Risk Compliance News September 2012

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International Association of Risk and Compliance Professionals (IARCP)
www.risk-compliance-association.com

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

Dear Member,

Modelling risks …
… this is really one of the most interesting
topics

Agathe Côté: Modelling risks to the financial system
Remarks by Ms Agathe Côté, Deputy Governor of the Bank of Canada, to
the Canadian Association for Business Economics, Kingston, Ontario, 21
August 2012.

***
Introduction

It has become a summer tradition for the Bank of
Canada to address the Canadian Association for
Business Economics.

This year it is my pleasure and I thank you for the kind invitation.

An audience of colleagues and fellow economists offers me an
opportunity to delve into a complex subject, and one that is particularly
timely: financial system risk.

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We continue to see today the enormous costs to the global economy of the
financial crisis that started five years ago.

Of the many lessons we have learned from the crisis, a key one is this: we
need to pay more attention to the stability of the financial system as a
whole.

This means understanding better how risks get transmitted across
financial institutions and markets, and understanding better the feedback
loop between the financial system and the real economy.

From a policy perspective, this means taking a system-wide approach to
financial regulation and supervision.

Major reforms of the global financial system now under way address this
need.

System-wide risk has been a focus of attention at the Bank of Canada, and
at other central banks, for some time.

Ten years ago, the Bank issued the first edition of its semi-annual
Financial System Review in which it identifies key sources of risks to the
Canadian financial system and highlights the policies needed to address
them.

A year later, in 2003, we organized our annual conference on the theme of
financial stability.

In the wake of the global financial crisis, the Bank has intensified its
research efforts in this area.

In particular, a priority is to improve the theoretical and empirical models
we use to analyze elements of the financial system that can lead to the
emergence of risks and vulnerabilities.

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With more finely tuned quantitative models and tools, the Bank will be
better able to identify risks on a timely basis so that the private sector and
policy-makers can take corrective action to support financial stability.

Let me acknowledge upfront that this task is complex.

While macroeconomic models have long been used to guide monetary
policy decisions by central banks, models of financial stability and
systemic risk are much less advanced.

In my remarks today, I want to talk about the progress that we have made
at the Bank in modelling risks to the financial system.

I will start by briefly describing the notion of systemic risk and various
approaches used to identify and measure it.

I will then discuss two state-of-the-art quantitative models that we have
developed to improve our assessment of risks to the Canadian financial
system.

The multiple dimensions of systemic risk

Systemic, or system-wide, risk goes beyond individual institutions and
markets.

It is the risk that the financial system as a whole becomes impaired and
that the provision of key financial services breaks down, with potentially
serious consequences for the real economy.

Systemic risk manifests itself in different ways.

There is a time dimension, which refers to the accumulation of
imbalances over time, and a cross-sectional dimension, which refers to
how risk is distributed throughout the financial system at a given point in
time.

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Procyclicality is the key issue in the time dimension.

It reflects the tendency to take on excessive risk during economic
upswings – too much punch from the punchbowl, if you will – and to
become overly risk averse during the downturns.

Procyclicality makes the financial system and the economy more
vulnerable to shocks, and increases the likelihood of financial distress.

Risk concentrations and interconnections are the key issues in the
cross-sectional dimension.

Financial institutions can have similar exposures to shocks or be linked
through balance sheets.

As a result, losses in one institution can lead to fears of contagion that
amplify the adverse effects of the initial shock.

For instance, uncertainty about the viability of counterparties can lead to
hoarding of liquidity, which may seem like an appropriate action for the
individual institution but can have disastrous consequences for the
financial system as a whole.

System-wide surveillance requires that we regularly assess the importance
of various types of systemic risk.

How we judge a particular risk will be based on the probability that it will
lead to financial system distress, and on the extent of its impact should
that distress materialize.

Early-warning indicators

A fundamental challenge is to detect the risks arising from both global
and domestic sources in an environment with a vast number of potential
indicators.

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Therefore, one direction of research at the Bank has been to isolate the
key signals from this broad information set by identifying a smaller group
of variables that can serve as early-warning indicators of emerging
imbalances.

Since financial crises in Canada have been rare, international data are
used to help establish numerical thresholds for each domestic indicator.

For example, if international evidence suggests that credit growth above a
certain rate tends to be associated with increased risk, then a period with
credit growth above the threshold would suggest an elevated probability
of financial stress.

Selecting the level of thresholds involves a difficult trade-off between false
alarms and failure to signal an event, so in practice the early-warning
indicators are used mainly to identify areas where more detailed
investigation may be warranted.

They provide an objective, practical starting point to detect the buildup of
imbalances in the financial system.

One early-warning indicator that we regularly track is the deviation of the
aggregate private sector credit-to-GDP ratio from its trend (the
credit-to-GDP gap), which serves as a rough measure of excessive
leverage across the financial system (Chart 1).

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This indicator has been shown to provide some leading information as a
predictor of banking crises, and has been proposed by the Basel
Committee on Banking Supervision (BCBS) as a useful guide for
decisions about when to activate the countercyclical capital buffer – an
important macroprudential policy instrument in the Basel III agreement.

Given the complexity of systemic risk, it is unrealistic to expect a single
measure or indicator to serve all purposes.

Combining indicators can produce better signals with fewer false alarms
and undetected crises.

For example, research shows that combining the Credit - to - GDP gap
with a measure of real estate prices produces an indicator that performs
better than either variable on its own.

Our own work at the Bank reinforces findings elsewhere that aggregate
private sector credit and real estate prices are among the most reliable
indicators of financial stress.
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Identifying sources of risk is essential, but so is determining the
likelihood that these risks will materialize.

Therefore, another important aspect of ongoing research is the
development of statistical models to help us forecast the probability that a
crisis will occur based on a group of indicators.

Macro stress tests

Early-warning indicators are useful to gauge the probability of financial
stress, but a thorough assessment also requires an analysis of what could
happen if the risk materializes.

