Risk management presentation May 20 2013

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International Association of Risk and Compliance
Professionals (IARCP)
1200 G Street NW Suite 800 Washington, DC 20005-6705 USA
Tel: 202-449-9750 www.risk-compliance-association.com
Top 10 risk and compliance management related news stories
and world events that (for better or for worse) shaped the
week's agenda, and what is next
Dear Member,
Whichisthe differencebetween triggersand
vulnerabilities?
Dear Mr Bernanke, can you clarifyplease?
He did, at the 49thAnnual Conferenceon Bank Structure and
Competition sponsored by theFederal Reserve Bank of
Chicago, Chicago, Illinois
He said:
―Torespond tothispoint, I will distinguish, asI haveelsewhere,between
triggersand vulnerabilities.
Thetriggers of anycrisis aretheparticular eventsthat touch off the
crisis--theproximatecauses, if you will.
For the2007-09crisis,a prominent trigger wasthe lossessufferedby
holdersof subprime mortgages.
In contrast, the vulnerabilities associated with a crisis are preexisting
features of the financial system that amplify and propagate the initial
shocks.
International Association of Risk and Compliance Professionals (IARCP)
www.risk-compliance-association.com

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Examplesof vulnerabilitiesincludehigh levelsof leverage, maturity
transformation,interconnectedness, andcomplexity, all ofwhichhavethe
potential tomagnify shocksto the financial system.
Absent vulnerabilities,triggersmight produce sizablelossestocertain
firms, investors,orassetclassesbut wouldgenerallynot leadtofull-blown
financial crises;thecollapseof the relativelysmall market for subprime
mortgages,for example, wouldnot havebeen nearly asconsequential
without preexistingfragilitiesin securitizationpracticesand short-term
fundingmarketswhichgreatly increased its impact.‖
Did you addressvulnerabilitiesthis week?
Mr Bernanke continued:
―Moreover, attemptsto addressspecific vulnerabilitiescan be
supplementedby broader measures--suchasrequiring banksto hold
more capital and liquidity--that makethesystem more resilient toarange
of shocks.‖
Read moreat Number 1below.
Welcometo the Top 10list.
BestRegards,
GeorgeLekatis
President of the IARCP
General Manager, ComplianceLLC
1200G Street NW Suite800,
Washington DC 20005,USA
Tel: (202) 449-9750
Email: lekatis@risk-compliance-association.com
Web: www.risk-compliance-association.com
HQ: 1220N. Market Street Suite
804,Wilmington DE 19801,USA
Tel: (302) 342-8828

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ChairmanBen S.Bernanke
At the 49thAnnual Conferenceon Bank Structure and
Competition sponsored by theFederal Reserve Bank
of Chicago, Chicago, Illinois
Monitoring the Financial System
―We are now more than four years beyond themost intensephaseof the
financial crisis,but itslegacyremains.
Our economy hasnot yet fullyregained the jobslost in the recession that
accompaniedthe financial near collapse.
And our financial system--despite significant healing over the past four
years--continues to struggle with the economic, legal, and reputational
consequencesof theeventsof 2007to2009.‖
Erkki Liikanen
Banking structure and monetary policy –
what have we learned in the last 20 years?
Presentation by Mr Erkki Liikanen, Governor of
theBank of Finland and Chairman of the
Highlevel Expert Group on the structure of the
EU banking sector, at the conference―Twenty
years of transition – experiencesand challenges‖,arranged by the
National Bank of Slovakia, Bratislava.

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The impact of the crisison financial integration
in Central and Eastern Europe
Speechby Mr IgnazioVisco, Governor of theBank of
Italy, at the conference―Twentyyears
of transition – experiencesand challenges‖, hostedby
theNational Bank of Slovakia, Bratislava
―Thetransitioncountriesof Central and Eastern Europe wereno
exception:their quiterapid financial integration over thepast
twenty-yearsbrought about lastingeconomicbenefits,but alsoleft them
relativelyexposedtothe global financial turmoil, in particular through
their linkswithWestern European bankswhichhold dominant stakesin
theregion‘smarkets.‖
Revised rulesfor markets in financial
instruments (MiFID/ MiFIR)
a)Proposal for a Directiveof the European
Parliament and of theCouncil on marketsin financial instruments
repealingDirective2004/ 39/ EC of the
European Parliament and of the Council (Recast) (MiFID)
b)Proposal for a Regulation of the European Parliament and of the
Councilon marketsin financial instrumentsand amending Regulation
[EM IR] onOTC derivatives,centralcounterpartiesandtraderepositories
(MiFIR)

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APRA releasessecond
consultation package for the
supervision of conglomerate groups
TheAustralian Prudential RegulationAuthority (APRA) hasreleased for
consultationproposed risk management and capital adequacy
requirementsfor thesupervision of conglomerategroups.
Conglomerategroups, referredto asLevel 3 groups,are groups
comprisingAPRA-regulated institutionsthat perform material activities
acrossmore thanoneAPRA-regulated industry and/ orin oneor more
non-APRA-regulated industry.
GovernorElizabethA. Duke
At the Housing PolicyExecutive
Council, Washington, D.C.
AView from the Federal Reserve Board:
The Mortgage Market and Housing
Conditions
―Sincejoiningthe Board in 2008amid a crisiscentered on mortgage
lending, I have focusedmuch of my attentionon housingand mortgage
markets,issuessurrounding foreclosures,and neighborhood
stabilization.
In Marchof this year, I laid out my thoughtson current conditionsin the
housing and mortgagemarketsin a speechto theMortgageBankers
Association.‖

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TheNeedfor Robust SEC Oversight of SROs
By CommissionerLuisA. Aguilar
U.S. Securitiesand ExchangeCommission
Washington, D.C.
Proposal for a structural
reform of EU banks
―There are concernsthat largeEU banking groups, are difficult to
manage, monitor, and supervise.
Furthermore, theymay alsobe difficult to resolve, due to their
complexity, interconnectedness, geographic scope, and abilityto expand
rapidly.
Also, theunrestricted co-minglingof depositssubject to government
guaranteeswith market and tradingactivitiesmay subject depositorsto
additional risks.‖

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APRA releasessecond consultation
package on Basel III liquidity reforms
TheAustralian Prudential RegulationAuthority (APRA) hastoday
releaseda second consultationpackageoutliningits proposed
implementationof theBasel III liquidityreformsfor authorised
deposit-takinginstitutions(ADIs) inAustralia.
Thepackage includesa discussionpaper, a reviseddraft Prudential
StandardAPS210Liquidity(APS210) and a draft Prudential Practice
GuideAPG 210Liquidity.
OTC derivatives statisticsat end-December
2012
Monetary and Economic Department
May 2013
―Notional amounts for interest rate derivatives, the
largest segment of the market, stood at $490 trillion
at end-2012.
While the overall figure wasmore or lessunchanged from end-June
2012,breakdownsshowedoffsettingmovements.
For swaps,notional amountsdropped in thesecond half of 2012by about
2% to$370trillion, owingin part to the compressionof tradesthrough
central counterparties(CCPs).‖

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ChairmanBen S.Bernanke
At the 49thAnnual Conferenceon Bank Structure and
Competition sponsored by theFederal Reserve Bank
of Chicago, Chicago, Illinois
Monitoring the Financial System
We are now more than four yearsbeyond the most intensephaseof the
financial crisis,but itslegacyremains.
Our economy hasnot yet fullyregained the jobslost in the recession that
accompaniedthe financial near collapse.
And our financial system--despite significant healing over the past four
years--continues to struggle with the economic, legal, and reputational
consequencesof theeventsof 2007to2009.
Thecrisisalsoengenderedmajor shifts in financial regulatorypolicyand
practice.
Not sincetheGreat Depression have weseen suchextensivechangesin
financial regulationasthose codifiedin the Dodd-Frank Wall Street
Reform and Consumer ProtectionAct (Dodd-FrankAct) in theUnited
Statesand, internationally, in theBasel III Accord and a rangeof other
initiatives.
Thisnewregulatoryframeworkisstill underconstruction, but theFederal
Reservehasalreadymade significant changestohow it conceptualizes
and carries out both itsregulatoryand supervisoryroleand its
responsibilityto foster financial stability.
In my remarkstoday I will discusstheFederal Reserve's effortsin an
areathat typicallygetslessattentionthanthewritingandimplementation
of new rules--namely, our ongoing monitoring of thefinancial system.

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Of course,the Fed hasalwayspaid closeattentiontofinancial
markets,for both regulatory and monetary policy purposes.
However,in recent years, wehavebothgreatlyincreasedtheresourceswe
devotetomonitoring and taken a more systematic and intensive
approach,ledbyourOffice ofFinancialStabilityPolicy andResearchand
drawingonsubstantial resourcesfrom acrosstheFederalReserveSystem.
This monitoring informs the policy decisions of both the Federal Reserve
Board and the Federal Open Market Committee as well as our work with
other agencies.
Thestep-up in our monitoring is motivatedimportantlybya shift in
financial regulationand supervisiontoward a more macroprudential, or
systemic, approach, supplementingour traditional microprudential
perspectivefocused primarily on thehealth of individual institutionsand
markets.
In thespirit of thismore systemic approachtooversight, theDodd-Frank
Act created the Financial Stability Oversight Council (FSOC), whichis
comprised of theheadsof a number of federal and state regulatory
agencies.
TheFSOC hasfostered greater interactionamong financial regulatory
agenciesaswell asa senseof common responsibilityfor overall financial
stability.
Councilmembersregularlydiscussriskstofinancial stability andproduce
an annual report, whichreviewspotential risksand recommendsways to
mitigatethem.
TheFederal Reserve's broad-based monitoring effortshave been
essential for promotinga closeand well-informedcollaborationwith
other FSOC members.

