinspections toapproximately100in2010,includingnumerousfocusedinspectionsofhighrisk(re)insurers.

Since2008,severalon-sitereviewswereconductedonthemesrelatingtothefinancialcrisis,includingalternativeinvestments,thereal-estateandmortgagemarket,andasset-backedsecurities.

Themainfocusofthesereviewshasbeentheimplementationofadequatesystemsandprocessesinthefirmaswellastheriskmanagementandvaluationoffinancialassets.

WiththeSSTbecomingeffectiveasof1January2011,theriskstakenbyinsurers,includingfinancialmarketrisks,aredirectlyreflectedintheircapitalrequirements.

TheSSTcoverageratiosfortheinsurancesectorin aggregateweregenerallysatisfactoryatend-2010,althoughinsurerswitharatiounder100%were askedtopresentatimelyrecoveryplan.

Fivelifeinsurersoutof128solo-entitySSTsubmissionshad,asattheend of2010,coverageratiosunder100%.

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Morebroadly,thelifeinsurancesectoringeneralhas arelativelylowaggregatecoverageratioof145%,comparedwith205%fortheentireinsurancemarket.

Financialmarketriskissubstantialforlifeinsurersbecauseoftheinterestratesensitivityoftheirlargeinvestmentholdings.

TheSwissQualitativeAssessment(SQA)complementstheSSTbyfocusingonthegovernance,risk managementandinternalcontrolsprocesseswithaview to amoreeffectivemonitoringofthefinancialconditionofinsurers.

SQAIwaslaunched in 2008withasurveyofover160insurers,andfollow-uptargetedon-sitereviewswherenecessary.

Asecondsurveyoffirmsbeganin2011(SQAII).

FINMA’sapproachtoinspectionsandsupervisionisevolvingto onethatismorerisk-based.

Assuch,ahigherlevelofresourceswillbedevotedtohighrisk insurers;similarly,expertisewillfocusonareasdeemed tobeofhigherrisk,forexampleliquidityrisks,technicalprovisionsandbusinessexposedtonaturalcatastrophes.

Therisk-basedframeworkwaslargelyoperationalattheendof2011,withmonitoringandfine-tuningcontinuing in2012.

Intra-groupbalances:Overallintra-groupbalancesremainrelativelyhigh,withintra-grouploansandinvestmentsrepresenting14.5%oftotalassetsfortheinsurancemarketasawholeattheendof2010comparedwith13.5%atthetimeoftheFSAP;thepercentagehasaveragedapproximately14%overthepasteightyears.

ThatlevelisnoteasilyreducedwithoutsignificantgrouprestructuringbecausemostSwisslifeinsurancecompaniesareownedbynon-lifeinsurancecompanies;asaresult,ifalifeinsurancesubsidiaryneedsadditionalcapital,theparentcompanygenerallyhas to increaseitsinvestmentoruseother intra-grouptransactions(IGTs)tomeet capitalrequirements.

Thehighintra-groupbalancesaremonitoredbyFINMAinbothsoloandgroupsupervision.

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FINMArequiresstandardizedanalysisofcapitalgearing,regulatoryarbitrageandincreasedriskfrom capitalusage.

Intra-groupreinsuranceisalsoanalysed.

CurrenteffortsarefocusedonlesstransparentIGTs,inparticulartoidentifyandeliminateunlimitedguaranteesofanykindthatmayleadtocontagionrisk.

Allmaterialtransactionsmustbereportedpromptly.

TheSSTtakes IGTsintoaccountandrequires capitalto coverthegroupriskarisingfromIGTs.

AllIGTsarereflectedinthegroupSST,includingthoseeliminatedonconsolidation.

Thismeansthatcapitalinvestedinsubsidiariesisnotdouble-counted.

WhileFINMAhasmadeprogresswithcollectingIGTdata,itsanalysistodetermineconsistentlywhethergroupriskisacceptableisstillwork inprogress.

AlthoughSSTfactorsin grouprisk,itcanbeveryhardtogetacomprehensivepictureofgroupriskwhereIGTsarecomplex(astheyareforthelargergroups).

Currently,FINMAusesExceltoolstoanalyseIGTs.

FINMAintendstodevelopadatawarehousetosupportsystematic

in-depthanalysisofmarketuseofIGTsandallow forimplementationofrisk indicators.

ICP 2(Supervisoryobjectives):TheFSAP recommendedprovidinggreaterclarityregardingtheauthority,circumstancesandprocessestoaddresspotentialconflictsinsupervisoryobjectivesaresetforthintheInsuranceSupervisionLaw(ISL).

ThosepotentialconflictsarisethoughArticle7ofFINMASA,whichrequiresFINMAtotakeintoaccountthecompetitivenessoftheSwissfinancialcentrewhenregulatingfinancialinstitutionsandmarkets(seesection2).

ICP 3(Supervisoryauthority):TheFSAPrecommendedthatindependenceandaccountabilitybeenhancedthroughthepublic

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disclosureofthereasonsiftheDirectoroftheFOPIisremovedfromoffice.

However,thereisatpresentnolegalobligationtopubliclydisclosethereasonsforremovalfromoffice,althoughtheparliamentarycommissionresponsiblefortheoversightofFINMAwouldhavetherightto demandsuchinformation.

TheFSAPalsorecommendedtheestablishmentofaninternalauditfunctionwithintheFOPI.Atitsinception,FINMAestablishedsuchafunctionthatreportsdirectly to theBoardofDirectors.

Supervisoryresources:FOPIhadfewstaffdedicatedtoreinsurancesupervision,includingthesupervisionofsophisticatedandgloballydiversifiedreinsurers.

TheFSAPrecommendationsincludedbuildingadequateregulatoryresourcesandcost-effectivesystemsandprocesses to:

enhanceglobalmarketanalysis(ICP 11);

conductrisk-focusedon-siteinspections(ICP 13);

enforcepreventiveandcorrectivemeasures(ICP 15);and

conductgroup/conglomeratesupervision.FINMAhasgenerallyincreaseditsresourcessinceitsestablishment,particularlythenumberofskilledstaffingroupsupervisionaswellasqualitativeandquantitativerisksupervision(seesections2and3).

Resourceshavealsobeenshiftedintorisk-basedsupervision,whichincludesgreaterfocusonthelargeandgloballydiversifiedreinsurerstoallow theiron-siteinspections(thiswasnotpossiblein2006duetoresourceconstraints)andgroup/conglomeratesupervision,whilst traditionalsupervisionhasbeentrimmed tobemoreefficientandeffective.

ICP 12(Off-sitemonitoring):TheFSAPrecommendedthatinsurancecompaniescompletequarterlyreportsonselectedkeyfinancialindicators,particularlyon solvencyandasset-liabilitymanagement,tofacilitateongoingoff-sitesurveillanceandtimelyintervention.

Quarterlyreportsonsolvency,assetsandtiedassetshavebeenfiled withFINMAsinceJanuary2009(monthlyfromJuly2010)forgroupsandreportedtoFINMAmanagementforconsideration.

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Additionaldatahasalsobeencollectedinthecaseofspecialsituations(e.g.exposuresonEUmemberstates).

ICP 5(Supervisorycooperationandinformationsharing):Forlargeglobalreinsurers,theFSAP recommendedtheestablishmentofformalregulatorycooperationandinformationexchangearrangementswithforeignregulatorsoutside theEuropeanEconomicArea(EEA).

In response,FINMAhasstrengtheneditscooperationwithforeignregulatorsbyestablishingmultiplesupervisorycolleges.

Asthehomesupervisor,FINMAtakesthelead inplanningandcoordinatingtheactivitiesofitssupervisorycollegesforSwissgroups.

FINMAalsoparticipatesininsurancesupervisorycollegesorganisedbyforeignsupervisoryauthoritieswheretheSwisssubsidiaryisofstrategicimportanceforthegroup.

In addition,FINMAisaSignatoryoftheIAISMultilateralMoUoncooperationandinformationexchange,inadditiontoexistingbilateralagreements.

ICP 6(Licensing):Nostepshavebeentaken to explicitlyrequirecompositereinsurerstoensurepropersegregationoflife andnon-liferisks intoseparatefunds.

ThisisconsistentwiththeEU ReinsuranceDirective,introducedsincetheFSAP,whichpermitscompositepurereinsurers.

FINMAbelievesthatthecurrentrisk managementrequirementsadequatelysafeguardtheinterestsofcedants.

ICP8(Portfoliotransfers):Althoughreinsurersarenotexplicitlyrequiredtoseekapprovalbeforetheytransferalloranypartoftheirreinsurancebusiness(asrecommendedforconsiderationbytheFSAP),FINMAconsiderssuchatransfertobeachangetothebusinessplanandrequiresreinsurerstonotifyitofsuchchangesinadvance.

In general,FINMAthenelectstoexaminethetransferandwillonlyapproveitifitdoesnotendangertheinterestsofthereinsured.

ICP 26(Information,disclosure&transparencytowardsthemarket):In2010,FINMAbegantostudypublicdisclosureswithaviewtoexpandingtheirscope.