This is the goal of macro stress testing.

A good part of the Bank’s efforts in recent years has been devoted to
developing and refining stress-testing models.

This class of models takes a large but plausible macroeconomic shock as
a starting point and analyzes its impact on the balance sheets of banks or
other sectors of the economy.

The Bank now has two main stress-testing models to help monitor risks
to the financial system.

These models can also be used to assess the potential impact of policy
tools or regulatory actions in mitigating financial system risks.

Assessing risks from elevated household debt

The first, the Household Risk Assessment Model, or HRAM, is a
microsimulation model that assesses how the debt burden of Canadian
households can affect financial stability.

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Using microdata from household balance sheets, the model allows us to
estimate how various shocks would affect the distribution of debt within
the household sector.

The simulations take into account changes over time in individual debt
levels, as well as changes in household wealth from savings and
fluctuations in the value of financial assets.

Tracking the asset side of household balance sheets gives us a more
accurate picture of systemic risk since changes in wealth affect
households’ ability to pay their debt.

Household vulnerabilities depend not only on the average level of debt,
but also on how debt is distributed across individuals.

One strength of the model is precisely its ability to account for this
distribution.

For instance, while record-low interest rates in recent years have
contributed to a relatively low aggregate household debt-service ratio, the
share of Canadian households that are considered most vulnerable –
those with a debt-service ratio equal to or higher than 40 per cent – has
climbed to above-average levels, as has the proportion of debt held by
these vulnerable households (Chart 2).

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Using HRAM, we estimate that if interest rates were to rise to 4.25 per
cent by mid-2015, the share of highly indebted households would rise
from slightly above 6 per cent in 2011 to roughly 10 per cent by 2016, while
the proportion of debt held by these households would rise from 11.5 per
cent to about 20 per cent over the same period.

So while the aggregate household debt-service ratio paints a somewhat
rosy picture, taking into account distributions gives us a clearer and more
cautionary indication of how vulnerable our financial system actually is to
household debt.

Another strength of the model is that it provides a flexible tool for
simulating the impact on household solvency of a wide range of potential
shocks, such as an increase in unemployment.

HRAM indicates that household loans in arrears would more than double
under a severe labour market shock similar to that observed in the
recession of the early 1990s.

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Despite the model’s strengths, we continue to enhance our analysis by
improving HRAM.

Expanding the behavioural aspects of the model is one way to do this.

For instance, the model currently allows distressed households to pay
their debts by selling their liquid assets, but not their homes.

Work is also under way to improve the design of the shock scenarios.

Results of stress tests using HRAM are regularly reported in the Bank’s
Financial System Review and constitute an important element of our
overall assessment of the risks associated with household finances.

Assessing contagion effects in the banking system

HRAM provides invaluable information on vulnerabilities in the
household sector, but the Bank is also interested in assessing risks more
broadly within the Canadian financial system.

To this end, we have been working for several years on developing a
Macro Financial Risk Assessment Framework (or MFRAF).

Drawing on detailed data from bank balance sheets, MFRAF is a
quantitative model that tracks the contribution of individual banks to
systemic risk.

Traditional stress-testing models focus exclusively on solvency risk, and
estimate the overall risk to the financial system by simply aggregating
credit (or other asset) losses that would materialize at individual banks in
the event of a severe shock.

MFRAF goes beyond this traditional approach by taking into account
linkages among banks arising from counterparty exposures – or network
spillover effects – as well as funding liquidity risk, that is, the risk of
market-based runs on banks.

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The financial crisis illustrated the significant risks associated with a
deterioration of funding liquidity.

The collective reactions of market participants led to mutually reinforcing
solvency and liquidity problems at banks around the world.

As funding liquidity evaporated, many well-capitalized institutions had to
take writedowns on illiquid assets, or sell them at a loss, creating
uncertainty in the market about their solvency and adding to the
downward pressure on asset prices.

MFRAF has been built to integrate funding liquidity risk as an
endogenous outcome of the interactions between solvency concerns and
the liquidity profiles of banks.

This strong microeconomic foundation constitutes a major innovation in
macro stress-testing models.

MFRAF also incorporates network externalities caused by the defaults of
counterparties, with the size of a counterparty’s interbank exposures
increasing the likelihood of spillover effects.

A key lesson from the model is that failure to account for either funding
liquidity risk or interbank exposures could lead to significant
underestimation of the risks to the financial system as a whole if the
banking system is undercapitalized and relies extensively on the
short-term funding market.

Importantly, the loss distributions generated by the model exhibit
fat tails, a key feature of the actual distribution of financial system risks
(Chart 3).

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The fact that the model is able to replicate this important stylized fact
demonstrates that it has significant potential as a tool for assessing
systemic risk.

Nevertheless, while MFRAF is already somewhat complex, the layers of
interaction will need to be further augmented.

For instance, the model misses any negative feedback that could occur
between heightened risks to the banking system and the real economy.

The model could also be expanded over time to include other types of
financial institutions and markets.

Compared with other approaches that use market-based data, such as the
asset-pricing approach, the transmission channel in models like MFRAF
is transparent, and this improves our interpretation of results.

Because of this “story-telling” ability, many central banks have begun to
use this type of framework in their financial stability analysis.

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In addition to assessing risks, MFRAF can be used to examine the merits
of policy or regulatory initiatives such as capital and liquidity rules.

As the model becomes more refined, the objective is to use it more to
complement other existing macro stress-testing exercises and to sharpen
our analysis and communication of risks in the Bank’s Financial System
Review.

Conclusion

Let me conclude.

The Bank of Canada is conducting extensive research into finding
methodologies and tools to identify and measure systemic risk.

While work in this area is extremely complex, the Bank has made
substantial progress in recent years.

We now have two state-of-the art models. And with HRAM, the Bank of
Canada is one of the few central banks at the leading edge of using
microsimulation models to assess vulnerabilities in the household sector.