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AFocus on Vulnerabilities
Ongoingmonitoringof the financial system isvital to the
macroprudential approach to regulation.
Systemic riskscan onlybe defused if theyare first identified.
That said, it is reasonable to ask whether systemic risks can in fact be
reliably identified in advance; after all, neither the Federal Reserve nor
economistsin general predicted the past crisis.
Torespond tothis point, I will distinguish, asI have elsewhere,between
triggersand vulnerabilities.
Thetriggers of anycrisis aretheparticular eventsthat touch off the
crisis--theproximatecauses, if you will.
For the2007-09crisis,a prominent trigger wasthe lossessufferedby
holdersof subprime mortgages.
In contrast, the vulnerabilities associated with a crisis are preexisting
features of the financial system that amplify and propagate the initial
shocks.
Examplesof vulnerabilitiesincludehigh levelsof leverage, maturity
transformation,interconnectedness, andcomplexity, all ofwhichhavethe
potential tomagnify shocksto the financial system.
Absent vulnerabilities,triggersmight produce sizablelossestocertain
firms, investors,orassetclassesbut wouldgenerallynot leadtofull-blown
financial crises;thecollapseof the relativelysmall market for subprime
mortgages,for example, wouldnot havebeen nearly asconsequential
without preexistingfragilitiesin securitizationpracticesand short-term
fundingmarketswhichgreatly increased its impact.
Of course, monitoring can and doesattempt to identify potential
triggers--indicationsof an asset bubble, for example--but shocks of one
kind or another are inevitable,soidentifying and addressing

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vulnerabilitiesis keyto ensuringthat thefinancial system overall is
robust.
Moreover,attempts toaddressspecific vulnerabilitiescan be
supplementedby broader measures--suchasrequiring banksto hold
more capital and liquidity--that makethesystem more resilient toarange
of shocks.
Twoother related pointsmotivate our increasedmonitoring.
Thefirst isthat the financial system is dynamic and evolving not only
becauseof innovation and the changingneedsof the economy, but also
becausefinancial activitiestend to migrate from more-regulatedto
less-regulatedsectors.
An innovativefeatureof the Dodd-FrankAct isthat it includes
mechanismsto permit the regulatorysystem, at leastin some
circumstances, to adapt tosuchchanges.
For example, theact givesthe FSOC powerstodesignatesystemically
important institutions,market utilities,and activitiesfor additional
oversight.
Such designationisessentiallya determinationthat an institutionor
activitycreatesor exacerbatesa vulnerability of thefinancial system, a
determinationthat canonlybemadewithcomprehensivemonitoring and
analysis.
Thesecond motivation for more intensivemonitoring is the apparent
tendencyfor financial market participantsto take greater riskswhen
macro conditionsare relatively stable.
Indeed, it may be that prolonged economic stability isa double-edged
sword.
Tobe sure, a favorableoverall environment reducescredit riskand
strengthensbalancesheets,all elsebeingequal, but it could alsoreduce

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theincentivesfor market participantsto take reasonable
precautions,which may lead in turn toa buildup of financial
vulnerabilities.
Probablyour best defenseagainst complacencyduring extendedperiods
of calm is careful monitoring for signsof emergingvulnerabilities
and, whereappropriate,the development of macroprudential and other
policytoolsthat can be used to addressthem.
TheFederal Reserve's Financial StabilityMonitoring Program
So, what specificallydoesthe Federal Reserve monitor?
In the remainderof my remarks, I'll highlight and discussfour
componentsof the financial system that are among thosewefollowmost
closely: systemicallyimportant financial institutions(SIFIs), shadow
banking, asset markets, and thenonfinancial sector.
Systemically Important Financial Institutions
SIFIs are financial firms whosedistressor failure hasthepotential to
createbroaderfinancialinstabilitysufficient toinflict meaningful damage
on thereal economy.
SIFIs tend tobe large, but sizeisnot theonlyfactor used to determine
whethera firm is systemically important; other factorsincludethefirm's
interconnectednesswith the rest of the financial system, the complexity
and opacityof itsoperations, thenature and extent of itsrisk-taking, its
useof leverage, its reliance on short-term wholesalefunding, and the
extent of its cross-border operations.
Under the Dodd-Frank Act, the largest bank holding companies are
treatedasSIFIs; in addition, asI mentioned, theact givestheFSOC the
powertodesignate individual nonbank financial companiesas
systemicallyimportant.
This designationprocessis under way.
Dodd-Frank alsoestablishesa framework for subjectingSIFIsto
comprehensivesupervisoryoversight andenhancedprudential standards.

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For all such companies, the Federal Reserve will have accessto
confidential supervisoryinformation and will monitorstandard indicators
such asregulatory capital, leverage, and fundingmix.
However,some of thesemeasures, such asregulatory capital ratios, tend
tobe backward lookingand thusmay be slow to flagunexpected, rapid
changesin the condition of a firm.
Accordingly, wesupplement the more standard measureswithother
typesof information.
Onevaluablesourceof supplementaryinformation is stresstesting.
Regular, comprehensivestresstestsare an increasinglyimportant
component oftheFederalReserve'ssupervisorytoolkit, havingbeenused
in our assessment of largebank holdingcompanies since2009.
Toadminister a stresstest, supervisorsfirstconstruct a hypothetical
scenario that assumesa set of highly adverseeconomicand financial
developments--for example, a deep recessioncombined withsharp
declinesin thepricesof housesand other assets.
Thetestedfirmsandtheir supervisorsthenindependentlyestimatefirms'
projectedlosses, revenues,and capital under the hypothetical
scenario, and the resultsare publicly disclosed.
Firms are evaluatedboth on their post-stresscapital levelsand on their
abilityto analyze their exposuresand capital needs.
Stresstestingprovidesa number of advantagesover more-standard
approachestoassessingcapital adequacy.
First, measuresof capital based on stresstestsare both more forward
lookingand more robust to"tail risk"--that is,toextremelyadverse
developmentsof the sort most likely tofoster broad-basedfinancial
instability.

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Second, becausetheFederalReserveconductsstresstestssimultaneously
on themajor institutionsit supervises, theresultscan be used both for
comparativeanalysesacrossfirmsand tojudge thecollective
susceptibilityof major financial institutionstocertaintypes of shocks.
Indeed, comparativereviewsof largefinancial institutionshave become
an increasinglyimportant part of the Federal Reserve's supervisory
toolkit more generally.
Third, the disclosureof stress-testresults,whichincreasedinvestor
confidenceduring the crisis, can alsostrengthen market disciplinein
normal times.
Thestressteststhusprovidecritical informationabout keyfinancial
institutionswhile alsoforcing thefirms toimprovetheir abilityto
measure and managetheir risk exposures.
Stress-testingtechniquescan alsobeused in more-focusedassessments
of thebankingsector's vulnerability tospecificrisksnot captured in the
main scenario, such asliquidityrisk or interest rate risk.
Like comprehensivestresstests, such focused exercisesare an important
element of our supervisionof SIFIs.
For example, supervisors are collecting detailed data on liquidity that
help them compare firms' susceptibilities to various types of funding
stressesand toevaluate firms' strategiesfor managingtheir liquidity.
Supervisorsalsoareworking with firms toassesshow profitability and
capital wouldfare under variousstressful interestrate scenarios.
Federal Reserve staff members supplement supervisoryand stress-test
information with other measures.
For example, though supervisorshave long appreciated thevalue of
market-basedindicatorsin evaluatingtheconditionsof systemically
important firms(or, indeed, any publicly traded firm), our monitoring

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program usesmarket information toa much greater degreethan in the
past.
Thus, in addition tostandard indicators--suchasstock pricesand the
pricesof credit default swaps,whichcapture market viewsabout
individual firms--weuse market-basedmeasuresof systemic stability
derivedfrom recent research.
Thesemeasuresusecorrelationsof asset pricestocapture themarket's
perceptionof agivenfirm'spotential todestabilize thefinancialsystem at
a timewhenthebroader financial marketsare stressed; other measures
estimatethe vulnerability of a given firm to disturbancesemanatingfrom
elsewherein the system.
Thefurther development of market-based measuresof systemic
vulnerabilitiesand systemic riskis a lively area of research.
Networkanalysis, yet another promisingtool under active
development, hasthepotential tohelp usbetter monitor the
interconnectednessof financial institutionsand markets.
Interconnectednesscan arisefrom common holdingsof assetsor through
theexposures of firms to their counterparties.
Networkmeasuresrely on conceptsused in
engineering, communications,and neurosciencetomap linkages
among financial firmsand market activities.
Thegoalsare toidentify keynodesor clustersthat could destabilizethe
system andtosimulatehowashock, suchasthesuddendistressofa
firm, could be transmitted and amplified through the network.
Thesetoolscan alsobe usedtoanalyze the systemic stabilityeffects of a
changein thestructure of a network.
For example, margin rules affect the sensitivity of firms to the conditions
of their counterparties; thus, margin rulesaffect the likelihood of financial
contagion through various firms and markets.

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Shadow Banking
Shadowbanking, a second area wecloselymonitor, wasan important
sourceof instability during the crisis.
Shadowbanking comprisesvariousmarketsand institutionsthat provide
financial intermediationoutsidethetraditional, regulated banking
system.
Shadowbanking includesvehiclesfor credit intermediation, maturity
transformation, liquidityprovision, and risksharing.
Such vehiclesaretypicallyfunded on a largely short-term basisfrom
wholesalesources.
In the run-up to the crisis, theshadowbankingsector involved a high
degreeof maturitytransformation and leverage.
Illiquid loanstohouseholdsand businessesweresecuritized, and the
tranchesof thesecuritizationswith thehighestcredit ratingswerefunded
byvery short-termdebt, such asasset-backedcommercial paper and
repurchaseagreements(repos).
Theshort-term fundingwasin turn provided by institutions,such as
moneymarket funds, whoseinvestorsexpected payment in full on
demand and had littletolerance for risk toprincipal.
As it turned out, theultimateinvestorsdid not fullyunderstand the
qualityof theassetsthey werefinancing.
Investorswerelulledby triple-Acredit ratingsand by expected support
from sponsoring institutions--support that was, in fact, discretionaryand
not alwaysprovided.
When investorslostconfidencein the qualityof the assetsor in the
institutionsexpected to provide support, theyran.

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Their flight createdseriousfunding pressuresthroughout thefinancial
system, threatenedthesolvency of many firms, and inflictedserious
damageon thebroader economy.
Securitiesbroker-dealersplay a central role in many aspectsof shadow
bankingasfacilitatorsof market-basedintermediation.
To finance their own and their clients' securities holdings, broker-dealers
tend to rely on short-term collateralized funding, often in the form of repo
agreementswithhighly risk-averselenders.
Thecrisisrevealed that thisfundingis potentiallyquitefragile if lenders
havelimitedcapacityto analyze the collateral or counterpartyrisks
associated withshort-term secured lending, but rather look at these
transactionsasnearlyrisk free.
As questionsemerged about the nature and value of collateral, worried
lenderseithergreatlyincreasedmargin requirementsor,more
commonly, pulledback entirely.
Borrowersunableto meet margin callsand financetheir asset holdings
wereforced to sell, drivingdown asset pricesfurther and settingoff a
cycle of deleveragingand further asset liquidation.
Tomonitorintermediationbybroker-dealers,theFederalReservein 2010
created a quarterlySenior Credit Officer OpinionSurvey on Dealer
FinancingTerms,whichasksdealersabout thecredit theyprovide.
Modeledon the long-established Senior Loan Officer Opinion Survey on
Bank LendingPracticessent to commercial banks,the survey of senior
credit officers at dealerstracks conditionsin marketssuch asthosefor
securitiesfinancing, prime brokerage, and derivativestrading.
Thecredit officer survey isdesigned to monitor potential vulnerabilities
stemmingfrom thegreater use of leverageby investors(particularly
through lendingbacked by less-liquid collateral) or increasedvolumesof
maturitytransformation.