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FINMA’sreviewisstillongoing,butFINMAnotesthatanexpansionof publicdisclosurerequirementswouldmostlikelyrequireachangeinlegislation.

Insurerorinsurancespecific dataprovidedto FINMAissubjecttoprofessionalsecrecyaslongasitdoesnotrelatetotheannualaccounts.

Lessonsandissuesgoingforward

Significantprogresshasbeenmadeinimplementing insurancesector reformssincetheFSAP.

TheSSTcameintofulleffect in2011;FINMAhasexpandeditssupervisoryresourcesandundertakesfocusedinspectionsofhighrisk insurers;thereisenhanceddatacollectionforIGTs;aninternalaudit functionwithinFINMAhasbeenestablished;andquarterlyreportingofselectedkeyindicatorsfor insurancecompanieshasbeenimplemented.

Lookingahead,FINMAneedstoensuretheproperoperationoftheSSTforallrelevant(re)insurers,anddataqualityand othermodellingissuesshouldberesolvedforfirmsthatarenotyetfullycompliant.

AlthoughtheSSTincludesanassessmentofgrouprisk,itcanbedifficult tofullyunderstandthewebofconstantlychangingandnumerousIGTsofcomplexgroups.

Accordingly,furthersteps(suchastheplanneddevelopmentofadatawarehouse)arenecessarytosupportin-depthanalysisoftheuseofIGTsandallow forimplementationofrisk indicatorstoassesstheleveland natureofgroupriskarisingthroughIGTsin asystematicmanner.

ThecontinuationoftheSQAisalsoimportant tounderpinthequantitativeassessment.

Asnotedinsection2,thedifficultyin recruitingspecialistssuchasactuariesandrisk managersisacommonthemeacrosssupervisoryauthorities,particularlyin EuropebecauseofthedemandsofimplementingSolvencyII.

ThisisaconstraintonthedevelopmentofSSTand to someextenttheSQA.

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  • Targetingscarceresources towardhigherrisk(re)insurerswillthereforeremainimportant.FINMAshouldcontinuetofocusonincreasingitsresourcesinordertodeliveronitssupervisoryobjectives.

  • ItisworthnotingthattheEuropean InsuranceandOccupationalPensionsAuthority(EIOPA)hasrecentlypublisheditsadvice to theEuropeanCommissiononitsequivalenceassessmentoftheSwisssupervisorysystem inrelation totheSolvencyIIDirective.

  • EIOPAfindstheSwisssystemtobelargelyequivalentwithafewcaveats,oneofwhichistheissueofpublicdisclosurementioned above.

  • EIOPAnotesthatFINMA’spublicdisclosurerequirementsarenotasextensiveasthoseunderSolvencyII.

  • FINMAisencouragedtotakeadditionalsteps toexpandpublicdisclosurebyrevisingtheISLasneeded,anissuethatitiscurrentlyconsidering.

  • Pensionsregulationandsupervision

  • TheFSAPnotedthatthesupervisionofthepensionfundsector(membershipofwhichismandatoryforallSwissemployees,bothinthepublicandprivatesector)isdividedbetweenthefederalagencyandthecantons,andthatitcontinues to fragmentedanduneven.

  • Itmadeaseriesofrecommendationstoupgradetheregulatoryandsupervisoryframeworkforpensionfunds,in particularto:

  • upgradetheproposedsupervisoryframeworkbyestablishinga centralizedbodywithsupervisoryresponsibility;

  • strengthenfundingrequirementsbyadoptingarisk-basedstandardsolvencytestafteranagreementonadequatecoveragemargins,andenhancetheproceduresinthecaseofunderfunding;and

  • enhancestandardsongovernance,structureofinvestments,andriskmanagement.

  • Stepstakenandactionsplanned

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Theso-calledstructuralreform(“Strukturreform”)oftheOccupationalPensionsLawwasadoptedbytheSwissparliamentinMarch2010.

Thelegislationisbasedontheprinciplesoftransparency,governanceandindependence,andincludesnewprovisionsonsupervision(implementedinJanuary2012)andgovernance,withaparticularfocusonconflictsofinterestandinternalcontrols(implementedinAugust2011).

Standardsonthestructureofinvestmentsandotheraspectsofriskmanagementwerenotaddressedinthestructuralreform,butshouldbeincludedintheplannedreviewofsolvencyregulations.

Supervisorystructure:Themainfeatureofthenewsupervisorystructureisthecompletedelegationofdirectsupervisoryresponsibilitiestothe26cantonsandtheestablishmentoftheOberaufsichtskommission(OAK),acentralsupervisorycommissiontooverseethecantonalsupervisorsandensuretheapplicationofcommonsupervisorystandardsforpensionfundsacrossSwitzerland,particularlyovergovernance,investmentandsolvency.

OAKbeganoperationsinJanuary2012andinitiallyconsistsofeightindependentexpertssupportedbyasecretariat(approximately15staff)attached totheFederalOfficeofSocialAffairs.

ThenewlawgivessubstantialoperationalautonomyandindependencetoOAK.

In particular,article64ofthereformedlawstatesthattheCommissioncannotreceiveanycommandsfromthegovernment.OAKisfundedprimarilyfromfeespaidbythecantonalsupervisors.

ThelawgiveskeyresponsibilitiesandpowerstoOAK,includingthereviewoftheannualreportsofthe cantonalsupervisors,theabilitytocarryoutinspectionsofthesupervisorsandthepower to issuegeneralguidanceforpensionsupervision,pensionfundauditorsandso-called“pensionexperts”(equivalenttoactuaries inotherjurisdictions).

OAKisalsoresponsibleforoverseeingthepensionguaranteefund.

Thestructuralreformalsorequires thecantonalsupervisorstobeestablishedasautonomouspublicsectoragencies,independentofthelocalgovernmentadministration.

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Similartoarticle64,article61ofthereformedlawstatesthatthe cantonalsupervisorscannotbesubjecttoanyexternaldirectiveintheexerciseoftheirfunctions.

Thesupervisorshavebeengrantednewpowers,includingtheability toreplaceapensionfund’sauditcommitteeandpensionexpert.

Thereformalsopermits thecantonalsupervisorstomergeintoasinglesupervisoryentity.

Atpresent,threelargegroupingsofsupervisorshavebeenestablishedalongregionallines:Central(cantonsofLuzern,Uri,Schwyz,Ob-undNidwalden,Zug),East(cantonsofGlarus,Appenzellinner-undausserrhoden,St.Gallen,Graubünden,Thurgau)andWest(cantonsofJura,Neuenburg,Wallis,Waadt).

Otherbilateralassociationsarealsoplanned,suchasthoseofthe canton ofFreiburgto Bern,Schaffhausen to Zurich,andBasel-Land to

Basel-Stadt.

Governancestandards:AspartofthestructuralreformoftheOccupationalPensionsLaw,newregulationsonpensionfundgovernancecameintoforcein August2011.

Themainchangesaretheintroductionofthebasicfiduciarydutyofloyaltyoftheboardofdirectorsofapensionfund towardsthebeneficiaries,supportedbyarequirementtoavoidconflictsofinterest,adetaileddescriptionoftheboard’sresponsibilities,andarequirementthat“thoseresponsibleformanagingoradministeringthepensionfundoritsassetsshallbepersonsofgoodreputationandoffereveryguaranteeofproperbusinessconduct.”

Thenewlegalprovisionsspecificallyprohibitcertaintransactionsthatareconsideredtogenerateaconflictofinterestandtodamagepensionfundmembers(e.g.front-,parallel-andafter-running).

Theyalsoobligepensionfundboardmembersandstafftoreportanygiftsreceivedbythirdparties.

Pensionfundsarealsorequired todiscloseadministrationandassetmanagementcostsindetailintheirannualreport.

Pensionfundshaveuntil2012tobringtheirinternalstatutes,governancestructuresandpracticesinlinewiththenewrules.

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Thenewregulationshavealsoclarifiedtheroleoftheindependentexternalauditandofthe“pensionexpert”.

In additiontotheircurrentresponsibilityofensuringcomplianceofthefundandannualaccountswiththelaw,auditorsmustdeterminetheadherenceoftheboardofdirectorstothefiduciarydutyofloyalty.

Theymustalsoverifythatthereareadequateinternalcontrolsin placeinlinewiththesizeandcomplexityofthepensionfund,thatis,correspondingto therisk profileoftheinstitution.

Theauditorshavealsobeengrantedwithstronger“whistle-blowing”responsibilities.

In particular,iftheauditorbecomesawareoffactswhichwould undermine theperformanceofapensionfund,heorsheshall notifythepensionfund’sboardatthesametimeas thesupervisoryauthority.

Theindependenceofthepensionexperthasalsobeenreinforced,asheorshecannolongeracceptotherservicecontractsfromthepensionfundorserveinany capacityin itsboardormanagement.

Thereshouldalsobenofamilyoreconomiclinksbetweenthepensionexpertandthosewithdecision-makingpowerinthepensionfund.