Our efforts to build these models have provided us with important
lessons.

First, distributions matter – we cannot rely solely on aggregate data:
distributional features and complex interactions are very important for
assessing risks.

This means developing models that capture these effects.

Our household simulation model is aimed directly at understanding how
the distribution of debts, assets and income affects financial stability.

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MFRAF uses information about the interconnections of individual
financial institutions because these can lead to non-linear network effects
that are also important for assessing systemic risks.

Second, predicting behaviour under stress conditions is very difficult.

Models need to be able to handle a variety of “what-if” scenarios
corresponding to different assumptions about behaviours under stress.

Finally, we need to consider the many different sources of risk to the
financial sector and take into account their cumulative effects and
interactions; otherwise we may underestimate risks.

Obviously, quantitative measures alone will never be enough to get a
complete picture, especially since the financial system evolves rapidly.

Intelligence gathered from discussions with the financial sector, as well
as information shared with other policy-makers and supervisors here in
Canada and in the international community, will always be critical to the
overall assessment of the risks.

While we are making progress, it is important to remember that financial
system modelling is still in its infancy.

The goal – understanding, preventing, and reducing systemic |risk –
deserves our attention, diligent research and hard work. It has been my
pleasure to share some of the Bank’s efforts with you today. Thank you
very much.

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Progress note on the Global LEI
Initiative

This is the first of a series of notes on
the implementation of the legal entity
identifier (LEI) initiative.

The G-20 in Los Cabos endorsed the FSB recommendations and asked
the Board to take forward the work to launch the global LEI system by
March 2013.

Progress reports on the LEI initiative will be prepared approximately
every three weeks.

Implementation Group: The FSB set up an Implementation Group (IG)
to take forward the work.

The IG comprises 55 experts from the global regulatory community, and
includes members from 20 jurisdictions, as well as representatives from
standard setters and international financial institutions.

There are three main workstreams:

- legal and governance;
- operations; and
- corporate hierarchy data.

A co-ordination group of 5-7 members guides each work stream,
providing a geographic balance.

Private Sector Preparatory Group (PSPG):
A call for members of a private sector expert group to collaborate on the
work solicited widespread interest – about 170 members from almost 30
jurisdictions are participating actively in the group.

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Following an inaugural meeting in New York on 25 July, working groups
have been set up to provide input in each of the three main areas,
facilitated by members of the IG.

A dedicated secure web based forum has been launched for
communication and knowledge sharing, hosted by the Cleveland Federal
Reserve.

Charter for the Regulatory Oversight Committee (ROC) and other
Governance Issues:
A key task for the IG is to prepare a draft Charter for the ROC for approval
by the FSB in October and G20 in November.

A first full draft will be reviewed by the IG in early September, prior to
review by the Steering Committee in mid - September.

The IG is working through a number of challenging issues, including:
delivery of adequate regulatory enforcement power over the global system
by the ROC; membership criteria (including the treatment of
sub-national regulatory bodies and international bodies); decision
making if consensus cannot be reached; what is an appropriate minimum
regionally balanced quorum of support from authorities to launch the
system that ensures balanced representation of early, medium and late
movers; and the structure of the not-for-profit Global LEI Foundation
(the legal form of the operational element of the LEI system).

The choice of location and hence jurisdiction for the Foundation will have
an important influence on the legal framework for the LEI system,
including possibly the legal form of the ROC and the means available for
expressing governance: the FSB Secretariat is seeking pro bono advice
from legal experts on the location issue by early September.

To facilitate the ultimate acceptance of the Charter by the FSB Plenary,
IG members are seeking feedback from legal staff on the document as
work proceeds.

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Operations:
The private sector has a key role in the operational implementation of the
system: the Central Operating Unit (COU) of the system will be formed
via the establishment of a not-for-profit global LEI foundation under the
oversight of the ROC.

A number of the PSPG Working Groups are focusing on operational
aspects – a structured framework (Enterprise Architecture) is being used
to organise the work.

Early results will be reviewed in October. A number of potential Local
Operating Units (LOUs) are involved in the analysis of operational
solutions to ensure that the proposed model is acceptable to participants
around the world.

Ownership and Hierarchy data:
An important short term objective is to develop concepts and plans for
extending the basic data on entity identification (which will be available
when the system is launched) to include information on corporate
ownership and other relationships.

The extension is necessary to support risk aggregation and consolidation
and thus capture the full benefits of the LEI system.

Additional data, however, implies an expansion of scope and thus the
benefits and costs of any particular extension must be considered
carefully.

The IG is working closely with the PSPG to develop preliminary
recommendations by end-2012.

Early movers:
The CFTC announced on July 24 that DTCC/SWIFT had been
designated as the provider of CFTC Interim Compliant Identifiers
(CICIs) for a limited period of two years.

The CFTC also confirmed that the Commission plans to adopt the
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governance principles and LEI reference data requirements endorsed by
the FSB, and that once these steps are completed the CICI system will
subsequently transition into the global LEI.

IG members are currently reviewing a number of technical issues to
ensure that decisions by early movers do not have an adverse impact on
the costs or operational flexibility of the global system, for instance by
locking the future global LEI system into early, local technical system
design choices.

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OCC Updates Stress Testing Implementation
Timeline
WASHINGTON — The Office of the Comptroller of
the Currency (OCC) today announced it is
considering changes to the implementation timeline
for the company-run stress testing required by the
Dodd-Frank Wall Street Reform and Consumer Protection Act.

The changes under consideration would delay implementation until
September 2013 for covered institutions with total consolidated assets
between $10 billion and $50 billion.

On January 24, 2012, the OCC published in the Federal Register a notice
of proposed rulemaking to implement section 165(i) of the Dodd-Frank
Act, which would require certain financial companies, including certain
national banks and federal savings associations, to conduct annual stress
tests in accordance with regulations prescribed by the OCC.