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Beforethefinancialcrisis, wehad onlyverylimitedinformationregarding
such trends.
We have other potential sourcesof informationabout shadow banking.
TheTreasuryDepartment's Officeof Financial Research and Federal
Reservestaff are collaboratingto construct data setson triparty and
bilateral repotransactions,which should facilitatethedevelopment of
better monitoring metrics for repoactivityand improvetransparencyin
thesemarkets.
We alsotalk regularlyto market participantsabout developments,paying
particular attention tothe creationof new financial vehiclesthat foster
greater maturity transformation outsidethe regulatedsector, provide
fundingfor less-liquid assets,or transform risksfrom formsthat are more
easilymeasuredtoforms that are more opaque.
Afair summary isthat, while the shadow banking sector is smaller today
than beforethecrisisand some of its least stablecomponentshave either
disappeared or been reformed, regulatorsand theprivatesector need to
addressremainingvulnerabilities.
For example, although money market fundswerestrengthenedby
reforms undertakenby the Securitiesand ExchangeCommission (SEC)
in 2010,thepossibilityof a run on thesefundsremains--forinstance, if a
fund should "break thebuck," or report a net asset value below99.5
cents, astheReservePrimary Fund did in 2008.
Theriskisincreasedbythefactthat theTreasurynolongerhasthepower
toguarantee investors' holdingsin money funds, an authoritythat was
critical for stoppingthe 2008run.
In November 2012, the FSOC proposed for public comment some
alternativeapproachesfor the reform of money funds.
TheSEC iscurrentlyconsideringtheseand other possiblesteps.
With respect to thetripartyrepoplatform, progresshasbeen made in
reducingthe amount of intradaycredit extendedbytheclearingbanks in

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thecourse of the dailysettlement process,and, asadditional
enhancementsare made, the extension of such credit should be largely
eliminated by the end of 2014.
However,important risks remain in theshort-term wholesalefunding
markets.
Oneof the keyrisksis how the system wouldrespond to the failure of a
broker-dealer or other major borrower.
TheDodd-Frank Act hasprovidedimportant additional toolstodeal with
thisvulnerability, notablytheprovisionsthat facilitatean orderly
resolutionof a broker-dealeror a broker-dealer holding companywhose
imminent failure posesa systemic risk.
But, ashighlightedin the FSOC'smost recent annual report, more work
isneededtobetterprepareinvestorsandothermarket participantstodeal
with the potential consequencesof a default by a largeparticipant in the
repo market.
Asset Markets
Asset marketsare a third area that wecloselymonitor.
We followdevelopmentsin marketsfor a widerangeof assets, including
public and private fixed-incomeinstruments,corporateequities, real
estate,commodities,and structured credit products,amongothers.
Foreign as well as domestic markets receive close attention, as do global
linkages, such as the effects of the ongoing European fiscal and banking
problemson U.S.markets.
Not surprisingly, wetry toidentifyunusual patternsin valuations,such
ashistoricallyhigh or low ratios of pricesto earningsin equitymarkets.
We usea varietyof modelsand methods;for example, weuseempirical
modelsof default risk and risk premiumsto analyze credit spreadsin
corporatebond markets.

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Theseassessmentsare complementedby other information, including
measuresof volumes, liquidity, and market functioning, aswell as
intelligencegleanedfrom market participantsand outsideanalysts.
In light of the current lowinterest rate environment, wearewatching
particularlycloselyfor instancesof "reaching for yield" and other forms
of excessiverisk-taking, whichmay affect asset pricesand their
relationshipswithfundamentals.
It is worthemphasizingthat lookingfor historicallyunusual patternsor
relationshipsin asset pricescan be useful even if you believe that asset
marketsare generallyefficient in setting prices.
For thepurposeof safeguarding financial stability, weare lessconcerned
about whether a given asset price isjustified in some averagesensethan
in thepossibilityof a sharpmove.
Asset pricesthat arefar from historicallynormal levelswouldseem tobe
more susceptibletosuch destabilizingmoves.
From a financial stability perspective, however, theassessment of asset
valuationsis onlythefirst step of theanalysis.
Also to be considered are factorssuchasthe leverageand degree of
maturitymismatch beingusedby theholdersof the asset, the liquidityof
theasset, and the sensitivityof the asset'svaluetochangesin broad
financial conditions.
Differencesin thesefactorshelp explainwhythecorrection in equity
marketsin 2000and2001didnot inducewidespreadsystemic
disruptions,while the collapsein housepricesand in thequalityof
mortgagecredit during the2007-09crisis had much more far-reaching
effects:
Thelossesfrom thestockmarket declinesin 2000and 2001werewidely
diffused, while mortgagelosseswereconcentrated--and, through various
financial instruments,amplified--incriticalparts of the financial
system, resultingultimatelyin panic, asset fire sales,and the collapseof
credit
markets.

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Nonfinancial Sector
Our financial stabilitymonitoring extendsto thenonfinancial
sector, includinghouseholdsand businesses.
Researchhasidentified excessivegrowthin credit and leveragein the
privatenonfinancial sector aspotential indicatorsof systemic risk.
Highlyleveragedorfinanciallyfragile householdsandbusinessesare less
ableto withstand adversechangesin incomeor wealth, includingthose
brought about bydeterioratingconditionsin financialandcredit markets.
Ahighly leveraged economy isalsomore pronetoso-calledfinancial
acceleratoreffects,aswhenfinanciallystressed firms are forced to layoff
workerswho, in turn, lackingfinancial reserves,sharplycut their own
spending.
Financial stressin the nonfinancial sector--for example, higher default
rateson mortgagesor corporatedebt--canalsodamage financial
institutions,creatinga potential adversefeedback loop astheyreducethe
availability of credit and shed assetsto conserve capital, therebyfurther
weakeningthefinancial positionsof householdsand firms.
The vulnerabilities of the nonfinancial sector can potentially be captured
by both stock measures (such as wealth and leverage) and flow measures
(such asthe ratio of debt serviceto income).
Sector-widedata are available from a number of sources,importantlythe
Federal Reserve'sflowof fundsaccounts,whichis a set of aggregate
integratedfinancial accountsthat measuressourcesand usesof fundsfor
major sectorsaswell asfor the economy asa whole.
Theseaccountsallowustotrace the flow of credit from itssources,such
asbanks or wholesalefundingmarkets,tothehousehold and business
sectorsthat receiveit.
TheFederal Reservealsonowmonitorsdetailed consumer- and
business-leveldata suitedfor pickingup changesin the nature of

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borrowingand lending, aswell asfor trackingfinancial conditionsof
thosemost exposedtoa cyclical downturnor a reversal of fortunes.
For example, duringthehousing boom, the aggregate data accurately
showedthe outsized pace of home mortgageborrowing, but it could not
reveal the pervasivedeterioration in underwritingthat implied a
substantial increasein the underlying credit riskfrom that activity.
Morerecently, gainsin household net worthhave been concentrated
amongwealthier households, whilemany householdsin themiddleor
lowerpartsof the distribution have experienceddeclinesin wealthsince
thecrisis.
Moreover,many homeownersremain "underwater," with their homes
worthlessthan theprincipal balanceson their mortgages.
Thus, more detailed information clarifiesthat many householdsremain
more financiallyfragile than might be inferred from theaggregate
statistics alone.
Conclusion
In closing, let me reiteratethat while the effectiveregulation and
supervision of individual financial institutionswill alwaysbe crucial to
ensuring a well-functioningfinancial system, the Federal Reserve is
movingtowardamoresystemic approachthat alsopayscloseattentionto
thevulnerabilitiesof thefinancial system asa whole.
Towardthat end, weare pursuing an activeprogram of financial
monitoring, supportedby expanded researchand data collection, often
undertaken in conjunction with other U.S.financial regulatoryagencies.
Our stepped-up monitoring and analysisis alreadyprovidingimportant
information for the Board and the Federal Open Market Committeeas
well asfor thebroader regulatory community.
We will continue to worktoward improving our ability to detect and
addressvulnerabilitiesin our financial system.

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Erkki Liikanen: Banking structure
and monetary policy – what have
we learned in the last 20 years?
Presentation by Mr Erkki
Liikanen, Governor of the Bank of
Finland and Chairman of the
Highlevel Expert Group on the
structure of the EU banking
sector, at the conference―Twenty
years of transition –
experiencesand challenges‖,arranged bytheNational Bank of
Slovakia, Bratislava.
How is today‘s perspectiveon monetarypolicy different from what
prevailed 20 years ago?
Twentyyears ago, the worldof todaywasbeingformed in manyways.
1993wasthe year whenthe Economic and MonetaryUnion project was
becomingpolitical reality: theMaastricht treatyhad been signedand was
in theprocessof beingratified.
It wasalsothetime whenthe mainstream approach to monetary policy
wasbeginningto convergetothe flexibleinflationtargetingframework.
Anumber of countrieshad then just adopted an explicit inflation
targetingstrategy.
In the sphere of banking regulation, too, a new era wasbeginning.
Asignificant reorientationwasgoingon, awayfrom regulating the
conduct of banks and towardsthe new risk-basedapproach.

P a g e | 24
Theregulatory trend, based on increasedfreedom for banksbut subject
torisk based capital requirements, wouldcontinueall the wayto the
eruption of the financial crisisin 2008.
In theEU, thesecondbankingdirectivetookeffectfrom thebeginningof
1993,creatinga singlemarket in banking.
Thedirectivesought to prevent discriminationand to increase efficiency
through competition.
There wasdiscussionontheimplicationsof thisfor supervision, but little
action.
So, whileEuropean bankingmarketswerebeingintegrated, financial
supervision remained a national competence.
In the U.S., deregulation wasalsomoving forward.
For instancethe Glass-SteagallAct, separatingbanking from securities
and insurance, wasunder growingcriticism and wouldbe ultimately
repealedin 1995.
One reason for the dissatisfaction with the Glass-Steagall system in the
US was competition from European banks which were less restricted in
what theycould do.
Twentyyears ago, the striking improvement in macroeconomic
performance,laternamed―thegreat moderation‖ bychairman
Bernanke, wasspreadingtothewholedeveloped world.
Thealmost surprising successof monetary policy in improving price
stability and reducingfluctuationsin economic activity, while also
keepinginterest ratesat historicallylowlevels, wasinterpretedasa major
victoryfor theart of economicpolicymaking.
Now weknow that there wastroublebrewingunder the surface.
Theunderpinningsof global financial stabilitywerebecoming weaker.