ThenewlegalprovisionsrequirepensionexpertstoobtainalicensefromOAK.

Thepensionexpert’smainroleremainstodetermineperiodicallywhetherpensioninstitutionsareabletomeettheirobligations.

Solvencyregulation:TheFSAP recommendedthe adoptionofarisk-basedstandardsolvencytest,valuingpensionliabilitiesona market-consistentbasis.

Swisssolvencyrulesarenotconsistentwith thisrequirement,sinceofficialactuarialvaluationsrelyonafixeddiscountrateto calculatepensionliabilities.

Thecurrentrateissetonaverageat3.6%,whichisratherhighcomparedtocurrent10-yeargovernmentbondyields(around1%)butclose totheaverageovertheperiod1994-2011(3.1%).

OAKisexpected todevelopnewsolvencyregulationsafteritsestablishment.

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In December2010,theSwissParliamentadoptedprovisionsrelatingtothefinancingofpublicsectorpensionfunds,whichuntilthenwerenotsubjecttoanyfundingorsolvencyregulation.

The objectiveoftherulesistostrengthenthefinancialsecurityofthoseinstitutions.

Tothisend,thenewrulesrequirepublicpensionfundstoreachafundingratioof80%within40years.Inaddition,suchinstitutionsshouldbelegallyandadministrativelyindependententities,separatedfromthestructureofthepublicadministrationthatsponsorsthem.

Lessonsandissuesgoingforward

Theimpendingchangein supervisorystructure,whilefallingshortoftheFSAP’smainrecommendation(establishasingle,centralisedsupervisoryauthorityforthewholecountry),stillrepresentsamajorimprovementcomparedtothecurrentsituation.

In particular,thelawaddressestheindependence,resourcesandpowersofOAKaswellasthoseofthe cantonalsupervisors,whichfollow (atahighlevel)muchoftheguidanceprovidedintheNovember2010InternationalOrganisationofPensionSupervisors’(IOPS)PrinciplesofPrivatePensionSupervision.

Thegroupingsofcantonalsupervisorswouldensurebetterpoolingofresourcesandgreaterconvergenceinsupervisorymethods.Thenewlegalprovisionsshouldalsoensuregreaterseparationbetween cantonalpublicsectorpensionfundsandtheirsupervisoryentity.

Whileafurtherregroupingofthesupervisorsmaybedesirable,therearealsoadvantagesintheregionalstructurecurrentlyemerging(suchasacommonlanguage).

Underthenewsupervisorystructure,OAKwillplayacriticalroleinensuringconsistentsupervisorystandardsacrossthecountry.However,itisunclearthatthecurrentresourcesallocatedwillbesufficienttoensurethatgoal.

ItisalsoessentialtoensureaclearlineofcommunicationandcooperationwithFINMA,giventheroleofinsurancecompaniesintheprivatepensionsystem.

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Itwouldthereforebeadvisable to establishaMOUsimilartotheonesignedbetweentheotheragenciesresponsibleforfinancialsectorregulationandsupervision.

Significantprogresshasbeen achievedinstrengtheninggovernanceprovisionsfollowingtheFSAPandinbringingtheminconformancewiththeJune2009OECDGuidelinesforPensionFundGovernance.

Thenewgovernanceprovisions,particularlytheenhancedindependenceandresponsibilitiesofauditorsandpensionexpertsandthenewconflictofinterestrulesapplicabletotheboardofdirectorsandpensionfundstaff,arewelcomeandshouldhelpcontaintheproblemsoffraudandmismanagementthathadbeenobservedinsomepensionfundsinrecentyears.

Ontheotherhand,thenewlegislationdoesnotspecificallyaddressotheraspectsofrisk management.

In particular,oneobviousgapintheSwisspensionfundlegislationistheabsenceofrequirementsforpensionfunds toestablishariskmanagementstrategy,whilethereisnosupervisoryguidanceontheinternalprocesses,internalcontrolsandreportingprocedures to identifyandmanagethevariousrisks(market,liquidity,counterparty,operationaletc.)thatthepensionfundmightbeexposedto.

Theoversightofinternalriskmanagementiseffectivelycarriedoutbytheauditor,whilethepensionexpertisinchargeofoverseeingthelevelofsolvencyofthepensionfund.

ThereisalsonorequirementunderSwisslegislationforappointinganexternalassetcustodian.

Thedevelopmentofsupervisoryguidelinesonrisk management,inaccordancewiththeJanuary2011OECD/IOPSGoodPracticesforPensionFunds’ RiskManagementSystemsandaddressed totheboardandmanagementofthepensionfunds,shouldbeoneofthefirstprioritiesoftheOAK.

Suchaninitiativewouldalsohelpstrengthenthecontroloverthestructureofinvestments,performanceandcosts,asrecommendedintheFSAPreport.

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TheFSAPrecommendationonarisk-basedsolvencytestalsoremainstobeimplemented.

In particular,thevaluationstandardsforpensionassetsandliabilitieswouldneedtobereformedtobetterreflectmarketconditions.

However,fullytransferringmarketvolatility to solvencyvaluationsmaynotmakesenseinthecontextofwhatareverylong-termcontractswherethereislittleriskofmembersleavingthefund(membershipismandatoryaspartofemploymentcontract)andwherebenefitpromises(abovetheminimumrequiredbythelaw)canbeadjusted.

In addition,somepensionfunds(all in thepublic sector)arebackedby thesponsoringemployer,whichmeansthatthemainrisk thatmembersareexposedtoisnotthefundinglevelofthepensionfundbuttheinsolvencyoftheplansponsor.

Thereisalsoaguaranteefundinthecaseofinsolvency,whichprovidesanadditionallayerofprotection topensionbenefits.

Anynewfundingregulationswouldneed to takeallofthesefactorsintoaccount.

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Annex:Switzerlandpeerreview–SelectedFSAP recommendations

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PCAOBEntersintoEnforcementCooperationAgreementwithChineseRegulators

Washington,DC

The PublicCompanyAccountingOversightBoard todayannouncedthatithasenteredintoaMemorandumofUnderstanding(MOU)onEnforcementCooperationwiththeChinaSecuritiesRegulatoryCommission(CSRC)andtheMinistryofFinance(MOF).

TheMOUestablishesacooperativeframeworkbetweenthepartiesfortheproductionandexchangeofauditdocumentsrelevanttoinvestigationsinbothcountries’respectivejurisdictions.

Morespecifically,itprovidesamechanismforthepartiestorequestandreceivefromeachotherassistancein obtainingdocumentsandinformationinfurtheranceoftheir investigativeduties.

"ThisagreementwithChinaisanimportantsteptowardcross-borderenforcementcooperationthatisnecessarytoprotecttheinterestsofinvestorsinU.S.capitalmarkets,”saidPCAOBChairmanJamesR.Doty.

“WelookforwardtocontinuedprogresswithourChinesecounterpartstoreachanagreementoncross-borderinspectionsofPCAOB-registeredfirmsaswell,”hesaid.

In additiontodevelopinganenforcementMOU,thePCAOBhasbeenengagedincontinuingdiscussionswiththeCSRCandMOFtopermitjointinspectionsinChinaofauditfirmsthatareregisteredwiththePCAOBandauditChinesecompaniesthattradeonU.S.exchanges.

UndertheSarbanes-OxleyAct,thePCAOB overseesallaccountingfirmsthatauditpubliccompanieswhosesecuritiestradein U.S.markets.

Approximately47auditfirmsin ChinaareregisteredwiththePCAOB.

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TheMOUisavailableonthePCAOBwebsite.

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Islamiccommerceandfinance

OpeningremarksbyDrMichaelGondwe,GovernoroftheBankofZambia,attheworkshopon“Islamiccommerceandfinance”,Lusaka.

TheGuestSpeakers,MuftiShafiqJakhuraandMaulanaBilalJakhura;Distinguishedinvitedguests;

Participants;

Ladiesandgentlemen;

OnbehalfoftheBankofZambiaandindeedonmy ownbehalf,IwouldliketoextendaverywarmwelcometoyoualltothisimportantworkshoponIslamicCommerceandFinance.

ToourGuestSpeakers,MuftiShafiqJakhuraandMaulanaBilalJakhura,Iwishtoextendaspecialwelcometoyou to ZambiaandinparticulartoLusaka.

Ladiesandgentlemen,theBankofZambiaishonouredanddelightedtobeinvited to giveakeynoteaddressatthisworkshop.

ThisWorkshoponIslamicCommerceandFinancecouldnothavecomeatamoreopportunetimethannow,whentheBankofZambiahasembracedfinancialinclusiononitspolicyagendaasawayofincreasingaccess to appropriatefinancialproductsandservicestoallsegmentsofsocietyinZambia.

Ladiesandgentlemen,Islamiccommerceandfinancehaveexpandedsignificantlyin thelastfewdecadesgloballybothintermsofsizeandthenumberofplayers.

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ForInstance,Islamicfinanceiscurrentlypracticedinmorethan50countriesworldwide.