In the notice of proposed rulemaking, the OCC stated that “[a] national
bank or federal savings association that is a covered institution shall be
subject to this part on [the effective date of the rule] and will conduct its
first stress test under this part using financial statement data as of
September 30, 2012, with results reported as required under this part in
January 2013.”

The OCC received a number of comments on the proposed immediate
effective date identifying concerns about resources, readiness, and ability
to conduct stress tests given the likely short period between publication of
a final rule and the start of the stress-testing process.

A key priority in implementing this section of the Dodd-Frank Act is to
ensure that banks have robust systems and processes to conduct the
stress tests.
In response to the concerns expressed in comments, the OCC is
considering delaying the effective date of the rule to conduct the annual
stress tests for certain institutions.
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The proposed delay would help ensure that all covered institutions have
sufficient time to develop sound stress testing programs.

Specifically, the OCC is considering a timeline under which covered
institutions with assets from $10 to $50 billion would be required to
conduct initial stress tests in accordance with the rule in late 2013.

The OCC is considering requiring covered institutions with assets greater
than $50 billion to begin conducting annual stress tests under the rule this
year, although the OCC would maintain its reservation of authority to
allow covered institutions above $50 billion to delay implementation on a
case-by-case basis where warranted.

As part of efforts among the federal banking agencies to coordinate the
implementation of Dodd-Frank stress test requirements, the OCC has
consulted on this proposed implementation delay with the Federal
Reserve Board (Board) and the Federal Deposit Insurance Corporation
(FDIC).

The Board and FDIC are considering similar changes to timelines
included in their proposed rules implementing Dodd-Frank stress test
requirements.

The final implementation timeline for all covered institutions will be
specified in the final rule.
Note:
Section 165(i) of the Dodd-Frank Act created two types of stress testing
requirements: stress tests conducted by the company and stress tests
conducted by the Board of Governors of the Federal Reserve System
(“Board”).

Section 165(i)(2) requires certain financial companies, including national
banks and Federal savings associations, to conduct stress tests and
requires the primary financial regulatory agency of those financial
companies to issue regulations implementing the stress test
requirements.
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A national bank or Federal savings association is subject to the stress test
requirements if its total consolidated assets are more than $10 billion.

Under section 165(i)(2), a financial company is required to submit to the
Board and to its primary financial regulatory agency a report at such
time, in such form, and containing such information as the primary
financial regulatory agency may require.

The primary financial regulatory agency is required to define “stress
test,” establish methodologies for the conduct of the company -
conducted stress test that must include at least three different sets of
conditions (baseline, adverse, and severely adverse), establish the form
and content of the institution's report, and compel the institution to
publish a summary of the results of the Dodd-Frank institutional stress
tests.

In general, section 165 of the Dodd-Frank Act sets forth a number of
requirements and responsibilities for the Board related to supervision
and prudential standards for nonbank financial companies and bank
holding companies with total consolidated assets equal to or greater than
$50 billion.

In addition to the company stress tests required under section 165(i)(2),
section 165(i)(1) requires the Board to conduct annual analyses of
nonbank financial companies supervised by the Board and bank holding
companies with total consolidated assets equal to or greater than $50
billion to determine whether such companies have the capital, on a total
consolidated basis, necessary to absorb losses as a result of adverse
economic conditions.

The Board published a proposed rule implementing this supervisory
stress testing on January 5, 2012.

As required by section 165(i)(2), this proposed rule implements the
company-conducted stress test requirements for national banks and
Federal savings associations.

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Under this proposed rule, a national bank or a Federal savings
association with total consolidated assets of more than $10 billion,
defined as a “covered institution,” would be required to conduct an
annual stress test as prescribed by this proposed rule.

The OCC is developing this rule in coordination with the Board and the
Federal Insurance Office, as required by section 165(i)(2)(C).

The Board and Federal Deposit Insurance Corporation (“FDIC”) are
planning to issue separate proposed rules with respect to their
supervised entities.

For purposes of this rule, the proposed rule defines a stress test as a
process to assess the potential impact of hypothetical economic
conditions (“scenarios”) on the capital of a covered institution over a set
period (the “planning horizon”), taking into account the current
condition of the covered institution including its material risks,
exposures, strategies, and activities.

The Purpose of Stress Tests
The OCC views the stress tests conducted by covered institutions under
the proposed rule as providing forward-looking information to
supervisors to assist in their overall assessments of a covered institution's
capital adequacy and to aid in identifying downside risks and the
potential impact of adverse outcomes on the covered institution's capital
adequacy.

In addition, the OCC may use stress tests to determine whether
additional analytical techniques and exercises are appropriate for a
covered institution to employ in identifying, measuring, and monitoring
risks to the financial soundness of the covered institution, and may
require a covered institution to implement such techniques and exercises
in conducting its stress tests.

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Further, these stress tests are expected to support ongoing improvement
in a covered institution's stress testing practices with respect to its
internal assessments of capital adequacy and overall capital planning.

The OCC expects that the annual stress tests required under the
proposed rule would be only one component of the broader stress testing
activities conducted by covered institutions.

In this regard, the OCC notes that the federal banking agencies have
recently issued for public comment proposed joint guidance on “Stress
Testing for Banking Organizations with More Than $10 Billion in Total
Consolidated Assets.”

These broader stress testing activities should address the impact of a
range of potentially adverse outcomes across a set of risk types affecting
aspects of the covered institution's financial condition other than capital
adequacy.

In addition, a full assessment of a covered institution's capital adequacy
must take into account a range of factors, including evaluation of its
capital planning processes, the governance over those processes,
regulatory capital measures, results of supervisory stress tests where
applicable, and market assessments.

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FSA statement regarding CRD IV implementation

The draft European Union legislation to update the
capital requirements framework, known as CRD IV, has
been under discussion between the European Parliament,
European Commission and Council of Ministers.

These discussions originally aimed to finalise an agreed position by end
June 2012 enabling adoption by the European Parliament plenary in early
July 2012.