P a g e | 25
Global indebtednessincreased, fuelledby current account balancesand
the―deepening‖ of international financial markets(read: recycling the
samefundsseveral timesover).
Thedecline of inflation wasnot only due to monetary policy, but alsothe
avalancheof cheap consumer goodsfrom theemerging economiessuch
asChina contributed to it.
For banks, the new financial environment wascharacterizedby low
interest ratesand low perceivedrisks.
It alsoturned out that the new risk-basedcapital requirementsallowed
the banks to expand their balancesheetsenormouslywithout increasing
their equitycapital in the same proportion.
So, graduallythe largebanking groupsstarted to increasetheir trading
portfolios.
This development happened in a gradual fashion in the 1990‘sbut
accelerateddramaticallyfrom about 2004.
Banks redirected their businessfocusfrom interest marginstofee-based
andtrading activities.
Universal banking, asit had been knownin Europe, startedtochange.
Theasset mix of thelargest banks changedsothat securitiesportfolios
activitiesgrew more and more important.
Onlynow, from theperspectivegiven by theworstfinancial crisis since
theSecond World War, doweseeclearlythefragility and weaknessof the
regulatoryarrangementswhichcame intoforce in the 1990s.
From today‘spoint of view, theyperformed wellonly aslong asnomajor
systemic risksmaterialized.
Even worse,theyallowedriskstoaccumulate in the financial system
whichwereonly waitingtobe realized.

P a g e | 26
Thencame 2007andthecollapseof theUS property market;2008and the
collapseof interbank moneymarketsfollowingthe Lehman Brothers
crisis;and 2009withThe Great Recession.
Thepainful processof competitivedeleveragingstarted.
Thereassessment of economicpoliciesfollowedin the lasttwodecades
hasalsostarted.
Especiallyfinancial regulationhasbeenreconsideredand is being
strengthened.
We needto think of monetary policy, too, especiallyin itsconnection to
financial stability.
Monetary policy and financial stability
There is a common dictum that a stable financial system is a necessary
condition for successful monetary policy, and that price stability in turn
createsthe best preconditionsfor financial stability.
I agree.
Still, the experienceof this crisishasthought usa lot more.
First of all, wenow know that pricestability doesnot by itself guarantee
financial stability.
Riskscan accumulate in thebankingsystem even if monetary policy
succeedsin maintainingprice stability and controllinginflationary
expectationsreallywell.
Second, wealsoknow that central bankscan maintain an admirable
degreeof pricestabilityeven whenfinancial stabilityis under a lot of
strain.
Dothesetwopointsmean that financial stability and monetary policyare
not connected after all?

P a g e | 27
No.
Theyare very closelyrelated.
Independence of monetary policy
Oneof the lastinglessonslearned in thelast decadesis the value of the
independenceof monetary policy.
The independence of central banks has been essential keeping inflation
expectations as well anchored as they have been in this crisis despite all
theturmoil in the financial markets.
Independencehasalsomade it easierfor central banksto act quickly
whenit hasbeen necessaryin order tomaintainfinancial stability.
It is especiallyimportant to avoid twothreats toindependence:fiscal
dominanceand financial dominance.
Fiscaldominanceisthe older concept of thetwo.
It wouldarise if thegovernment financing constraint wouldbecome an
overridinginfluenceon monetary policy.
Theideaof fiscal dominancewasformalizedby Tom Sargent and Neil
Wallacein 1981,but of coursethe worrythat deficit financingmay cause
inflationhasmuch longer rootsin monetarythought.
Theideathat tight monetary policy may become impossiblewithout
accompanyingfiscal adjustment wasalsowellunderstood whenthe
blueprintsfor the EMU werebeingprepared.
ThisiswhytheMaastrichttreatyhaditsfiscalpolicyclausesandalsowhy
theStabilityand GrowthPact wasconcluded.
Also the prohibitionof direct central bank credit to the government and
theinstitutional independenceof thecentral banks are in effect
protectionsagainst fiscal dominance.

P a g e | 28
Now weknow, of course,that the fiscalframeworkasput in placebefore
thestart of the EMU wasnot strong enough to prevent fiscal problems
from emerging.
Somehave argued that fiscaldominancehas takenhold in thein thebig
industrializedcountries during the crisiswhen thecentral banks have
used government bond purchasesin order tostabilize the markets(asthe
ECB) or to produceadditional monetary stimuluswhenthe interest rate
instrument hasalreadybeen used tothemaximum (like theFederal
Reserveand the Bank of Japan).
As to the euroarea, for me there is nownoevidenceof fiscaldominance.
Fiscaldominanceimpliesthat monetary policy wouldbreak its price
stability objectivefor the sakeof maintainingthesolvencyof the
government sector.
This is not the case.
Price stabilityhasnot and will not be abandoned.
We have well knownfiscal problemsin some of the euro area countries.
Still, theECB‘sability togoon maintainingprice stabilityhasnot been
weakened.
In particular theinflation expectations,whichare themost essential
indicatorsof thecredibility ofmonetarypolicy, haveremainedwellin line
with the pricestability objective.
Theparallel ideaof financial dominanceis more recent than fiscal
dominance.
Financial dominancerefers tothepossibilitythat thecondition of the
bankingsystem could become a constraint, or dominant influence,on
monetary policy, effectivelyforcing the central bank topursuesecond- or
third-best monetary policiesin order tomaintainfinancial stability.

P a g e | 29
Is thespill-over from financial instabilityto monetary policy a realistic
threat?
Can financial stabilityconsiderationslead the central bankstotolerate
toohigh inflation, just to keep the banking sector afloat?
In principleit is easyto see whyit could be.
Onecanimagineacentralbank whichwouldhavetotightenitsmonetary
policy for pricestabilityreasons,but isprevented from doing sofor the
fearthat thevalueof theassetsof thebankingsystem woulddecreaseand
a financial crisiscould ensue.
Episodeswhichfit the description of financial dominancehave been
observed in emergingeconomiesafter some banking crisesin thepast.
But lookingat recent experience, thishasnot been the casein the
developed economies.
Thebust of thecredit boom hasnot ledmonetary policy totolerate a
higher-than-mandatedrate of inflation.
Instead, in the largedeveloped economiesat least, theburstingof the
bubblehascoincidedwith a sudden contractionof privatedemand and a
deep recession.
Thenegativeeffect of thebust on economicactivityhasactuallyreduced
inflationarypressuresand in some cases(such asin Japan in the1990‘s)
created a real danger of deflation.
Themain problem hasthenbecomehowtoprevent thecredit contraction
from startinga deflationaryspiral.
In such conditions,the same monetarypolicy will then both easethe
strain onthe bankingsector and support price stability.
Thisobservationdoesnotmeanthat financialinstabilitywouldnotposea
seriouschallengetomonetary policy.

P a g e | 30
On the contrary, thedownwardimpact of a bust, if it is large, may be
more difficult tocontrol than the precedingperiod of credit expansion.
There was a famous discussion on how monetary policy should relate to
asset prices in the Jackson Hole conference of 2007, where Rick Mishkin
introduced thetopic.
At that time, the prevalent thinkingin central bankingcircleswaswhat
professor Issinglater called ―theJacksonHole consensus‖, meaning that
it is better for monetary policy onlyto ―clean‖ (up afterwards)than to
―lean‖ (againstthe wind).
After thehard lessonswelearned over thelast five years thecasefor
benign neglect of asset boomsand only pickingup the piecesafterwards
is not sostrong anymore.
Thecrisisexperiencesupportsrather theidea that financial excessesare
better prevented astheyhappen than onlymanaged after theyhave
causeda recession.
This wouldbe thebest wayto prevent ―downwardfinancialdominance‖
whichcould ariseif monetary policy could not effectivelycounteract
credit contraction.
Unconventional toolsand the independence of monetary policy
Recent experienceshowsthat thecentral banks‘box of potential toolsis
actuallyvery deep, and if it hasbecomenecessarytoutilize
unconventional tools,asin thepresent crisis, thesenew toolshave been
developed and deployed.
In the caseof theECB, the new toolshave included the transitiontofull
allotment auctions,thelong term refinanceoperationsup tothree
years, wideningof the scope of eligible collateral, and the variousbond
purchaseprogrammes.
Themost recent oftheseistheOMT programmeannouncedlastsummer
but not yet commenced in practice.

P a g e | 31
Thedevelopment of new toolshasbeen justified.
The slip of the depressed economies to dangerous deflation has been
averted, and the debt and banking problems have not developed into
systemic financial meltdownsin the affected countries.
We have seen that central bankscan pursuesuccessful price stability
policy alsounder very difficult conditions.
Theeventsaround the worldsincethecollapseof Lehman Brothersare
evidenceof that.
Deflationhasbeen avoided despitea severe recession in many countries.
However,there are alsocertain problemswithrelying on theenlarged
toolkit of the central banks.
Theabilitytoact in crisishasled to thecentral banksbeingeven called
―theonlygame in town‖.
We should resist thisideaand bewareof thedanger that problemswhich
are fundamentallypolitical could be pushedtocentral banksto solve.
Adivision of responsibilitiesbetweenappointed officialsand elected
politiciansshould be preserved.
Monetarypolicycannot administer the needed structural transformation
in thereal sector of theeconomy or solve excessivedeficit problemsof
governments.
There aresituationswherethe central banks just haveto act and do their
best to stabilize the economy, even if they wouldhave to use tools which
gobeyond just adjustingthe short rate of interest or the aggregate
liquidityof thebanking system.
Thepresent financial crisishasconstitutedone such situation.

P a g e | 32
Avoiding the bustswhichseem to followcredit boomsand periodsof
―financial exuberance‖wouldmake thetasksof monetary policy much
easierand protect the independenceof central banks.
But there are alsodifficultieswith theleaningagainst the wind.
Onehasto dowiththe problem of detectingthe credit cycle in time, and
correctlytiming themonetary policy response.
Another problem is that price stability might get lessattention.
To mitigate these problems, something else besides more vigilant interest
rate policy is needed to prevent low and stable interest rates from leading
toexcessesin banksand financial markets.
Onedevelopment can be thedevelopment of macro-prudential
instrumentswhichare designed to improve the stability of the financial
system asa whole.
Themajor workin this fieldwasdonebythedeLarosière group.
Otmar Issingwasa member of thegroup.
Especially interesting are those macro-prudential instrumentswhich have
a time dimension so that they can be adjusted according to the changing
situationin the credit markets.
Such instrumentsinclude, in particular, thecountercyclical capital
requirements,aswell astheadjustablerestrictionson Loan-to-Value
ratios.
TheCRD IV directivewill make theformer instrument obligatoryin the
EU countries; implementationof the latter is left to national discretion.
Now it is very important to establishan effectivetoolkit for both
European and national authorities.