In manycountries,Islamicfinanceco-existswithconventionalfinanceandisnotlimited toMuslimcountries.

Distinguishedparticipants,recentindustryestimatesindicatethatIslamicfinanceissettocontinuegrowingatanannualrateofabout15%.

Theincreasedtradebetweenthesub-SaharanregionandIslamicnationsintheMiddleEastonlyreinforcesourviewthatpartnershipsamongthecorporateplayersbetweenthetwo regionswillfostermoredevelopmentsinthearea ofIslamicfinance.

Ladiesandgentlemen,

theGovernmentoftheRepublicofZambia(GRZ)recognizesthatthelimitedaccesstofinancialservicesandlow numberofproductsavailabletothedifferentsectorsoftheeconomyhashinderedthedevelopmentpotentialofZambia’seconomy.

Thereisneedtherefore,to revitalizethefinancialsectorsothatitmeetsthechallengesof acceleratedandsustainedinvestmentsinkeysectorsoftheeconomy.

This canonlybe achievedwherethefinancialsystemisabletoimproveitsallocativeefficienciesbyprovidingappropriatelydesignedproductsandservicestoallsegmentsofthepopulationlike theMuslimcommunity.

Recentdevelopmentsin thefinancialsectorworld-wideoffersomeencouragementthatworkingtogethercouldextendtherangeandreachoffinancialservicesthatareavailabletoourpeople.

Stillalotremainstobedonetoextendfinancialservicestothemajorityofourpeople,particularlythosethatareeconomicallyactiveandto fosterongoingsustainabilityofourfinancialinstitutions.

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ItisagainstthisbackgroundthatBankofZambiaacceptedyourinvitation topresentthekeynoteaddressasawayofmarkingourcommitmenttoensuringthatthefinancialsystem catersforallsegmentsofthepopulation.

Distinguishedparticipants,therapidgrowthofIslamicfinanceraisesaseriesofimportantquestions,suchaswhetherIslamicfinanceshouldberegulateddifferentlyfromconventionalfinance.

BecausemodernIslamicfinanceisrelativelynewtomostcountries,rulesforfinancialaccounting,bankgovernance,andlendingstandardsarecontinuallyevolvingasbusinesspracticesbecomemorerefined.

Ladiesandgentlemen,

youmaywishtonotethatsinceOctober2008,whentheBankofZambiahostedthefirsteverIslamicBankingConferenceherein Lusaka,workhasbeenongoingtodeveloparegulatoryframeworkforIslamicbanking.

TheBankhasheldseveralconsultationsbothinternallyandexternallyandhasalsosubjectedtheIslamicBankingframeworktoexpertreviewbyinternationallyrenownedIslamicbankingexperts.

Theframeworkisnowin itsfinalstagesandisexpectedtobecomeoperationalbeforetheendoftheyear.

WeareawarethatthefinancialsectorhaswaitedforsolongtostartofferingIslamicbankingproductsandservices.

Asacentralbank,weassureyouthattheregulatoryframeworkisreceivingactiveattentionandthemarketwillbeinformedoncealltheformalitieshavecompleted.

Ladiesandgentlemen,

althoughtheMuslimCommunityconstitutesonlyanestimated12percentofZambia’spopulation,thecommunityconstituteshighvalue

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businessmenwhocontrolaverysignificantshareoftheZambianeconomyinvarioussectors.

Theirexclusionfromthefinancialsectortherefore,hassignificantimpactontheBankofZambiaeffortsonfinancialinclusion.

YoumaywishtonotethatthemajorityoftheMuslimcommunityshuntheuseofcommercialbanksduetolackofbankingproductsandservicesthatarecomplianttotheirreligiousethosandyettheycontrolasignificantshareofeconomicactivitiesinallthemajorsectors.

TheintroductionofIslamicfinancemayprovideasolutiontoinjectingthemuchneededliquiditycurrentlybeingkeptinhomesonaccountoflackofshariahcompliantbankingproductsandservices.

ItisthefirmbeliefoftheBankofZambiathatarobustregulatoryframeworkwillnotonlyseektoexpandaccess to financebutwillalsohavepositiveeffectsontheoverallinterestratesinthemoneymarketsandultimatelyaffecttherateatwhichfinancingforeconomicactivityisbeingprovided.

Ladiesandgentlemen,

theintroductionofIslamicbanking wouldcomewithits ownchallenges.

ForusatBankofZambia,thisentailsfurtherstrengtheningofoursupervisorycapacity.

Wewouldwelcomethischallengeandhope to risetotheoccasionbyprovidingadequatesupervisoryinfrastructureandasoundenvironmentinwhicheconomicagentscanconducttheirbusinesses.

Ihavenodoubtthatthisworkshopisverytimelyandthatitprovidesauniqueopportunityforparticipants toshareknowledgeandexperiencesonhowbesttopromotefinancialdiversityandinclusivenessespeciallywithregardtoIslamiccommerceandfinance.

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Distinguishedparticipants,onbehalfofBankofZambia,Iwouldlike tothanktheorganizersandpresentersofthisworkshopforrecognizingtheimportantrolethatIslamiccommerceandfinanceplaysinaneconomylike ours.

Itismyhopethatalldelegateswillengagefullyin thesediscussionsand makethemostofthewealthofknowledgegeneratedinthehouse.

Ladiesandgentlemen,Itisnow myhonourandprivilegetodeclaretheIslamicCommerceandFinanceWorkshopofficiallyopen.

ThankYou.

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Supervisionofnon-banksandmicrofinance institutions

RemarksbyDrMichaelGondwe,GovernoroftheBankofZambia,attheopeningceremonyoftheMacroeconomicandFinancialManagementInstituteofEasternandSouthernAfrica(MEFMI)regionalworkshopon“Supervisionofnon-banksandmicrofinanceinstitutions”,Lusaka.

TheMEFMIProgrammeOfficer,DistinguishedResourcePersons,MEFMIStaff,

Participants,

Ladiesandgentlemen,

ItgivesmegreatpleasuretoofficiateatthisworkshoponSupervisionofNon-BankFinancialInstitutionsandMicrofinanceorganisedbytheFinancialSectorManagementProgrammeofMEFMI.

MayItakethisopportunity,onbehalfofMEFMIandonmyownbehalf,towelcomeyoualltothisimportantworkshopand, inparticular,towelcomeyou to Lusaka.

Iurgeyoutomakesometimetovisitandsamplesomeofthebeautifulspotsthatourcityandcountryhastooffer.

IalsowishtowelcomeandthankourdistinguishedresourcepersonsMr.JaphethKattofromCapitalMarketsAuthorityofUganda,Mr.NkosilathiMoyofromWorldVisionhereinZambia,Mrs.RachelMushoshofromtheReserveBankofZimbabweandMr.KagisanyoKelobangfromtheAfricanDevelopmentBank(AfDB)in Tunisforacceptinginvitations topresentatthisworkshopandhopethattheirparticipationwillenrichthedeliberationsofthisworkshopaswellasincreasetheknowledgeoftheparticipants.

Ladiesandgentlemen,

Non-bankfinancialinstitutionsareasignificantcomponentofthefinancialsectorastheirassetsconstituteasignificantproportionofthetotalfinancialsectorassetsinmostcountriesintheregion.

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Similarly,microfinanceinstitutionsplayacriticalroleinpovertyalleviationandeconomicempowermentofmarginalizedcommunitiesinourregion.

Assuchtheseinstitutionsaresystemicallyimportantastheycanexacerbatethefragilityofthefinancialsystemparticularlywherethereislackofeffectiveregulation.

Overthepastfewyears,wehaveseenatrendwheretheseinstitutionshaveincreasedinnumbersin ourregion;somehavebeenestablishedaspartoffinancialconglomerateswhile othersareonastandalonebasis.

Sadly,oursupervisoryandregulatorystructuresforthissector intheMEFMIregionhaveremainedratherincoherentandsomewhatunderdevelopedtohandlethechallengesthathavebeenidentifiedwiththissector.

Thetrendmakesitmoreimportantthaneverforsupervisorsintheregiontogettogetherandtalkaboutmattersofcommoninterest.

Iampleasedtonotethatoverthepastfewyears,theregionhastakenaproactivestancetowardspromotingharmonisationofregulatoryandsupervisoryframeworksandtheintegrationoffinancialsystems.

ThroughMEFMI,SADC,COMESA,theEastAfricanCommunity(EAC)andtheWestAfricanbloc,membercentralbanksareworkingtogethertopromoteeffectivesupervisorystandardsgeared towards achievinglongtermgoalsoffinancialinclusionandfinancialstability.

Ladiesandgentlemen,

Inotewithgratitudethatthisworkshopisdesigned to addresssupervisorystandardsin thenon-bankandmicrofinancesectorthroughthreemainthemes,namely;

regulatorystructures,

internationaltrendsandstandards,and

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iii)integrationofnon-banks intotheformalsector.

Theseareallveryimportantandtopicalissuesandallowmetotalkalittlebitmoreaboutoneofthesethemes– thedevelopmentofregulatorystructures.