Following the delay of the Parliament’s plenary vote and the recent
statement by the Rapporteur of the European Parliament and the
discussion of the Council of Economic and Finance Ministers, it is clear
the legislation will not be adopted earlier than autumn 2012.

Following adoption it is necessary for verification, translation and
signature of the EU legislation to take place before it can be published in
the Official Journal of the European Union.

Publication in the Official Journal is a necessary pre-cursor of EU
legislation entering into force.

On this basis it does not appear feasible that the legislation can enter into
force in line with the implementation date of 1 January 2013 as included in
the original European Commission proposal of July 2011.

No alternative date has yet been communicated by the EU institutions.

Furthermore, reflecting the delay in the negotiation process, the
European Banking Authority (EBA) issued a press release on 31 July
setting out the potential need to phase-in or flexibly apply certain
technical standards to ensure a practical approach to implementation.

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In light of these developments the FSA will keep the situation under
active review and continue to support the European institutions in their
efforts to reach a conclusion on the final version of the legislation.

The FSA will continue to undertake all preparatory work that is possible
in the absence of finalised legislative text, in full expectation that the EU
legislation will follow the Basel III implementation timetable.

We expect all firms in scope of CRD to do likewise.

Banks must remain mindful of the vital importance of the direction set by
Basel III for banking system stability.

In particular the FSA will continue to undertake its supervision of banks
in a manner consistent with the recommendations of the 22 June meeting
of the interim Financial Policy Committee (FPC) of the Bank of England.

The interim FPC recommended that: taking into account each
institution’s risk profile, the FSA works with banks to ensure they build a
sufficient cushion of loss-absorbing capital in order to help to protect
against the currently heightened risk of losses; that cushion may
temporarily be above that implied by the official transition path to Basel
III; and banks should continue to restrain cash dividends and
compensation in order to maximise the ability to build equity through
retained earnings.

The FSA reminds those investment firms that are currently subject to the
Capital Requirements Directive that they will be impacted by the CRD IV
legislation and that they too should prepare accordingly.

The introduction of Common Reporting, which is incorporated into the
requirements in CRD IV, is dependent on delivery of the necessary
technical systems and on implementing technical standards to be drafted
by EBA under CRD IV and adopted by the European Commission.

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The FSA is proceeding with the necessary preparatory work to be ready to
begin collecting data under Common Reporting for the period beginning
1 July 2013, should the legislation and related standards be finalised by
this date.

In line with the press release issued by EBA, the FSA will take account of
any phase-in plans incorporated into the implementing technical
standards on supervisory reporting.

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An interesting article about China. We will be
glad to discuss other opinions in our next
newsletter.

China’s Slowdown May Be Worse
Than Official Data Suggest
by Janet Koech and Jian Wang
In the months following the 2008–09 economic
crisis, emerging-market economies robustly
rebounded.
Output in China and India expanded more than
10 percent in 2010, and Brazil’s gross domestic product (GDP) growth of
7.5 percent was its best performance in 25 years.

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Emerging-market economies retraced their precrisis level of industrial
production by 2009, while advanced economies remained below their
precrisis levels in 2012 (Chart 1).

But the strong emerging-market rebound—most significantly in China—
hasn’t endured.

When China’s average GDP growth remained above 9 percent in 2011,
hopes rose that a sustained recovery would prop up the world economy
amid the European sovereign debt crisis and subpar growth in the U.S.

However, China’s economy deteriorated rapidly in 2012, with GDP
growth slowing to 8.1 percent in the first quarter from 8.9 percent at
year-end 2011.

Second quarter GDP growth slid further, to 7.6 percent, the lowest
reading since the height of the global financial crisis in early 2009.

Even with the decline, there is speculation that these figures may still
understate economic slowing.

Economists have long doubted the credibility of Chinese output data.

For example, some studies indicate that GDP growth was overstated
during the 1998–99 Asian financial crisis, when official figures reported
that China’s GDP grew on average 7.7 percent annually.

Alternative estimates using economic activity measures such as energy
production, air travel and trade data ranged from 2 percent to 5 percent.

The dubious character of the official figures is no secret in China.

Senior government officials, including Vice Premier Li Keqiang, dismiss
official GDP data as “man-made” and “for reference only” because of
political influence, particularly at the local level, on data reporting.

_____________________________________________________________

Data Reliability

To get a more accurate picture of China’s economy, economists examine
other measures of activity that closely track growth but are less prone to
political interference than output data.

Industrial electricity consumption, a major production input, serves as
such a proxy.

If industrial output grows at a slower pace, electricity consumption
should behave similarly.

China’s year-over-year growth rates of industrial electricity consumption
and industrial production are shownfor 2011 and 2012 in Chart 2.

_____________________________________________________________

Red dots, illustrating 2012 activity, are below the blue dots, depicting 2011,
which indicates that the growth rate of industrial electricity consumption
is relatively lower this year.

This is consistent with China’s recent economic slowdown.

The chart also shows fitted linear trends—a way of extrapolating activity
over a longer period—computed using 2011 data only (solid line) and 2011
and 2012 data (dashed line).

This depiction relies on just these two years because of limited
electricity-consumption reporting by the China Electricity Council.

Hence, these results should be viewed with caution.

As expected, Chart 2 shows that there is a tight relationship between
industrial electricity consumption and industrial output.

As industrial production growth expands, China’s industries consume
more electricity, and vice versa.

However, a closer look at the chart raises questions.

Consider a scenario in which electricity consumption doesn’t increase.

To illustrate this, we extend the linear trend lines to the horizontal axis
(representingno change in electricity consumption).

The lines intercept the axis at 5 and 7.5, implying that China’s industrial
production continues to grow 5 percent or 7.5 percent annually
(depending on which trend line we use) even when electricity
consumption remains constant.