P a g e | 33
We must alsocreateinstitutional conditionswhichdonot prevent these
toolsto beused when needed.
Therefore, weneed cleardecision makingcompetencesat all levels.
Theconnectionbetweenmacro-prudential policy and itstime dimension
with monetary policyis sointimatethat central banksmust be closely
involved in macro-prudential analysis and decisionmaking.
Macro-prudential policy is important, but it needsto be supportedby
structural reformswhichwouldmake thebanking system more
resilient, and - I emphasise- lesspronetounstablebehaviour.
The Structural reform proposals
In order toprevent the present crisisfrom being ever
repeated, governmentsand authoritieshave started a large-scale
overhaul of financial regulation.
Theregulatory agenda can be broadly dividedintothe followingareas:
•Strengtheningof the prudential regulation of solvencyand liquidity
• Improvingtheinstitutionalbasisforsupervisionandcrisismanagement
•Introduction of macro-prudential instrumentstoprevent systemic risks
in thebankingsystem and financial markets
• Regulatingthe structureof the banking sector
Thestructural reform proposalswhichappear asthe last item on thislist
aim toseparate the riskiest securitiesand derivativesbusinessfrom the
deposit banking activities.
This is theessential content of theproposalsby theEU High Level
Expert Group, whichI chaired, publishedlast autumn.
It is alsoat thecore of the Volcker rule whichis beingimplemented in

P a g e | 34
theUS, and the Vickersproposal in theUK.
Thecurrent legislativeproposalswhichare underwayin Franceand
Germanyare alsoin thesamevein.
Aparticular concern of theseproposalshasbeen tolimit theextent of
explicit or implicit public guarantees,sothat theywouldnot induce
additional risk taking.
This kind of competitivedistortion could result in securitiestrading
gettingconcentratedin the largest deposit banks, and thesedeposit
banksbecoming enormousrisk concentrations built on implicit or even
explicit public guarantees.
Separation proposalstry to isolatesecurities businessfrom thesourcesof
thisdistortion and reducethe incentivesto excessiverisktaking and risk
concentration.
In must be emphasized that the structural reform weproposed is not a
cure-all but should be seen asa part of a comprehensive regulatory
agendawhich isalreadymoving forward.
This includesbetter solvencyand liquidityrules.
Also, theEU will finallyget supervisionand resolution frameworksat the
union level.
Thedifferent componentsof thecurrent regulatory agendacomplement
and support each other.
In thisEuropean context, thestructureandstabilityof thebankingsector
is of vital importanceto the economy.
It is imperativeto improve itsresiliency.
TheHigh Level Expert Group report containsfive main
recommendationson how to reform thebankingsector.

P a g e | 35
I will just refer tothreeof them here:
•Thefirst is toseparate any significant proprietary tradingin securities
andderivativesfrom deposit banks.
These activities could be carried out in a separately capitalized and
funded subsidiary, a trading entity, which could belong to the same
bankinggroup asthedeposit bank.
We proposed that alsomarket making be allocated to thetrading
subsidiary in order toprevent the useof tradinginventoryto circumvent
the prohibition on proprietary trading.
•The use of trading subsidiaries would allow the banking groups to offer
―one-stop banking‖ to their clients, but without the possibility of funding
tradingactivitieswithinsuredretail deposits.
Financial linkagesbetweenthe deposit bank and the trading unit would
haveto be restrictedin accordancetonormal largeexposure rules.
•Another of our proposalsisto develop specific, designatedbail-in
instrumentsto improve the lossabsorbencyof banks.
Arequirement to issuesuch bail-in debt wouldhelp ensure the
participationof investorstothe recapitalizationof a bank if this should
becomenecessary.
Such designatedbail-in instrumentswouldclarifythe hierarchyof debt
commitmentsand allowinvestorstopredict theeventual treatment of the
respectiveinstrumentsin caseof recapitalizationor resolution.
•Thegroup alsoproposedthat thecapitalrequirementsontradingassets
and real estaterelated loansbe reviewed.
Both of theseasset categoriescame to have very low risk weightsin the
Basel II regime, mostlybecausethewayinternal models wereapplied.

P a g e | 36
Whybanking structure mattersfor monetary policy
Let me recapitulatemy main points.
First, for monetary policy, financial stabilityis very important.
While monetarypolicyhasproventobeabletopursuepricestabilityeven
under rather strained financial conditions,the central banksare not able
toinsulatethe real economy completelyfrom theafter-effectsof financial
crises.
Amore stablebanking sector whichis lessprone tocrisiswill reducethe
likelihoodof crisesand thereforeprotect thebalancesheetsof the central
bank from financial risksand therebyprotect itsindependenceand
credibility.
Second, themost important part of stability policy is crisisprevention.
Improvinglossabsorbencyof banks and thecrisismanagement powers
of the authorities arenecessary, but it is even more important to make
sure that excessivegrowthof credit and indebtednesscan bebetter
controlledin the future.
In this way, credit crunchesand bankingcrisescan be made lesslikely –
andmilder, should theyhappen.
Third, financial stability wouldbenefit from structural reform of the
bankingsystem.
By separatingthe most riskysecurities and derivativeactivitiesfrom
deposit banking, thespill over from deposit protection tospeculativerisk
takingwouldbe prevented.
This would reducethe distorted incentivestoexpand tradingactivities
and concentraterisksin deposit banksbecauseof their privileged
positionin the deposit market.

P a g e | 37
Finally,thestructural reform ofbankingisacomplement, not asubstitute
for other regulatory improvements.
For central banks, thedevelopment of macro-prudential policiesand
instrumentsisespeciallyrelevant.
Thosemacro-prudential instrumentswhich can be adjustedover time to
managethe conditionsin the credit market will offer a waytobetter
control the accumulation of excessriskand help prevent future crises.
Theseinstrumentsoperatesocloseto monetary policythat central banks
should be very closelyinvolved, if not themselvesresponsible, in
developing and using them.

P a g e | 38
Theimpact of the crisison financial
integration in Central and Eastern Europe
SpeechbyMr IgnazioVisco, Governor of theBank
of Italy, at theconference―Twentyyears
oftransition– experiencesandchallenges‖, hosted
bythe National Bank of Slovakia, Bratislava.
I wishtothank for useful discussion and help
Emidio Cocozza, PaoloDel Giovane and Valeria
Rolli.
Introduction
Theglobal financialcrisishasbeen severeand widespread, and has
affected different economiesin different and long-lastingways.
Thetransition countries of Central and Eastern Europe wereno
exception:their quiterapid financial integration over thepast
twenty-yearsbrought about lastingeconomicbenefits,but alsoleft them
relativelyexposedtothe global financial turmoil, in particular through
their linkswithWestern European bankswhichhold dominant stakesin
theregion‘smarkets.
Financial stability hasonce again become a fundamental objectiveof
policy making, and central banksare beingheavily involved in this
endeavor.
This callsfor a substantial overhaul in financial regulation and
supervision.
Thefinancial system of tomorrow will be different from theone that has
developed over the last twodecades.

P a g e | 39
Global financial integration during the past decade
In the decadebeforethefinancial crisisboth the sizeof the financial
system and itsroleand pervasivenessin the economy increased
dramatically.
Theprocesshasonlysloweddown sincethe crisis.
In theeuroarea,theoverall amount offinancialresourcescollectedbythe
private sector(bank credit, bondsissued domesticallyand stock market
capitalization) rosefrom 160per cent of GDP in 1996to240in 2007, and
then declinedto230in 2011.
Asimilar pattern is found for theUnitedStates,wherethe ratio rose from
230percent in1996to330in 2007andthendeclinedto260in 2011(Fig. 1).
Driven by thebreakthroughsin informationtechnologyand
telecommunicationsand theprocessof financial integration, thesupply
of derivativesproducts, the securitizationof banks‘assets,together with
thegrowth of so-calledstructured financial instruments, expanded
considerably.

P a g e | 40
Thetotal outstandingnotional amount of over-the-counter(OTC) and
exchange-tradedderivativeshasrisenfromabout 94trillionU.S.dollarsat
theend of 1998to around 670trillion at the end of 2007, hovering around
that level afterwards(Fig. 2).
An important dimensionof thisprocesshasbeen the increased
international financial integration.
In the last decade industrial countries‘ gross external financial assets and
liabilities more than doubled in proportion to GDP, reaching 440 per cent
at the end of 2007(Fig. 3).

P a g e | 41
Thedevelopment of financial marketsin emerging economieshasalso
been dramatic.
Theoverall amount of financial resourcescollectedby the private sector
(outstandingstocksof bank credit, domestic debt securitiesand equity
market capitalization) increased from about 120to230per cent of GDP
between1996and 2007for the averageof emergingAsia, and from about
40toalmost 100per cent for the averageof CEE countries (Fig. 4).

P a g e | 42
International financial integration – withforeign direct and portfolio
investmentsand theinvolvement of foreign banks in domesticfinancial
systems– washelped bythe removal of earlier obstacles: macroeconomic
instability, vulnerableexternal positionsand inefficient institutional and
regulatorysetups.
Sincethe mid 2000s,this processwashugely supportedby exceptionally
favorableglobal financial conditions,withabundant liquidity, lowrisk
aversion, and fallinglong-term interest rates.
Financial integration in Central and Eastern Europe
Thetransition countries in Central and Eastern Europe werethe
recipientsof a largeinflux of internationalcapital, mostly flowingin from
Western Europe.
Between 2003 and 2008 capital inflows reached sustained levels – more
than 12 percent of GDP on average – well above the overall average for
emergingmarket countries (about 6 percent) (Fig. 5).

P a g e | 43
Transition countrieswereperceivedasattractiveoutlets:potential high
returns,underpinnedby relatively lowwagesand capital-output
ratios,weremagnified bythe prospectsfor faster income convergence
entailedby theeconomicand institutional developmentsin thecontext
of EU membership, and by theexpectationsof rapid interest rate
convergencelinkedtothe eventual euro adoption.
Financial integration in the CEE hastended tobe quiteunique.
International banksplayed a fundamental role indeed in spurring
financial integrationin the region.
In the years running up tothe global financial crisis, Western European
banksexpanded rapidly, gaininglarge market sharesthrough their
subsidiariesand branches,up to about 80 percent of total banking assets
by2008.
Theentryof foreign intermediarieswithlong-term strategicgoalsandthe
ensuingprofound transformation of theownership structure of banking
systemsin CEE countrieswasacrucialelement of disciplineandstability
in breaking theviciouscycle of systemic bankingcrisesand
macroeconomicvolatility that had characterizedthe earlyyearsof
transition.

P a g e | 44
It isgenerallyacceptedthat internationalfinancialintegrationhastended
toplay a positiverolein the long-term economicconvergenceprocessin
CEE transition countries:
Long-term per capitaGDP growth in theregion beforethe crisiswas
positivelycorrelatedwith conventional measuresof financial
integration, such asthe ratio of grossforeign assetsand liabilitiestoGDP
(Fig. 6).
Thecorrespondingevidencefor other emergingareastendsto be less
clear cut.
Theaforementionedfavourablefeature possiblyreflectsthe interaction
with institutional convergence, implicit in theEU accessionprocess, asa
key contributingfactor.
Thankstothis uniqueand favourablecombination, financial integration
in itselfmostlikelyactedasacatalystforthedevelopment ofthedomestic
financial sector and the adoption of structural reformsto strengthen the
institutional framework.