First,whilethereisadefiniteroleforinternationalstandardsforregulationofthissector,itisveryimportantthattheyareimplementedinawaythattakes intoaccounttheindividualcircumstancesofeachcountry.

Secondly,thestandardsweadoptshouldintheendnotimpedefinancialsector inclusion.

Weneedtobalancethisinordertoachieveouroverallobjectivewhichisasoundandefficientfinancialsystem.

Ladiesandgentlemen,

Itisimportantnottoassumethatsupervisoryarrangementsshouldbe,orcan be,thesameineverycountry.

Theymustbetailored to theindividualcircumstancesofeachcountry.

Asanexample,whatisappropriateforNamibiamaybetotallyinappropriateforanothercountrylike Uganda,andviceversa.

However,therearelikelytobecommoncharacteristicsthatcutacrossandcanenableusallto learnfromeachother.

Idonotwish toprescribewhatyoushouldtalkaboutthroughoutthisworkshop,butIamhopefulthatwhatIhavementionedabove canformsomediscussionpointsinthedeliberationsofthisworkshop.

Itisalsomydesirethatasyoutravelbacktoyourrespectivecountries,youwouldhavelearntsomethingyou canimplement to improveourrespectivefinancialsystems.

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In conclusion,asfinancialmarketsbecomeincreasinglyglobalised,supervisoryco-operationandharmonisationbecomeincreasinglyimportant.

OrganisationssuchasMEFMIplayanimportantroleindevelopingcapacityintheidentifiedareasofmacroeconomicandfinancialsectormanagement.

Ladiesandgentlemen,

Allow metocommendMEFMIwhichhasbeenintheforefrontof buildingsustainable capacityinfinancialsupervisioninthesub-region.

Ithasshownthe causeforfosteringbestpractices,raisingawarenessand helpingustoimproveourprocessesespeciallyin thisareaoffinancialstabilityintheregionin general.

Finally,IhopethatyouwillfindthisworkshopstimulatingandthatyouwillenjoyyourstayinZambia.

Withtheseremarks,Ideclarethisworkshopofficiallyopen.IThankyou.

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Threequestionsonthenatureandmanagementofrisk

KeynotespeechbyMrNormanTLChan,ChiefExecutiveoftheHongKongMonetaryAuthority,attheHongKongMonetaryAuthority-GlobalAssociationofRiskProfessionals(GARP)GlobalRiskForumOpeningDinner,HongKong.

Richard(Apostolik),LadiesandGentlemen,

1.Itismygreatpleasuretowelcomeyouallto thisdinnergatheringtonight.

Iwouldlike totakethisopportunitytothankGARPforco-hostingtomorrow’sGlobalRiskForumwiththeHongKongMonetaryAuthority.

ThisisthethirdinaseriesofjointforawhichGARPhaveorganisedwithregulators,andfollowssimilareventsin NewYorkandLondon,focusingonrisk andrisk managementfromaglobalperspectivein thewakeoftheGlobalFinancialCrisis.

Incontrasttothetwoprevioushostcities,HongKong(andindeedAsiamoregenerally)hasbeenfortunatenottohavebornethefullbruntoftherecentCrisis.

But,wehavehadourownfairshareofcrisesinthepastand,speakingassomeonewhowastaskedwithtacklingaspectsoftheAsianFinancialCrisisinsomewhatunconventionalways,Icanassureyouthatweareonly“alltoowellaware”ofthesevereeconomicandsocialdisruptionsthatfinancialcrisescan anddo cause.

Hence,wearelikewiseengagedinadegreeof“soulsearching”onthenatureoffinancialrisk andhowitmightbestbemanagedandhowthemanagementofthatrisk mightbestberegulated.

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  • Andwecertainlyhave“bought-in”totheglobalregulatoryreformagendaspurredbytheGlobalFinancialCrisis.

  • ClearlyAsianbankingsystemsandAsianmarketsdonotoperateinisolationfromglobalmarketsandhence,weareall in thistogether!

  • Withthisinmind,Iwouldliketotakethisopportunitytoposeacoupleofquestions,theanswerstowhichwouldhavefundamentalrelevancetothenatureandshapeoftheglobalfinancialsystemgoingforward–

    • Towhatextentisthemainstreamthinking,thatfinancialorsystemicriskscanbeassessedandforecastthroughtheuseofthefinancialmodelsthathavebeendevelopedinthelasttwodecades,stillvalid?

    • Thefinancialmarketshavebecomeverycomplexand,aswenowknow,havegeneratedhugerisksfortheglobalfinancialsystem.

  • Isthecurrentinternationaleffortonregulatoryreformadequateinaddressingtherisksarisingfromthiscomplexity?and

    • TheBasleCommitteeonBankingSupervisionisundertakingmajor reforminupgradingglobalstandardsonthequalityandquantityofthecapital,andintroducingglobalstandardsontheliquiditythatbankshavetoholdin ordertoimprovetheirresiliencetorisksandshocks.

  • Somecountrieshavealreadyimplementedthesestandardsbutsomeadvancedeconomieshavenotyetdoneso.

  • Doesthiscreateanunlevelplayingfieldthatmightcompromisefaircompetitionaswellasthesoundnessofthebankingsystem?

  • Needtorethinkthenatureandmanagementoffinancialrisks?

  • 5.Mainstreamthinking in recentyearshasbeentoseerisk intermsof probabilitiesofeventsthatcanbequantitativelyexpressedandforecastwithstatisticalmodels.

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However,ifwedidnotknowbeforewecertainlyknownow,thatsomeofthesemodelsmakestrongassumptions,suchas“normallydistributedreturns”orothernotsufficientlyfat-taileddistributionassumptions,whichareusuallynotsupportedbyempiricalevidence.

Thesequantitativemodelsunderestimatethelikelihoodofthe“tailevents”andthe amountoflossesthatwouldoccurinsuchevents.

Aswenow know,the highlyimprobableevent,orthe“tailrisk”,hasoccurredalltoofrequentlyandwithhighlydisruptive,ifnotdevastating,impactonfinancialaswellasmacroeconomicstability.

Thishasbeenonthecardsforawhile.

Accordingto theaccountbyRogerLowensteininhisbook“When GeniusFailed”,theill-fatedLongTermCapitalManagement,LTCM, inoneofitsinvestornewslettersbackin1994,suggestedthatitsVaR

analysisshowedthat,“onlyoneyearinfiftyshoulditloseatleast20%of

itsportfolio.”

LTCMalsocalculatedthatlosingallofitscapitalwithinoneyearwasa10-standard-deviationevent.

Thissuggeststhattheprobabilityofsuchaneventoccurringwouldbenomorethanoncein300yearsundereventheveryconservativeassumptions.

ButtheeventhadoccurredwithinfiveyearsofLTCM’sbirth.

Itisnatural,andindeedprobablyinevitable,that, in seekingto predicttheprobabilityofaneventoccurring,wetend to looktopastexperience.

However,aswealldutifullywarninvestorswhenselling investmentproducts,“pastperformanceisnoguaranteeoffutureperformance”andsowemuststandreadytoadmitthattherearefundamentallimitationsinourexistingriskmanagementtools.

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Thatis,thepredictivepowersofmodelsareinherentlyrestrictedbyhistoricalexperience.

Whereweencountersomethingnew,suchasinnovativeproductsorbusinessmodelchangesresulting indifferentformsofconnectednessandcreatingdifferentandnewtransmissionchannels,themodelsfacesignificantdifficultyinaccuratelyestimatingrisk.

Furthermore,evenifonecouldfindbettermodels,anymodelsmustinevitablyassumemarketbehaviourremainsconstanttosomedegree,yetweknowtoowellthatuncertaintyandpanicmayanddoengenderirrationalorherd-like behaviourwhichamodelstrugglestoaccommodate.

So,ifthemodel’sfindings canbe“misguided”,toogreatarelianceonthem,ortoolimitedanunderstandingofwhatthemodelactuallytellsus,mayresultinasignificantmisjudgementofrisk.

Allofthisprompts thequestionofhowfarweshouldreflectontheefficacyofourmethodsforassessing,measuringandmanagingrisksinthefinancialsystem.

Howcanweavoidthetemptation to seemodeloutputastheonlycrystalballforthefuture?

Howcanweequipmanagement,boardmembersandregulatorsandsupervisorstooverlaymodeloutputwithinformedexpertjudgementwhich canlook tosurroundingcircumstances,bemoreforwardlookingandtakeintoaccountpossiblebehaviouralresponsestoevents?

Tomorrowoneofthepanelsessionswillbeonstress-testingandthework inthisareaIthinkoffersasignificantopportunity,bothatthebankandsupervisorylevel,to examineriskand testthe“whatif”scenarioswhichthemodels cannotreach,andto “thinktheunthinkable”.

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Addingcomplexitytothefinancialmarketsandregulation?

Apartfromthewidespreaduseofmodelsinrisk management,thefinancialinnovationofthepasttwodecadesandtheglobalisationofourmarketshavegreatlyincreasedthecomplexityoffinancialmarketsandtheir inter-linkages.