Although heightened electricity consumption efficiency could induce
positive industrial production growth, a 7.5 percent growth rate seems too
large to attribute to efficiency gains alone.

_____________________________________________________________

The solid line computed using just 2011 data is flatter than the dashed line
computed using both 2011 and 2012 data.

Extrapolating from the trend line that includes just 2011 data points yields
a lower, more reasonable industrial production growth rate of about 5
percent when the electricity consumption growth rate is zero.
The same data are shown in Chart 3, with only the 2011 trend line
depicted.

Suspiciously, all 2012 data (red dots) lie below the trend line.

This suggests that given the amount of electricity consumed, China’s
official industrial production figures for 2012 are higher than those
implied by the 2011 data trend.

_____________________________________________________________

For instance, China’s industrial electricity consumption grew 5.6 percent
on a year-over-year basis in March 2012.

Using the trend from 2011 data, the estimate for March’s industrial
production growth is about 9.3 percent rather than the 11.9 percent
reported in the official data.

This discrepancy could be due to unintentional, random survey errors.

However, it is hard to imagine that all available 2012 data erred on the side
of overstating industrial production growth.

Rather, it suggests that China might have overstated its 2012 industrial
production data to mask the economy’s weakness.

In other words, the slowdown in China could be worse than the official
data indicate.

Composition of Production

Of course, other factors may explain why all red dots lie below the trend
line in Chart 3.

For example, growth of industrial production varied across sectors whose
consumption of electricity per unit of output differs.

For a unit of output, a company involved in steel production will generally
consume more electricity than a factory making T-shirts.

If the growth rate of the steel industry slowed more than that of the textile
industry, we would expect to see the growth in electricity consumption
decline faster than the growth of total industrial output.

To address this industry composition effect, we include output growth of
two different sectors in our data: the heavy and light industrial sectors.

_____________________________________________________________

The heavy industrial sector (for example, the steel industry) usually
consumes more electricity than the light sector (the textile industry).

The relationship between electricity consumption and industrial output
can be more accurately estimated by analysing the two sectors separately
than by using aggregate industrial output data.

Accounting for the sectoral difference yields more sensible results when
2011 data are analyzed.

When industry electricity consumption remains constant—that is, it
shows a zero growth rate—light industrial sectors grow at an annual rate
of 2.8 percent, a much smaller reading than the 5 percent for aggregate
output.

On the other hand, the heavy industrial sectors contract 1.9 percent,
reflecting this industry’s relatively heavy reliance on electricity.

_____________________________________________________________

Chart 4 plots actual electricity consumption growth in China (purple line)
together with estimated electricity consumption using 2011 output data
for light and heavy industries (orange line).

The two lines track each other closely, indicating a tight relationship
between electricity consumption and output in the heavy and light
industries.

The blue line shows the forecast growth of electricity consumption in
2012, computed from the relationship estimated from 2011 data.

The official industrial production data square well with electricity
consumption in March 2012; predicted consumption data almost perfectly
match the reported data.

_____________________________________________________________

During March, growth in heavy industries declined sharply to 11.2
percent from 13 percent in December 2011, while growth in the light
industries increased to 13.9 percent from 12.6 percent over the same
period.

The difference in growth between the heavy and light industries explains
the overall sharp decline in electricity consumption, while overall
industrial output growth remained strong in March 2012.

In the subsequent months, however, the out-of-sample forecasts diverge
substantially from the actual data.

Given the official industrial production numbers, our model suggests that
China should have consumed about twice as much electricity as it
actually did.

This is not surprising after closer examination of the data.

From April to June, growth in the light industries declined more than in
the heavy industries, a reversal of March’s activity.

Given such a pattern in China’s official industrial production data,
electricity consumption growth should have dropped only moderately.

However, China’s actual electricity consumption continues to decline
sharply from April to June, raising doubts about the accuracy of the
official industrial production figures.

Improving Data Reporting

Although China’s economic growth has slowed sharply in recent months,
evidence suggests that the situation may be worse than reported.

Several factors contributed to China’s slowdown.

_____________________________________________________________

Demand for China’s exports in Europe and the U.S. has weakened amid
the deepening European sovereign debt crisis and sluggish U.S.
economic activity.

Additionally, China’s policy response following the global financial crisis
is having unintended effects on its economy.

China loosened monetary policy and undertook a massive fiscal stimulus
program in response to 2008–09 developments.

These policies, which cushioned the economy from the impact of falling
demand for exports, had the unintended consequence of generating
higher inflation and rising asset prices, particularly in the real estate
sector.

These developments forced China to reverse course and institute tighter
monetary policy last year, creating another round of effects on the
economy that continue this year.

China’s abrupt policy changes during the past two years are not
historically unusual and have been criticized as a source of the country’s
big economic swings, which hurt long-run growth.

Future policymakers will need more, high-quality quantitative (as
opposed to qualitative) economic research to avoid overshooting policy
targets and to better stabilize the economy.

A critical first step is acquiring highquality economic data, a process
already in the works.

China’s National Bureau of Statistics started a new data-collecting system
under which businesses report industrial production data online directly
to the national statistics agency in Beijing, reducing the chance of
manipulation by local authorities.

As the world’s second largest economy, China plays an increasingly
important role in the global economy.
_____________________________________________________________

Acquiring accurate economic data isnot only useful to China’s
policymaking, but also helpful to other nations, allowing them to better
understand China’s current economic conditions and design their
policies accordingly.

Koech is an assistant economist and Wang is a senior research economist
in the Research Department at the Federal Reserve Bank of Dallas.