P a g e | 45
Yet a balancedaccount of the processof financial integrationin this
region should not overlook its drawbacksin termsof excessive, cheap
lending, currencymismatchesand demand overheatingin theyears
runningup tothe crisis.
Between2003and 2008, many economiesrecordedrapid import
growth, real estatebubblesand wageincreaseswell above productivity
gains– sometimesrooted in overly optimistic expectationsof fast
incomeconvergence.
Inflationarypressuresspilled over intothetradablesector and worsened
export performance.
Balanceof paymentscurrent account deficitswidened(Fig. 7).
Several countriesbuilt up high external debt levels (Fig. 8), largely private
and denominated in foreign currency, making them vulnerable to capital
flowreversalsand currencydepreciation.

P a g e | 46
When theeffectsof the global crisisreachedthe CEE countries, their
economieswerehit by a sharp declinein capital inflowsand the ensuing
slowdownin bank credit (Fig. 9).
Notwithstandingconcernsregarding a possiblemeltdownof domestic
financial systems drivenby a run for theexit of foreign banks, a

P a g e | 47
fully-fledgedfinancial crisis– similar to the oneswhichoccurred in East
Asia in 1997–98– did not materialize.
Overall, theregion even experienced, in the first phaseof thecrisis, a less
severereversalof capital flowsthan other emergingareas.
In some cases(Hungary, Latvia and Romania) largeinternational
financial support by theEU and themain international financial
institutions(IFIs) wasa key factor in avoidingthe worst;coordination
effortsby home and host country authorities, IFIs and multinational
banks,in the context of theVienna Initiative, alsohelped prevent
collectiveaction problemsthat could have triggered the dreadedmassive
withdrawal from thesemarketsby foreign banks.
There is evidencethat foreign banksthat participated in the Vienna
Initiativewererelativelystablelenders.
Moreover,thedistinctivemodel of financial integrationin the CEE region
– whereforeign banks operatemainlythrough their localsubsidiariesand
branchesin the retail market – probablyprovided a high degreeof risk
sharingandstabilityduringthecrisis, asparent banksweregenerallyless
sensitivetoinformation asymmetry and counterparty credit risk and more
committed tolong-term market prospects,given theimportant sunk costs
associatedtothesestructures.
This comparesfavourably tothepattern prevailingin the other EU
countries,whereexternalborrowingbydomestic banksoccursmainlyvia
crossborder wholesalemarkets.
Thedifferent intensityof the boom-bust cycle observed acrossthe CEE
countriessuggeststhat, in addition totheinfluenceof specificstructural
features(such asdifferencesin startingincome levels,international trade
and financial links),domestic policy had a role, although capital inflowsof
themagnitudesobserved in theregionin therun uptotheglobal crisis
wouldcertainlyhavestrainedany toolkit availabletonational policy
makers.

P a g e | 48
Monetaryand exchangerate regimesmost likely played a critical rolein
determiningthe country‘sabilityto counteract the effectsof capital
inflows, asthere weredifferencesin the size of the internal and external
imbalancesbetweenfixed and floatingexchangerate countries.
Indeed, countriesadoptinga fixed exchangeregime experiencedmore
pronouncedcredit booms, higher inflationratesand larger account
deficitsthan the averagefor floatingexchangesregimecountries.
Yet, the assessment of thecontribution of the exchangerateregime
remainsan open issue, asit isunclear towhat extent themost
pronouncedboom-bust cycle wasmainlydriven by thefixedexchange
regimeper seor by the inconsistencyof theoverall policy mix pursued in
countrieswherethissettingwasin place;in particular, a stricter fiscal
stanceand a better framework of macroprudential policy could have at
least partlycompensated for theabsenceof exchangerate flexibility.
As for monetarypolicy, theexperienceof CEE countriestendstoconfirm
that in small, financiallyopen economiesit is a lesseffectivelever for
restraining credit booms.
This is thecaseeven for floatingexchangeregimes, asanumbers of
factors– currencysubstitutionin the form of balancesheet effects
associated withinitial high euroization, or theshiftsto
foreign-currency-denominatedlending– could restrain the effectiveness
of monetarypolicy tightening, or even reverseitsintended effects.
This underscorestheimportanceof maintainingprudent fiscal stances
during credit booms.
Indeed, in the run up to thecrisis,headlinefiscal positionsremained
broadlybalanced in most CEE countries; yet theseoutcomeswere
frequentlythe result of exceptional revenuesassociatedtocyclical
demand and asset price booms.
Onceadjusted for thelatter underlying fiscal positionslooked much less
healthy.

P a g e | 49
Onerecognizes, in retrospect, theneed for aconservativeapproachin the
assessment of tax revenuesduring a boom phase,and theuseful roleof
automatic stabilizers(particularlyincome taxesand welfarespending) in
order to increasefiscal policy flexibilityand dampen economic
fluctuations.
In additiontostandard macro policy tools,CEE countriesalsoadopteda
widerangeof prudential actionsbeforethe last global crisis.
Prudential instrumentshave the potential to prevent or contain systemic
financial risksin theupswings(affectingtheincentivesassociatedwith
asset pricebooms, foreign exchangelending, excessiverisk takingand
the erosion of lendingstandards) and alsoto build buffersthat can
cushionthe impact of downturns.
In general the evidenceisthat thesemeasuresproduced theintended
effectsin the short run, but theysometimesfailed to have a long lasting
impact on credit dynamics.
Indeed, in some instancescircumventionthrough direct cross-border
financingand/ or lendingfrom nonbank (unregulated) financial
intermediariesproved to be a major issue; this hasbeen thecasefor
examplefor measuresconsisting in direct limitson credit growth.
Amore effectiverolein containing systemic financial riskshasbeen
played by measuresspecificallydevisedtobuild liquidityand
loss-absorbingcapital buffers,such asreserve and capital requirements.
Moreover, when appropriately formulated, prudential regulations helped
to curb the growth of foreign exchange loans and to keep related default
rateslowerduring thecrisis.
Lessons learnt from the global crisis: in search of better
regulation
Global financial deepeningand international integrationhasallowed
greaterrisk sharingandhasmadefinanceaccessibletolargernumbersof

P a g e | 50
countries,householdsand firms, thusbeinginstrumental to broadening
economicdevelopment.
But an interlinkedand more connectedfinancial system heightensthe
risk that contagion setsoff and spreadsmore widely.
Most importantly, thecrisishasshownthat market participantswerenot
capableof masteringtheinherent complexityof the system that they
themselveshad contributedto develop.
And it hashighlightedthelimitsof the ideathat self-regulationand
market disciplineare sufficient to ensure stablefinancial systems.
In thisregard, acceptingtheideathat benign neglectwastheright course
of action wasa critical mistakeon the part of regulators.
Rather, financial regulation and supervision must keep pacewith
developmentsin the financial industry.
Moreover,national authoritiesneed to beawareof the risk that their
powersmay become narrow compared tothe sphere of influenceof the
global financial players.
Thecoordinationof financial supervisionacrossbordersand across
sectorsis a key condition for the stabilityof theglobal financial system.
Amajor effort is required, at a national but especiallyat an international
level, in order tostrengthenthe regulatory and supervisory framework.
At the international level, under the politicalimpulseof theG-20, the
Financial Stability Board (FSB) and theBasel Committeeon Banking
Supervision(BCBS) have introducedsubstantial regulatorychangesto
prevent new financial crisesand increasetheresilienceof economic
systems.
Much hasbeen alreadyachieved.

P a g e | 51
Thequantityand qualityof capital that banksneed to hold hasbeen
significantlyenhancedto ensure that theyoperateon a safeand sound
basis.
There alsohavebeen introducedinternational standardsfor bank
liquidityand funding, designed to promote the resilienceof banksto
liquidityshocks.
Initiativeshave been promoted to strengthenthe regulationof the OTC
derivativesmarket, aimed at reinforcingmarket infrastructures,in order
tominimize contagion and spill-over effectsamong players that have
become more and more interconnected.
However,further progressis needed in important areas,asbank capital
and liquidityregulation must be accompaniedby improvementsin
internalrisk control arrangementsand actionsaimed at correcting
incentivestoexcessiverisk-taking.
Moreover,a level playing field must beachieved, ascountriesrelaxing
rules in order toattract financial intermediariesgeneratenegative
externalitiesfor other countries.
Thetransition to a uniform system of rulesand oversight of the financial
sectormust be hastened.
In the euro area, and in theEuropean Union at large, theplan for a
bankingunion is ambitious,but it goesin the right direction.
It would, among other things, limit regulatoryarbitrage, help remove
national bias in supervision, reducethephenomenon of ―regulatory
capture‖bypowerful cross-borderbanks, at thesametimereducingcosts
of compliancefor cross-borderbanks and enhancingthe functioningof
theSinglemarket for financial services.
TheenvisagedEuropean banking union wouldalsobenefit CEE
economies:it wouldworkagainst thefragmentationof the European
financial marketsalongnational lines;moreover – by enhancingthe
financialresilienceof theeuroarea – it wouldreducetherisksof negative

P a g e | 52
spill-overeffectsfrom the euro area to CEE banking systems.
Final remarks
Therecovery of CEE economies remainsfragile.
With few exceptions, output hasnot yet returned to pre crisis
levels,dragged by debt overhang and direct and indirect exposureto
theeurozonedebt crisis.
Import demand by theeuro area remainsat depressed levels. Financial
conditions, although improved comparedtotheend of 2011,
remain volatile.
Bankcredit dynamicsremain weak,reflectingsubdueddomesticdemand
andhigh non-performingloans.
Thebanking systemsof most CEE countries, however, remain well
capitalized and can thereforewithstandthe lingeringdeterioration of
their asset quality.
Moreover,the financial legacyof the crisiswill not be transitory.
Theevolution of theinternational banking sector over the comingyears
will continuetoshape financial conditionsalsoin CEE countries.
Theregulatory and supervisory responsesadopted at global level will
implymore stringent prudential requirementsfor capital and liquidity.
In responseto thesemore demandingrules,aswell asto spontaneous
market forces,international banksare adapting their business
strategies,unwindingpre-crisisunsustainablepracticesand shiftingto
longer-termfinancingsources.
In this context themain European bankswithlargestakesin CEE
marketsare graduallyswitchingtomore decentralizedbusinessmodels,

P a g e | 53
wheresubsidiarieswouldhave to relymore on localsourcesof
funds,settinglendingconditionsaccordingly.
Although orderlyand evendesirablefor the resiliencyof theglobal
financial system, thisprocessmay exert significant pressureson emerging
countriesthat are highlydependent on external financingowingto
underdevelopeddomestic financial systemsand structurallylownational
savingsrates.
Indeed, this processcallsfor decisivereforms tobolster the development
anddeepeningof localmoney and capital markets, includinglocal
currencydenominatedbonds.
This is a long-term and complexprocess, whichinvolvesa suitablelegal
framework,adequateinfrastructures,a largeinstitutional investor
base,stablemacroeconomicconditionsand predictablepolicymaking, as
exemplifiedin extensiveanalysis and ensuing guidelinescarriedout at the
Bank of InternationalSettlements(BIS), theWorldBank andtheG20.
Several of theseconditionshave alreadybeen achieved in the processof
integration in theEU.
Against thischangingfinancial environment, there is the riskthat, on the
groundsof preservingfinancial stability at domestic level, national
regulatorscould adopt ring fencing measures,hamperingthesmooth
functioningof theEU singlemarket.
As thelong-term benefitsof free capital mobilityand international
financial integrationremain sizable, this risk callsfor a stronger roleby
theEU institutions,notablytheEuropean Commission (EC) and the
European BankingAuthority (EBA), in monitoring thesemeasuresand
enhancingcoordination among national regulators,in order toavoid a
fragmentation of theEuropean financial markets.