TheGlobalFinancialCrisisdemonstratedalltooclearlythatcertaintypesoffinancialinnovation,resultingintheemergenceofavastvarietyof highlycomplexandopaquefinancialderivativeinstruments(eveniforiginallydesignedtorepackageanddiversifyrisk), in factledto greater,ratherthanless,financialinstabilitythatneitherthefirmsnortheirregulatorsfullyforesaworunderstood.

Toaddresstherisk arisingfromthisincreasingcomplexityin thefinancialsystem,theregulatoryframework has alsobecomemorecomplex.

Forexample,theBaselICapitalAccordhasabout80pagesin total.

ForBaselII,itrunsto333pagesplusanother76pagesforBasel2.5.

AsforBaselIII,insofarasitcovers capital(andnotliquidity),itis562pages(includingasitdoesBaselIIand2.5onthe capitalside).

In theUSA,theDodd-FrankActruns toover800pageswithprobablyinexcessof10,000pagesofsubsidiaryrulesexpectedeventually.

Haven’twehitthelimithereofwhatmightbeconsideredoptimalorindeedsensible?

Shouldwerethinkwhetheraddingcomplexity to theregulatorysystemistheonlyeffectivewayofreducingtherisks ofcomplexityinthefinancialsystem?

Isthereanyroomtoinjectanelementofamoreprinciplebased,commonsense,approachinbankregulationandsupervision?

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Iknowthatthemainproponentsof“LessisMore”,suchasAndyHaldane,arenotheretoday,butIhopetherewillbesomediscussionofthisimportantissueofcomplexityattheForumtomorrow.

Needtoavoidaracetothebottom?

Apartfromreflectingonrisk managementandtheincreasingcomplexityofregulation,Iwouldalsolike to inviteyou to joinmeinrethinkingwhatthebankingindustryisreallyabout.

Tome,bankingisallabouttrustandconfidence.

Ourcitizensentrusttheirhard-earnedsavingstobanksand,asasociety,weallow banks tousedepositors’moneytofundproductiveenterprisesandother investments.

In theory,the safetyandsoundnessofabankshouldbea keyfactorforcustomersinchoosingthebankwithwhichtheywanttoentrusttheirmoney.

Again,intheoryabankwithalarge capitalcushionshould(allthingsbeingequal)haveacompetitiveedgeingainingcustomerconfidenceascomparedtootherbankswithaweakercapitalposition.

Thisbeingthecase,banksshouldhaveanincentive to maintainhighercapitallevels.

However,incentiveshavebecomesomewhatdistortedinmoremoderntimes,thanks to formalsafetynetsextendedbydepositprotectionschemesandinformalsafetynetscharacterisedbyimplicitgovernmentguaranteearisingfromthe“toobigtofail”consideration.

IntherunuptotheGlobalFinancialCrisis,itwascommonforthebigbanks tomaximisetheirReturnonEquity(RoE)byoptimisingtheleveloftheir capitalbaseandbyleveraginguptheirbalancesheets.

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Thisresultedin asteadyreductioninthelevelsofcapital,andasaresultinthelossabsorbancy capability,ofbanks in relationtothesizeoftheriskstakenbythemonandoffbalancesheet.

Evennow,thereisstillaviewamongstsomebanksthattheBaselAccordservesmoretoindicate“optimal”levelsofcapitalorliquidityratherthantheabsolutebareminimumstandard.

Somebanks, includingafewhereinHongKong,havearguedthatthelateadoptionofBaselIIIbysomeadvancedeconomiescreatesorconstitutesanunevenplayingfield,placingtheminacompetitivelydisadvantagedposition.

Itwillbeevenworse,accordingtothebanksadvocatingthislevelplayingargument,iftheirnationalsupervisorimposes capitalorliquidityrequirementsthatexceedtheinternationalstandards.

14.Pillar2oftheBaselAccordwasofcourseintroduced,atleastinpart,todojustthisbyenablingsupervisorstomakeadjustmentsinminimumrequiredlevelsofcapitaltoreflectindividualbankriskprofiles,butevenherewearemetwith“levelplayingfield”arguments – complaintsthatotherjurisdictionsdon’tusePillar2tothesameextent–oratall–andsoweshouldnotusePillar2aggressivelyorelsewewill“damage”or

“ham-string”ourbanks.

Butifthisisthe case,thenifallbanksseek to maximisetheirprofits,bypushingdownor“optimising”theircapitalandliquiditylevelsandtakingonmorerisk–focusedontheBaselstandardastheultimatebenchmark– thendowenotriskthestandardactuallyencouraginga“race to thebottom”?

Isitaracethatmaylead tohigherprofitsorRoEforbanks andtheirshareholdersonlyintheshortterm?

Isitaracethatcouldcreate,inthelongerterm,seriousproblemsforthesafetyandsoundnessofthebanksconcernedandfinancialvulnerabilitiesforsocietyasawhole?

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Idon’tprofesstoknow allthe answers to thequestionsIhavejustraised.

Nomatterwhat,thereisaclearandindisputableneedtoenhancetheresilienceandrobustnessoftheglobalfinancialsystem.

TheBaselCommitteehasdoneagreatdealinupgradingcapitalandliquidityrules.

UnderthedirectionofG20,thereislonglistofotherregulatoryreforms,includingthosedealingwiththemoralhazardproblemarisingfrom“toobigtofail”andtherisksobservedin theOTCderivativemarkets.

Somenationalauthoritieshaveintroduced,orplan tointroduce,measuresthatwouldseparatecoreretailandcommercialbankingfromurgentreforms,therearedifferencesinviewsonwhetherthereformsthatareunderwayareindeedadequateorentirelyappropriate.

Ihopethat,attomorrow’sForum,youwillhavetheopportunity todiscusstheseandotherpertinentissuesaswecontinueseekingto

re-evaluateboththenatureofriskmanagementandtheroleofregulationandsupervisioninthewakeoftheGlobalFinancialCrisis.

OnceagainletmewelcomeyouallandwishyouBonAppétit!

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InvestorProtectionThroughEconomicAnalysis

ByCraigM.Lewis,ChiefEconomistandDirectorDivisionofRisk,Strategy,andFinancial

Innovation,U.S.SecuritiesandExchangeCommission

SpeechatthePennsylvaniaAssociationofPublicEmployeeRetirementSystemsAnnualSpringForumHarrisburg,PA

Thankyousomuchforinvitingmeheretospeakwithyou.

BeforeIbeginmyremarks,ImustmakeclearthattheviewsIexpresstodayareminealoneanddonotnecessarilyreflecttheviewsoftheCommissionorofmycolleaguesontheCommissionStaff.1

ThemissionoftheSEC isbothstraightforwardandbroad:Toprotectinvestors,maintainfair,orderly,andefficient markets,andfacilitatecapitalformation.

Thoughnoneoftheseobjectivesexistsinisolation-andindeed,theyinteractandreinforceeachother-todayIthoughtIwouldfocusonourprimarymissionofprotectinginvestors.

Specifically,Iwouldlike to discusstheroleofeconomicanalysisinfurtheringtheCommission'smissiontoprotectinvestorsandhowthepublic canhelptheCommissioncraftregulationsthateffectivelyaccomplishthatgoal.

EconomicAnalysisinSupportofCommissionRulemaking

TheDivisionofRisk,Strategy,andFinancialInnovation(or"RSFI") supportstheCommissioninavarietyofways,buttheonethatperhapsmostdirectlyimpacts theinvestingpublicistheDivision'sroleinprovidingeconomicanalysisinsupportofCommissionrulemaking.

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AndIbelievethattheeconomicanalysisprovidedbyRSFIisoneoftheessentialelementsofhow theCommissionworks to fulfillitsmissiontoprotectinvestors.

First,somebackground.

WhatdoImean whenIkeepsaying"economicanalysisin supportofrulemaking"?

ForthoseofyouthatareunfamiliarwiththeCommission'srulemakingprocess,orRSFI'sparticularrolein it,whentheCommissionproposesandadoptsrules,ittypicallyanalyzestheeconomiceffectsofthoserules.

ThatanalysisisthenincludedinthepublicreleasesthattheCommissionissueswhenitproposesoradoptsarule.

Ingeneral,theeconomicanalysiscontainedinrulemakingsconsidersthepotentialeconomicconsequencesoftheSEC'spolicy choicesandexaminestheeffectofthosechoicesonthemarket.

OnecleargoalofeconomicanalysisistoensurethattheCommission,whenmakingitsregulatorychoices,isinformedofthepotentialmarketimpactsofthosechoices.

ButasI'venoted,theeconomicanalysisisincludedinareleasethatissharedwiththepublic,thusallowingstakeholders tounderstand-andinthecaseofaruleproposal,commentupon-theeconomicbasesfortheCommission'sdecisions.

Indeed,whentheCommissionproposesrulesforpubliccomment,itoftenasksmanyspecificquestionsintendedtosolicitinformationrelatedtothepotentialeconomiceffectsandanyreasonablealternativeregulatoryapproaches.