_____________________________________________________________

Some Thoughts on Global Risks and Monetary
Policy
Charles L. Evans, President and Chief Executive Officer
Federal Reserve Bank of Chicago
Introduction
Thank you for the invitation to speak to you today. I am
very happy for the opportunity to participate in Market News
International seminar and to offer my thoughts on the U.S. and world
economies.
We live in an amazingly interconnected world — a world in which
financial markets are linked by the instantaneous transmission of
information and business activity is intertwined among nations.
For a long time, U.S. consumers and firms have been an important source
of demand for Asian economies.
This comes with pluses and minuses: Without the robust growth in the
U.S. in 1997–98, the Asian financial crisis may well have been much worse
than it actually was; in contrast, the recession and sluggish growth in the
U.S. over the past five years have weighed heavily on the demand for
products from Asia.
My comments today will focus primarily on the outlook for the U.S., but
with an eye on its potential impact on Asian economies.
Of course, here I have to cover the substantial downside risks to the
forecast stemming from both the European debt situation and the U.S.
fiscal cliff.
I will also discuss how this outlook and other economic analyses shape
my views for the appropriate stance of monetary policy.

_____________________________________________________________

Before I turn to the focus of today’s discussion, I would like to remind you
that the views expressed are my own and do not necessarily represent
those of the Federal Open Market Committee (FOMC) or the Federal
Reserve System.
Outlook
Let’s start with the economic outlook.
We are all too familiar with the fact that the financial crisis that unfolded
in 2007 and 2008 precipitated a global recession that was unusually deep
and lengthy in the U.S. and other advanced economies.
Perhaps this shouldn’t have been surprising.
The detailed analysis by Carmen Reinhart and Kenneth Rogoff (2009)
concludes that recessions caused by financial crises generally are severe
and are followed by anemic recoveries.
By any yardstick, this certainly describes the U.S. recovery to date:
Output growth has averaged only 2-1/4 percent annually, and resource
gaps remain huge.
In particular, the unemployment rate remains over 8 percent — well
above the 5-1/4 to 6 percent rate most FOMC participants view as being
consistent with a fully employed labor force over the longer run.
Both public and private sector forecasts see relatively modest rates of
growth over the next few years.
For example, most recent forecasts by the private sector have 2012 gross
domestic product (GDP) growth at less than 2 percent; a pace that may
not even be enough to keep up with potential.
Growth in 2013 is expected to be only moderately higher.
Moreover, both the European debt situation and the looming U.S. fiscal
cliff impart substantial downside risks to the forecast.

_____________________________________________________________

Even absent any negative shocks, such tepid growth rates would close the
large existing resource gaps only very gradually.
Indeed, I expect that we will face unemployment well above sustainable
levels for some time to come.
Implications for Asia
In the aftermath of the Great Recession, most Asian economies enjoyed a
return to solid levels of growth.
Today, however, growth in Asia faces some new challenges.
One of these challenges is that Asian economies will not be immune to
the tepid growth prospects facing the world’s advanced economies.
Forecasts for growth in Asia have been marked down over the past year,
reflecting in part the impact of the downgrade in the outlook for Asian
exports for the U.S. and the euro area.
For example, the U.S. and the euro area account for about one-third of
China’s merchandise exports.
The recession and weak recoveries in those economies were big factors in
the Chinese current account surplus falling from about 10 percent of GDP
in 2007 to less than 3 percent in 2011.
This weakness remains a consideration as we look forward; indeed, it is
an important reason why the International Monetary Fund (IMF) is
projecting that the Chinese current account surplus will fall even more by
2013.
International trade is an excellent thing: Exploiting comparative
advantages raises living standards for all nations.
However, all countries can’t simultaneously export their way out of their
problems. For the world as a whole, the current account has to balance.
Thus, countries with large external surpluses face risks to their economies
posed by slowdowns in their trading partners.

_____________________________________________________________

Aggregate world growth must reflect aggregated domestic demands. So if
demand is going to be sluggish in a large share of the world economy,
other nations must take up the slack, or world growth will fall.
Inflation
With regard to inflation, as you know, the FOMC’s long-run inflation
objective is 2 percent as measured by the price index for personal
consumption expenditures (PCE).
For a number of reasons, I don’t foresee much risk that inflation will rise
above reasonable tolerance levels relative to this objective.
First, we see evidence of low expectations for inflation and growth in the
today’s historically low Treasury yields.
If there were warning signs of dangerous inflationary pressures, the
ten-year rate wouldn’t be in the neighborhood of 1-3/4 percent!
Second, even with the latest increase in oil prices, energy and commodity
prices remain well off their recent peaks as the global outlook dims.
Third, as I just noted, the output gap remains large and is likely to close
only slowly.
In this economic environment, wage pressures are practically
nonexistent.
And it is hard to envision how major persistent inflation pressures will
emerge without a parallel increase in wage costs. Such parallel price and
wage increases were a big part of the 1970s inflation, a scenario some fear
repeating today.
Fourth, inflationary dynamics depend in large part on the momentum
generated by people’s expectations of future inflation; currently, inflation
expectations are well anchored, which will tend to keep inflation from
moving either up or down.
Putting all of these factors together along with the fact that core inflation
averaged 1.8 percent over the past year, I conclude that inflation will likely
remain near or below our 2 percent target over the medium term.
_____________________________________________________________

Sources of Risk and Their Implications
I would now like to turn to two important downside risks to the outlook
for growth.
This will be a bit of a U.S.-centric view, but clearly these risks also have
important implications for growth here in Asia and the rest of the world.
Europe
Let me begin with the European debt situation.
Obviously, the developments in Europe pose a significant downside risk
to the U.S. economy and world economic growth more broadly.
The direct effects of slower European growth on the U.S. economy would
be relatively small.
The eurozone nations account for less than 15 percent of U.S.
merchandise exports.
Thus, according to standard elasticity estimates, even a moderate
eurozone recession would reduce U.S. exports by only a couple of tenths
of GDP.
The indirect effects of eurozone developments could, however, be more
severe, both in the U.S. and Asia. One possible channel would be through
financial contagion.
If losses on euro-centric assets put a large enough dent in the balance
sheets of financial institutions that lend to U.S. households and
businesses, the increases in the cost and availability of credit would
reduce growth in the U.S. with possible spillover effects into Asia as well.
Clearly, this is a risk worth monitoring.
Fortunately, though, U.S. financial institutions are in much better shape
to handle such potential losses than they were in 2008.
Recognizing the risks posed by the European debt situation, U.S.
institutions have reduced their direct exposure to European assets and
tightened lending standards to European banks.
_____________________________________________________________