P a g e | 54
Revised rulesfor markets in
financial instruments
(MiFID /MiFIR)
a)Proposal for a Directive of the
European Parliament and of the
Councilon marketsin financial
instrumentsrepealingDirective2004/39/ EC of the
European Parliament and of the Council (Recast) (MiFID)
b)Proposal for a Regulation of the European Parliament and of the
Councilon marketsin financial instrumentsand amending Regulation
[EM IR] on OTC derivatives,centralcounterpartiesandtraderepositories
(MiFIR)
I. INTRODUCTION
1.TheCommission transmittedtheabovementionedproposalstoamend
thecurrent MiFID to the Council on 20October 2011.
Theobjectiveof this legislativepackageis, inter alia, to furtherthe
integration, competitiveness, and efficiencyof EU financial marketsby
respondingtothechallengescreatedbydevelopmentsin financial
markets,and dealingwiththe weaknessesthe financial crisishas
exposed.
2.ThelegislativepackageamendingMiFID has twoparts:
- ARegulationsetsout requirementsin relationtothedisclosure of trade
transparencydata to thepublic and transaction data tocompetent
authorities, removingbarriers to nondiscriminatory accessto clearing
facilities,themandatory tradingof derivativeson organised
venues,specificsupervisoryactionsregardingfinancialinstrumentsand
positionsin derivatives.

P a g e | 55
- ADirectiveamendsspecific requirementsregarding the provision of
investment services, thescope of exemptionsfrom the current
Directive,organisational and conduct of businessrequirementsfor
investment firms, organisationalrequirementsfor tradingvenues, the
authorisationand ongoing obligationsapplicabletoprovidersof data
services, powersavailabletocompetent authorities, sanctions,and rules
applicableto third-country firmsoperatingvia a branch.
3.Intensivenegotiationshave been going on during the PL, DK, CY and
IE Presidenciesaimingat an agreement on theCouncil's general
approach,whichwouldallowthePresidencytostart negotiationswiththe
European Parliament witha view toreachinga first readingagreement.
TheEPECON Committeevoted onitsreportson26September2012,and
theEP positionwasfurther confirmed bythePlenaryon 26October 2012.
4.During the discussions at the Working Party on Financial Services the
Presidencies have tabled several overall compromise proposals and other
textsin order tomake progresson the file.
II. STATE OF PLAY
5.While significant progresshasbeen madetowardsachievingagreement
on a Council general approach, during the latestmeeting of theWorking
Partyon Financial Services(Attachés) on 11April 2013,therewasnot yet a
qualifiedmajority supporting an overall compromise in particular because
of the key outstandingissue of accessto tradingvenuesand central
counterparties(CCP) (MiFIR, Articles 28-30).
6. Access(Articles 28-30MiFIR)
Toavoid anydiscriminatorypracticesand toremovevariouscommercial
barriers that can be used to prevent competitionin the clearingof
financial instruments,the Commission Proposal provided in the
Regulation (MiFIR) that CCPs should accept to clear transactions
executedin different tradingvenues, to theextent that thosevenues
complywiththe operational and technical requirementsbythe CCP.

P a g e | 56
Accessshouldonlybedeniedif certainaccesscriteriaarenot met (Article
28MiFIR).
Trading venues should also be required to provide access including data
feeds on a transparent and non-discriminatory basis to CCPs that wish to
clear transactionsexecuted on thetradingvenue (Article 29MiFIR).
In addition, accesstolicencesof, and information relatingto, benchmarks
that areused to determinethe value of financial instrumentsshould be
providedto CCPs and tradingvenues(Article 30MiFIR).
Thenon-discriminatoryclearingaccessfor financial instrumentshas
proved tobe a difficult issuethroughout thenegotiationson MiFIR, with
delegationsbeingsplit into twogroups.
Onegroup isin favor of maintainingtheprovisionsofArticles28and
29,asproposed by theCommission, for thereasonsmentioned
above, whereasthe other group isin favor of deletingtheseArticlesas
they believethat non-discriminatoryaccesswill lead to fragmentation at
thetradinglevel and toreduction in liquidity.
Furthermore,somedelegationshave doubtson the relationship between
Article 30 (nondiscriminatoryaccessand obligationto licence
benchmarks) and intellectual property rightswhereasother delegations
consider that Article 30is necessaryasit tacklesthe issueof monopolies
andthusenhancescompetition.
ThePresidencyhasproposed a compromisesolution in Articles 28-30of
MiFIR (doc. 7743/ 13REV 2), whichis basedon a non-discriminatory
accesstoCCPs, tradingvenuesand licencebenchmarks, providingat the
sametime necessarysafeguardsrelated toorderly functioningof the
marketsand liquidityfragmentation.
This solution is acceptable to several delegations, but there
are, however, a number of delegations which have outstanding
concerns, and to whom the deletion of Articles 28-30 would be the
preferred option.

P a g e | 57
7.In thesecircumstances,the Presidencyconsidersthat itscompromise
solution isthe onlyviableoption toaddressthis issue.
However,the Presidencyacknowledgesthat there are still serious
concerns.
If theseconcernsarenot resolvedthePresidencysuggeststhat at thetime
of the agreement on the general approach, a statement asset out in the
Annex wouldbe enteredintothe minutesof Coreper.
8.Apart from theabovementionedissuetherearecertain otherissuesthat
requirefurther work.
ThePresidencyconsidersthat thisworkcan becompleted at Working
Party level, if an agreement onArticles 28-30in MiFIR can beachievedat
Coreper.
III. CONCLUSION
9. The Presidencythereforesuggeststhat thePermanent Representatives
Committee:
-agreesonArticles28-30in MiFIR asset out in doc. 7743/13REV 2;
-in theevent that agreement isnot reachedon articles28-30
MiFIR, agreeson the content of thestatement set out in Annex, whichis
tobeentered intothe minutesof Coreper at thetimeof final agreement
on thegeneral approach, and
-invitestheWorkingPartyonFinancial Services(Attachés) tofinalisethe
thetext, and submit the general approach for agreement by Coreper in the
very near future .
Statement by the Council
The Council notes the divergent positions of Member States on certain
aspects of the Presidency's proposed general approach, in particular as
regards toclearing accessprovisions(articles28-30).

P a g e | 58
It invitesthePresidencytostart negotiationswiththeEuropean
Parliament on the basisof this general approach, takingintoaccount the
need for further work totry toresolve outstandingissues.

P a g e | 59
APRA releasessecond
consultation package for the
supervision of conglomerate
groups
TheAustralian Prudential RegulationAuthority (APRA) hastoday
releasedfor consultation proposed risk management and capital
adequacyrequirementsfor the supervisionof conglomerategroups.
Conglomerategroups, referredto asLevel 3 groups,are groups
comprisingAPRA-regulated institutionsthat perform material activities
acrossmore thanoneAPRA-regulated industry and/ orin oneor more
non-APRA-regulated industry.
Theconsultationpackagereleased todayincludesa response to
submissionsreceived onAPRA‘s March2010discussionpaper on the
supervision of conglomerategroupsand a set of draft prudential
standards.
Thepackage, on risk management and capital adequacy, complements
theconsultation packagereleasedin December 2012on proposed
requirementsfor group governance and risk exposures.
Theproposed Level 3 framework will assistAPRA toensure that its
supervision adequatelycapturesthe risksto whichAPRA-regulated
institutionswithin Level 3 groupsare exposed and which arenot
adequatelycovered by existingprudential arrangementsfor stand-alone
entities(Level 1supervision) and singleindustry groups(Level 2
supervision).
APRA Chairman Dr John Laker said that theintroduction of a Level 3
frameworkinAustralia is a significant progression ofAPRA‘s prudential
regime.
‗Oneof thekey lessonsfrom theglobal financial crisis is theneed to

P a g e | 60
enhancesupervisoryregimes tobetter capture the risksfacingregulated
institutionsthat arepart of a widerconglomerategroup.‘
‗By implementinggroup-widerequirementson governance, exposure
management, risk management and capital adequacy, APRA‘sproposed
Level 3 supervision frameworkwill underpin asafer financial system in
Australia,‘ Dr Laker said. ‗At this stage, potential Level 3 groupsare
unlikelyto need additional capital to meet the proposedLevel 3
requirements.‘
Submissionson theproposed risk management and capital adequacy
prudential standardsaredueby 5 July2013.
Over thecourseof 2013,APRA will consult on a set of prudential practice
guides,reportingstandards, reportingforms and instructions,and
consequential amendmentsto other prudential standardsthat give effect
tothe Level 3 framework.The Level 3prudential standards are expected
totake effect from 1January 2014.
Theresponsepaper and draft prudential standardscan be found on the
APRA websiteat:
www.apra.gov.au/ CrossIndustry/ Consultations/ Pages/ Supervision-of-c
onglomerate-groups-2013.aspx
TheAustralian Prudential RegulationAuthority(APRA) istheprudential
regulator of thefinancial servicesindustry. It overseesbanks, credit
unions,buildingsocieties, general insuranceand reinsurance
companies, life insurance, friendlysocieties, andmost membersof the
superannuation industry. APRAis fundedlargely bytheindustries that it
supervises. It wasestablished on 1July1998. APRAcurrentlysupervises
institutionsholding$4.2trillion in assetsforalmost 23millionAustralian
depositors, policyholders and superannuation fund members.