Inthesequestions,theCommissionoftenseeksdatathatcanfurtherhelpevaluatetheeconomiceffectsofitsproposedrules.

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ThestaffandtheCommissionwillevaluatethesecommentsandconsiderthemwhendecidingwhatrule to adopt.

TheCommissionalsohas recentlypublishedguidanceonhowitconductseconomicanalysisinsupportofrulemaking.

In Marchoflastyear,RSFIandtheOfficeoftheGeneralCounselcirculatedtotherulewritingDivisionsandOfficesadocumentthatprovidesguidanceonhowtheStaffshouldapproacheconomicanalysis.Colloquiallyreferredto as"TheGuidance"withintheCommission,itlaysoutfourbasicelementsofaneconomicanalysis.

Specifically,arobusteconomicanalysisshouldcontainthefollowingelements:

anidentificationofthejustificationfortheregulatoryaction;

adefinitionofthebaselineagainstwhich tomeasuretheeconomiceffectsofthatregulatoryaction-in otherwords,thecurrentstateoftheworldwithouttheregulation;

anidentificationofreasonablealternativeregulatoryapproaches;and,

anevaluationoftheeconomicconsequencesoftheproposedruleandtheprincipalregulatoryalternatives,includinganevaluationofthebenefitsandcosts.

Iwanttoemphasizethatourapproachtoeconomicanalysistreatscostbenefitanalysisasonlyoneaspectofthefourelementsratherthanasastand-aloneapproach to evaluatingtheeconomiceffectsofarule.

IbelievethesefourbasicelementsofarobusteconomicanalysisalllendthemselvestofurtheringtheCommission'smissiontoprotectinvestors.

Indeed,asIwillexplainlater-afterIletthesuspensebuild-IthinkeachelementaddsauniquedimensiontotheCommission'sconsiderationofinvestorprotection.

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EconomicAnalysisandInvestorProtection

Now,Iamnotalawyer,soIwill notweighin onthespecificlegalrequirementsgoverningCommissionrulemaking,but, in general,CongresshasrequiredthatinmanyrulemakingstheCommissionmustconsider,inadditiontotheprotectionofinvestors,whethertheactionwillpromoteefficiency,competition,and capitalformation.

ItmaybeeasytoseehowtheeconomicanalysisprovidedbyRSFIassiststheCommissioninconsideringwhetheranactionwillpromoteefficiency,competition,and capitalformation;thesearefundamentalconcepts-atleastforeconomists-that canbeanalyzed,evaluated,andinsomecasesquantified.

But,asIhopetoexplain,theCommission'sapproach to economicanalysisalso canplayavitalroleinfulfillingourmissiontoprotectinvestors.

Itisimportant tonoteattheoutsetthatthereisnoclearlinebetweenconsiderationsofefficiency,competition,andcapitalformation,andconsiderationsoftheprotectionofinvestors.

Ibelieve theCommission'sconsiderationofefficiency,competition,andcapitalformationisimportant totheconsiderationofinvestorprotection.

Indeed,rulesthatensureefficientandcompetitivemarketsoftengoalongway to ensuringthatinvestorsareprotected.

Ifrulescreateinefficiencyorhampercompetition,theremaybemoreincentivesoropportunitiesformarketparticipantstoengagein fraudorforcertainfirmstotakeadvantageof investors.

Butifmarketsareoperatinginawaythatmaximizesefficiency,competition,and capitalformation,manyofthesesamevulnerabilitiesmaynotexist.

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In anyevent,IthinktheCommission'sapproachtoeconomicanalysisprovidesahelpfulframeworkthat canfacilitateandexpanduponconsiderationsofinvestorprotection.

Andthisiswherethefourelementsofarobusteconomicanalysiscomein.

AsImentioned,thefirststepinconductinganeconomicanalysisisidentifyingthejustificationfortheregulatoryaction-inshort,whytheruleisneeded.

Sometimes,theneedforregulatoryactionisamarketfailurethatrequirestheCommission'sintervention.

In othercases,theCommissionneedstoengagein rulemakingbecauseCongresshasrequiredittoadoptrulesonaparticulartopic.

And,importantly,thejustificationforaparticularrulemakingalso can berelatedtoinvestorprotection.

Forexample,iftheCommissionbelievesthatinvestorsarevulnerablebecauseofemergingmarketpractices,orifitbelievesthatnewdisclosuresarenecessarytoprovideadditionalprotectiontoinvestors,thesejustificationscouldserveas thebasisforrulemaking.

Theeconomicanalysiswouldexplainwhyinvestorsarevulnerableandwhyaparticularrulemakingwouldhelpaddressthatvulnerability.

ThisexplanationwouldhelpprovideaclearpictureofCommissionviewsaboutneededinvestorprotectionsandwouldallow thepublic,includinginvestors,tocontributetothedecision-makingprocess.

Second,afterwedeterminewhyaregulationisneeded,weneedtodevelopafullunderstandingofthecurrentstateoftheworldintheabsenceofthatregulation,orasweeconomistslike tosay,wedefinethebaseline.

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Thisisacriticalstepbecausethebaselineservesasthebenchmarkagainstwhich to measurethepotentialeconomiceffectsoftherule.

AnimportantaspectofthebaselinediscussionisthatitprovidesthepublicwithinsightintohowtheCommissionviewstheworldasitexistswithouttheproposedregulation.

Thus,thebaselineinaneconomicanalysisisanimportanttooltoexplain,ifrelevant,whatinvestorprotectionsexistandhowmarketscurrentlyoperate.

Thepubliccanthenunderstand,andcommenton,theCommission'sviews tohelpensurethattheCommissionisawareofareaswhereinvestorsbelieveadditionalprotectionsareneeded.

Third,aneconomicanalysisalsoidentifiespotentialreasonablealternativeregulatoryapproachesto achievethegoalwehaveidentified.

Again,thisstepintheeconomicanalysis canhelpensurethattheCommissionisabletofulfillitsmissiontoprotectinvestors.

Forexample,byidentifyingandevaluating potentialalternatives,theCommissionhastheopportunity to grapplewithvaryingapproaches toregulation,someofwhichmayproducegreater investorprotection benefitsthanothers.

Finally,theCommission'seconomicanalysisgenerallyconsiderstheeconomicconsequencesoftheregulatoryactionatissue,includingthebenefitsandcosts.

Oftenthiselementoftheeconomicanalysiscanprovidethemost thoroughdiscussionofinvestorprotection.

Typically,provisionsofaregulationthatfurtherinvestorprotection providebenefitsthattheCommission candescribe.

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Forexample,iftheCommissionbelievesthatcertaindisclosureprovisionswillprovideprotectiontoinvestors,itwillexplainthenatureofthisbenefit.

Then,theCommission cantransparentlyevaluatehow thisinvestorprotectionbenefitcompares to anyassociatedcosts.

Butincertainrulemakings,issuesrelated to investorprotectionalsomayshowupontheothersideoftheledgerasacost.

Forinstance,iftheCommissionisevaluatingaregulatoryapproachthatprovideslessinvestorprotectionthananalternativeproposedbyacommenter,theCommissionmayconsiderthepotentialdecreaseininvestorprotectionasacostoftheregulatoryapproach.

Regardlessofwherethediscussionofinvestorprotectionshowsup,whatisimportantisthataneconomicanalysisallowstheCommissiontoclearlyspelloutbenefits andcostsrelated to investorprotectionsothat thepublic canunderstand,andcommenton,theCommission'schosenapproach.

Ithinkitisimportanttonote,however,thatanalyzingthebenefitsandcostsofaproposedregulation canbecomplicatedandnuanced,especiallyconsideringthatnotallbenefitsandcostscanbequantified.

Forinstance,theCommission cansometimesquantifythenumberofentitiesthatwillbeaffectedbyaproposedruleandperhapsassignadollarcosttothecomplianceburdenthatanewregulatoryapproachwillimposeonthoseentities.

But,withregardtoinvestorprotection,theCommissionisoftenunabletoreasonablyquantifytherelatedbenefitsorcostsfornumerousreasons.

Forexample,theCommissionmaylackdatanecessary to quantifythebenefitsorcostswithprecision,oruncertaintyabouthow investorsorothermarketparticipantswillreactto regulatorychangesmayhinderprecisequantification.

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Additionally,asamoreconcreteexamplethatisrelevant tomanyoftheDodd-Frankrelatedrulesdesignedtoreducesystemicrisk,itmaynotbepossibletocalculatethedegreeofreductioninsystemicrisk that canbeattributed to aspecificrulemaking.

Becauseitisnotalwayspossibletoquantifyimportantinvestorprotection benefitsandcosts,somecommentatorsarguethateconomicanalysismayundervaluethesebenefitsandcosts.

ButtheapproachtoeconomicanalysisIhavedescribedacknowledgesthatnotall benefitsandcosts canbequantified,anditisdesigned toensurethattheevaluationisstillmeaningfulanddoesnotgiveundueimportancetoanyonebenefitorcost.

Specifically,theevaluationofbenefits andcostsalwaysbeginswith developingageneralframeworkthatisentirelyqualitative.

Onlyoncethisframeworkhasbeendevelopeddoestheanalysisprogresstoquantifyingbenefitsandcosts,wherepossible,andevaluatingthebenefitsandcostsoftheproposedregulatoryapproachandreasonablealternatives.

Byfirstdevelopingabroad,qualitativeviewoftheeconomicbenefitsandcostsofaproposedrule,thisapproachplacesthequantifiedbenefitsandcostsintoabroadercontext.

In myview,thishelpspreventanyparticularbenefitorcostfromtakingonunjustifiedsignificance.

Andthepublic can furtherassisttheCommissioninensuringthatitfullyunderstandsandgivesappropriateweighttoinvestorprotectionconcernsbyprovidingcomments.

In particular,Ihopeyoutaketheopportunitytoprovidemoreinformation totheCommissionintherulemakingprocessregardinginvestorprotectionrelatedbenefitsorcostsofproposedrules.

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Quantifyingbenefitsandcosts canbeoneofthemostchallengingaspectsofeconomicanalysis.

Itisnotalways easyfortheCommissiontocollecthelpfuldata,asconstraints,includingthoserelatedtothePaperworkReductionAct,limithow andwhentheCommission cancollectcertaininformation.

Butthesechallengescanbemitigatedwhenwereceivespecificcommentscontainingdataandotherinformationthatclearlydocument thescopeof investorprotectionthat canbeattributedtotherule.

Andifcommentersareunable toprovidequantitativeinformation,providingthorough,descriptive,qualitativeinformationalsocan assistin helpingusunderstandthepotentialeffectsoninvestorprotection.

Moreover,regardlessofwhethercommentersareabletosubmitquantitativeorqualitativedata,itishelpfuliftheyclearlylayout,amongotherthings,thescopeoftheinformationtheyareproviding,themethodologyusedtocollecttheinformation,anyassumptionsunderlyingtheconclusions,andany otherinformationthatwouldassisttheCommissioninevaluatingtheinformationsubmittedinthecomment.

StandardsofConductandotherObligationsofBroker-DealersandInvestmentAdvisers

IthinkrecentCommissionactionrelated to standardsofconductforbroker-dealersandinvestmentadvisershighlightstheimportanceof publiccommentandhow economicanalysisassiststheCommissioninfulfillingitsmissiontoprotectinvestors.

Asyoumayknow,broker-dealersandinvestmentadvisersroutinelyengageinmanysimilaractivitiesrelatedtoprovidingpersonalizedinvestmentadviceaboutsecurities to retailcustomers.

Butthetwo regulatoryschemesthatinvestmentadvisersand broker-dealersaresubject to aredesignedtoprotectretailandothercustomersthroughdifferentapproaches.

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Forexample,investmentadvisersarefiduciariestotheirclientsandtheirregulationundertheInvestmentAdvisersActislargelyprinciples-based.

In contrast,abroker-dealerisnotuniformlyconsideredafiduciarytoitscustomersandbroker-dealerconductissubjecttoregulationundertheSecuritiesExchangeActandtherulesofeachself-regulatoryorganization to whichthebroker-dealerbelongs.

In lightofthesedifferences,Congressmandatedastudyoftheeffectivenessoftheexistinglegalorregulatorystandardsofcarethatapplywhenbroker-dealersandinvestmentadvisersprovidepersonalizedinvestmentadviceandrecommendations aboutsecuritiestoretailcustomers.

In thestudyresultingfromthisCongressionalrequirement,theCommissionstaffrecommendedthattheCommissionengageinrulemakingusingauthorityprovidedintheDodd-FrankActto adoptrulesestablishingauniformfiduciarystandardofconductforallbroker-dealersandinvestmentadviserswhenprovidingpersonalizedinvestmentadviceaboutsecurities to retailcustomers.

TheCommissionhasnotyetdeterminedwhethertocommencea rulemakingasrecommendedbytheCommissionstaff,buthasrecentlypublishedareleaserequestinginformation,andinparticularquantitativedataandeconomicanalysis,relatedtothebenefitsandcoststhatcouldresultfromvariousalternativeapproachesregardingthestandardsofconductandotherobligationsofbroker-dealersandinvestmentadvisers.

Astherequestnotes,theCommissionexpectsthatthisrequesteddataandother informationwillassistindeterminingwhethertoengageinrulemaking,andifso,whatthenatureoftherulemakingoughttobe.

TheCommission'srequestfordataisaprimeexampleofhoweconomicanalysisisakeytoolto furtheritsmission toprotectinvestors.

Forexample,intherequesttheCommissionisseekinginformationtobetterunderstandtherelationbetweenstandardsofconductandtheexperienceofretailcustomers,andinformationrelatedtochangesinthe

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marketplaceforpersonalizedinvestmentadviceforretailcustomersthatmightoccurasaresultofimplementingcertainrules.

Indeed,theCommissionspecificallyisrequestinginformation,data,andcommentontheextenttowhichalternativeregulatoryapproachesaffect investorprotectionandconfusioninvestorshaveaboutthestandardofconductapplicabletotheirfinancialprofessionalswhenprovidingpersonalizedinvestmentadviceaboutsecurities.

Thedataandeconomicanalysisthatthe Commissionreceives inresponsetoitsrequestwillbehelpfulasitdetermineswhetherandhowtoengagein rulemaking in thisspace.

IftheCommissiondoesdecide to goforwardwitharulemaking,theinformationsubmittedthroughpubliccommentcouldalsoassisttheCommissioninpreparingitsowneconomicanalysis.

Forexample,thedatasubmittedbycommenterscouldidentifythatthereisaneedforregulatoryactionrelatedtoinvestorprotectionandthusinvestorprotectioncanserveasajustificationforarulemaking.

Additionally,commenterscouldassistininformingtheCommissionaboutthecurrentpracticesofretailinvestorsandifthereareparticularvulnerabilitiesthatexistinthemarkets.

And,ofcourse,theinformationthatcommentersmaypotentiallysubmitaboutthebenefitsandcostsofalternativeregulatoryapproachesmaybehelpfulto evaluatethepotentialinvestorprotectionrelatedbenefitsandcoststhatdifferentregulatoryapproachesmayimpose.

Thisrequestforcommentalsoillustratesthedifficulty theCommissionoftenfacesquantifyingcertainbenefits andcoststhatIdiscussedearlier.

In particular,intherequesttheCommissionexpresslyrecognizesthatretailcustomersareunlikelytohavesignificantempiricaland quantitativeinformation.

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Butthefactthatretailcustomersmaynothavesignificantquantitativeinformationshouldnotstopusfromaskingthequestionsanditdoesnotpreventapotentialeconomicanalysisfromevaluating,qualitatively,theinvestorprotectionbenefitsthatmaybehighlightedbythesecustomers.

Indeed,thequalitativeinformationprovidedcanbevitaltotheCommission'sunderstandingofthemarketandtheeffectsoftheCommission'sregulatorydecisions.

ConcludingThoughts

Inconclusion,IhopeIhavemadeclearwhyIconsidereconomicanalysisanessentialpartofSEC rulemaking.

Itseekstoensurethatdecisions to proposeandadoptrulesare informedbythebestavailableinformation aboutarule'seconomicconsequences.

Andbyensuringthatrulemakingsareinformedbyinformation abouttheeconomicconsequencesofCommissionaction,economicanalysisfurtherstheCommission'smissiontomaintainfair,orderly,andefficientmarkets,tofacilitatecapitalformation,and,asIhavefocusedontoday,toprotectinvestors.

EconomicanalysisinCommissionrulemakingsalsofacilitatestheCommission'sefforts to determinethemostappropriateregulatoryapproach,byhelpingtheCommissionmeaningfullycompareaproposedactionwithreasonablealternatives,includingthealternativeofnotadoptingarule.

Thismaybethemostimportantwaythateconomicanalysisfacilitatesinvestorprotection.

Indeed, inmyopinion,aregulatoryapproachthatiswell-craftedandischoseninlightofthesignificantpotentialeconomicconsequencesoftheregulationandcompetingalternativesisthebestwaytoprotectinvestors.

Whereregulationsoperateeffectivelyandtakeintoaccountexistingeconomicrealities,investorswillnotfacethesamevulnerabilitiesthat

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mayarisefromaregulatoryapproachthatignorestheseeconomicrealities.

Iwanttothankyouagainfor invitingmeheretospeakwithyoutodayandIlookforwardtotakingyourquestions.

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CompanieslikeIBM, Accentureetc.consider the CRCMPapreferredcertificate.Youmayfindmoreifyousearch(CRCMPpreferred certificate) usinganysearchengine.

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D.TheDoddFrankActandthenewRiskManagementStandards(976slides,includedinthe3285slides)

TheUSDodd-Frank WallStreet Reform andConsumerProtectionAct isthe mostsignificant pieceoflegislation concerning thefinancialservicesindustryinabout80years.

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Thebillestablishesnewrisk managementandcorporategovernance principles,setsupanearly warning

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