P a g e | 61
To all Chief Executive Officersof potential Level 3 groups
APRA hastoday releasedthe second consultationpackageon the
supervision of conglomerategroups(Level 3 groups).
This packageincludesa responsepaper totheMarch 2010discussion
paper and draft prudential standards, whichfocuson requirementsfor
group risk management and capital adequacy.
This packagecomplementsa first consultationpackage, releasedin
December 2012,regardingproposed requirementsfor group governance
and risk exposures.
APRA hasalsoreleaseda consultation packageon harmonisingand
enhancingcross-industryriskmanagement requirements,whichcontains
a new cross-industryrisk management prudential standard and an
updatedgovernancestandard.
Thesestandardsare proposed to applytoall Level 1ADIs, general
insurers,life companies, Level 2 groupsand Level 3 groups.
Aseparate letter on this consultationpackagehasbeen issued to all
affected institutions.
However,proposalsin therisk management prudential standard which
affect Level 3 groupsare addressed aspart of thesupervisionof
conglomerate groupsresponse paper.
During the courseof developing theseproposals,APRA hashad a
number of positivediscussionswithpotential Level 3 groupsand have
taken intoconsideration many of the issuesraisedin thosediscussions.
Consultationon theproposed risk management and capital adequacy
prudential standardscloseson 5 July2013.
Over thecourseof 2013,APRA will consult on a set of prudential practice
guides,reportingstandards, reportingforms and instructions,and

P a g e | 62
consequential amendmentsto other prudential standardsto give effect to
theLevel 3 framework proposals.
Theconsultationpackageis available on theAPRA websiteat:
http:/ / www.apra.gov.au/ CrossIndustry/ Consultations/ Pages/Supervisi
on-of-conglomerate-groups-2013.aspx
TheLevel3prudentialstandardsandthecross-industryriskmanagement
prudential standard are expected to take effect from 1January 2014.
Queriesin relationtothe Level 3 project should be directedtoyour
ResponsibleSupervisoror the dedicated Level3Framework@apra.gov.au
email address.

P a g e | 63
GovernorElizabethA. Duke
At the Housing PolicyExecutive
Council, Washington, D.C.
AView from the Federal Reserve
Board: The Mortgage Market and
Housing Conditions
Sincejoiningthe Board in 2008amid a
crisiscentered onmortgagelending, I have
focused much of my attentionon housing
andmortgage markets,issuessurrounding
foreclosures,and neighborhood stabilization.
In Marchof this year, I laid out my thoughtson current conditionsin the
housing and mortgagemarketsin a speechto theMortgageBankers
Association.
Today I will summarize and update that information witha focuson
mortgagecredit conditions.
Before I proceed, I should note that the viewsI expressare my own and
not necessarily those of my colleagueson the Board of Governors or the
Federal Open Market Committee.
Asustained recoveryin thehousing market appearsto be under way.
Houseprices,asmeasuredbyavarietyofnationalindexes,haverisen6to
11percent sincethe beginningof 2012(figure 1).

P a g e | 64
The recovery of house prices has been broad based geographically, with
90 percent of local markets having experienced price gains over the year
endingin February.
Also since the beginning of 2012, housing starts and permitshave risen by
nearly 30 percent (figure 2), while new and existing home sales have also
seen double-digit growthrates.

P a g e | 65
Homebuilder sentiment hasimprovednotably, and real estate agents
report stronger trafficof people shoppingfor homes(figure 3).
In national surveys, householdsreport that low interestratesand house
pricesmake it a good time to buy a home; they alsoappear more certain
that house pricegainswill continue(figure 4).

P a g e | 66

P a g e | 67
Despitetherecent gains,thelevel ofhousingmarket activityremainslow.
Existinghome salesare currentlyat levelsin linewiththoseseen in the
late 1990s,while single-familystartsand permitsare at levels
commensuratewiththe early1990s.
And applicationsfor home-purchasemortgages, asmeasuredby the
MortgageBankersAssociation index, wereat a level in linewiththat of
themid-1990s(figure 5).
Thesubdued level of mortgage purchaseoriginationsis particularly
strikinggiven therecordlow mortgageratesthat haveprevailedin recent
years.
Thedrop in originationshasbeen most pronounced amongborrowers
with lowercredit scores.
For example, between2007and 2012,originationsof prime purchase
mortgagesfell about 30 percent for borrowerswithcredit scoresgreater

P a g e | 68
than 780, comparedwith a drop of about 90percent for borrowerswith
credit scoresbetween620and 680(figure6).
Originationsarevirtuallynonexistent for borrowerswith credit scores
below 620.
Thedistribution of credit scoresin thesepurchaseoriginationdata tells
thesamestoryin a different way:
The median credit score on these originationsrose from 730 in 2007 to770
in 2013, whereas scores for mortgages at the 10th percentile rose from 640
to690(figure 7).

P a g e | 69
Many borrowerswhohave faced difficultyin obtaining primemortgages
haveturned to mortgagesinsured or guaranteed by the Federal Housing
Administration(FHA), theU.S.Department of VeteransAffairs (VA), or
theRural Housing Service(RHS).
Data collectedunder the Home MortgageDisclosureAct indicatethat
theshare of purchasemortgagesguaranteedor insured by theFHA, the
VA, or theRHS rosefrom 5 percent in 2006tomore than 40percent in
2011(figure 8).

P a g e | 70
But here, too, loanoriginationsappear tohave contracted for borrowers
with low credit scores.
Themedian credit score on FHApurchaseoriginationsincreasedfrom
625in 2007to690in 2013,whilethe10thpercentile hasincreasedfrom 550
to650(figure 9).

P a g e | 71
Part of the contraction in loan originationsto householdswithlower
credit scoresmay reflect weakdemand among thesepotential
homebuyers.
Although wehave littledata on thispoint, it may be the casethat such
householdssuffereddisproportionatelyfrom thesharp risein
unemployment duringtherecessionandthushavenot beenin afinancial
positionto purchasea home.
There is evidencethat tight mortgage lendingconditionsmay alsobe a
factorin thecontraction in originations.
Data from lender ratequotessuggest that almost all lendershavebeen
offeringquotes(through thedaily "ratesheets" providedtomortgage
brokers) on mortgageseligiblefor saletothegovernment-sponsored
enterprises(GSEs) toborrowerswithcredit scores of 750over the past
twoyears.
Mostlendershave been willingto offer quotestoborrowerswith credit
scoresof 680aswell.

P a g e | 72
Fewer than two-thirdsof lenders,though, arewillingto extend mortgage
offersto consumerswithcredit scores of 620(figure 10).
And thisstatistic mayoverstate theavailability of credit toborrowerswith
lowercredit scores:
Therateson many of these offersmight be unattractive, and borrowers
whosecredit scoresindicateeligibilitymay not meet other aspectsof the
underwritingcriteria.
Tight credit conditionsalsoappear tobepart of the story for
FHA-insured loans.In theFederal Reserve's October 2012Senior Loan
Officer Opinion Survey on Bank LendingPractices(SLOOS), one-half to
two-thirdsof respondentsindicatedthat they werelesslikelythan in 2006
tooriginate an FHAloanto a borrowerwith a credit score of 580or 620
(figure 11).

P a g e | 73
Standardshave tighteneda bit further since: In theApril 2013
SLOOS, about 30percent of lendersreported that theywerelesslikely
than a year agotooriginateFHAmortgagestoborrowerswithacredit
scoreof 580or 620(figure 12).

P a g e | 74
TheApril SLOOS offerssome cluesabout whymortgagecredit isso
tight for borrowerswith lowercredit scores.
Banks participatingin the survey identifieda familiar assortment of
factorsasdamping their willingnessto extend any type of loan to these
borrowers:the riskthat lenderswill be required torepurchasedefaulted
loansfrom theGSEs("putback" risk), the outlook for housepricesand
economicactivity, capacityconstraints,the risk-adjustedopportunitycost
of such loans,servicing costs,balancesheet or warehousing
capacity,guaranteefeeschargedbytheGSEs,borrowers'abilitytoobtain
privatemortgageinsuranceor second liens,and investorappetitefor
private-label mortgage securitizations.
Respondentsappeared to put particular weight on GSE putbacks,the
economicoutlook, and the risk-adjustedopportunitycost.
In addition, several largebankscited capacityconstraintsand borrowers'
difficultiesin obtainingprivatemortgage insuranceor second liensasat
least somewhat important factorsin restrainingtheir willingnessto
approvesuch loans.

P a g e | 75
Over time, some of thesefactorsshould exert lessof a drag on mortgage
credit availability. For example, asthe economic and housingmarket
recoverycontinues,lendersshould gain confidencethat mortgage loans
will perform well, and theyshould expand their lending accordingly.
Capacityconstraintswill likely alsoease. Refinancingapplicationshave
expanded much moreover thepast year and ahalf than lenders' ability to
processthese loans.
For example, one measureof capacityconstraints--thenumber of real
estatecredit employees--hasonlyedgedup over thisperiod (figure 13).
When capacityconstraintsare binding, lendersmay prioritize the
processingof easier-to-completeor more profitableloan applications.
Indeed, preliminaryresearch by theBoard's staff suggeststhat the
increasein the refinanceworkloadduring the past 18monthsappears to
havebeen associatedwitha 25to 35percent decreasein purchase
originationsamongborrowerswithcredit scoresbetween620and680and
a 10 to 15percent decreaseamong borrowerswithcredit scoresbetween
680and 710.

P a g e | 76
Any such crowding-out effect should start to unwindasthe current
refinancingboom decelerates.
Other factorsholdingback mortgagecredit, however, may be slowerto
unwind.
As the SLOOS resultsindicate, lendersremain concerned about putback
risk.
Theabilitytohold lendersaccountablefor poorlyunderwrittenloansis a
significant protection for taxpayers.
However,if lendersareunsureabout theconditionsunder whichtheywill
berequired torepurchaseloanssoldtotheGSEs,theymayshyawayfrom
originatingloansto borrowerswhoserisk profiles indicatea higher
likelihoodof default.
TheFederal Housing Finance Agency launched an important initiative
last year toclarify the liabilitiesassociatedwithrepresentationsand
warranties, but, sofar, putback risk appearsto still weigh on the
mortgagemarket.
Mortgageservicingstandards,particularlyfordelinquent loans,aremore
stringent than in thepastdue to settlement actionsand consent orders.
Servicing rulesrecentlyreleased by the Consumer Financial Protection
Bureau (CFPB) will extend many of thesestandardstoall lenders.
Thesestandardsremedypast abusesand provideimportant protectionsto
borrowers,but alsoincreasethecostof servicingnonperformingloans.
This issueis compounded by current servicingcompensation
arrangementsunder whichservicersreceivethesame feefor the routine
processingof current loansasthey dofor the more expensive processing
of delinquent loans.
This model--especiallyin conjunction withhigher default-servicing
costs--giveslendersan incentivetoavoid originatingloansto borrowers
whoaremore likelytodefault.

Risk management presentation May 20 2013

Risk management presentation May 20 2013

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