On the regulatory front, the most recent stress tests made large U.S.
banks demonstrate that they would have adequate capital even in the
event of a sharp European recession with contagion to global financial
markets.
A second possible channel would be through the effects of uncertainty on
current demand.
Throughout the recovery, U.S. business and household sentiment has
been very fragile.
Every hint of bad news seems to generate a wave of increased caution and
an associated pullback in spending as firms and families seek to protect
their individual balance sheets.
After what the U.S. economy went through in the Great Recession, this
skittishness is understandable — particularly if one can envision a very
large downside to the news event.
And, as I just noted, given developments in Europe, there certainly are
some serious downside scenarios one can envision, even if they are not
the most likely outcomes.
So it would be no surprise if yet another wave of uncertainty put a further
dent in consumption and investment.
U.S. fiscal cliff
Another risk to the U.S. economy comes from the so-called fiscal cliff.
Under current U.S. law, numerous tax and spending provisions enacted in
various stimulus packages dating as far back as 2001 are scheduled to
expire on January 1, 2013.
In addition, if no budget agreement is reached by Congress, there will be
significant automatic spending sequestration and other spending cuts in
January.
According to projections made by the Congressional Budget Office
(CBO), if all these things took place, real GDP growth would be reduced
by about 4 percentage points in 2013.
_____________________________________________________________

I’m not saying that a pullback of this magnitude should be the base-case
scenario.
The orders of magnitude are just too big to be a base case.
But when you go through the various items and make guesses at which
may stay and which may go, it is easy to envision scenarios that include a
marked increase in fiscal restraint in 2013.
In addition, given the political process, it seems unlikely that we will
know much about the size or composition of the cuts until late in the
process.
It’s also easy to see how the rhetoric of public negotiating stances could
produce an atmosphere that causes already jittery households and
businesses to put some spending plans on hold.
In sum, a messy resolution to the fiscal cliff problems presents an
important downside risk to U.S. growth prospects and, by extension, to
world economic growth.
And even the possibility of such an outcome could be a drag in the second
half of the year.
Policy Choices
Let me now switch gears and talk about my views regarding the choices
facing monetary policymakers in the U.S.
Yes, we have substantial liquidity already in place in our financial system.
On the surface, this looks like substantial monetary accommodation.
But as a large body of economic theory tells us, for this liquidity to be
sufficiently accommodative, the public needs to expect that we will keep
it in place for as long as is necessary to restore the economy to a sound
footing.
This is why I believe we should clarify the Fed’s forward guidance with
regard to the future course of policy. Let me now go into the details
behind these thoughts.
_____________________________________________________________

An explicit economic state-contingent policy
In weighing alternative policy approaches, I think the best way to provide
forward guidance is by tying our policy actions to explicit measures of
economic performance.
There are many ways of doing this, including setting a target for the level
of nominal GDP.
But recognizing the difficult nature of that policy approach, I have a more
modest proposal: I think the Fed should make it clear that the federal
funds rate will not be increased until the unemployment rate falls below 7
percent.
Knowing that rates would stay low until significant progress is made in
reducing unemployment would reassure markets and the public that the
Fed would not prematurely reduce its accommodation.
Based on the work I have seen, I do not expect that such policy would
lead to a major problem with inflation.
But I recognize that there is a chance that the models and other analysis
supporting this approach could be wrong.
Accordingly, I believe that the commitment to low rates should be
dropped if the outlook for inflation over the medium term rises above 3
percent.
The economic conditionality in this 7/3 threshold policy would clarify our
forward policy intentions greatly and provide a more meaningful guide on
how long the federal funds rate will remain low.
In addition, I would indicate that clear and steady progress toward
stronger growth is essential.
Because we are not seeing that now, I support further use of our balance
sheet to provide even more monetary accommodation.
In June we decided to continue our Maturity Extension Program, which
puts downward pressure on long-term interest rates by extending the
average maturity of the Federal Reserve’s securities portfolio.
_____________________________________________________________

I thought that was a useful step.
However, I believe it is time to take even stronger steps, such as the
purchase of more mortgage-backed securities, to increase the degree of
monetary support for the recovery.
As suggested recently by my colleagues Eric Rosengren and John
Williams, these could be open-ended purchases, meaning that they would
continue at a certain rate until there was clear evidence of improvement in
economic conditions.
To me, one example of clear evidence would be a resumption of relatively
steady monthly declines in unemployment for two or three quarters.
Once this momentum was confidently established, the Fed could stop
adding to our balance sheet but keep the funds rate at zero.
The funds rate would remain unchanged in my thinking, until the
unemployment rate hit at least 7 percent or the medium-term inflation
outlook deteriorated dramatically and rose above 3 percent.
Later, reductions in the Fed’s balance sheet assets would occur sometime
after the first increase in the funds rate.
This corresponds to the general exit principles the FOMC agreed upon
last year.
Presumably, the pace of asset reductions would be measured and
consistent with a continued, robust recovery in the context of price
stability.
Accommodation in the Context of a Symmetric Inflation Target
and Balanced Policy
I can’t tell you how often people look at me in horror when I say that we
should adopt a conditional policy that tolerates the risk of inflation
exceeding our target by as much as 1 percentage point.
How can I accept inflation rising above our stated target? Isn’t this
blasphemy for a central banker?

_____________________________________________________________

In January, in the same framework document that announced our 2
percent inflation target, we also stated a number of principles for the
conduct of monetary policy.
One was that policy would take a balanced approach in achieving the two
legs of the Federal Reserve’s dual mandate — maximum employment
and price stability.
An explicit real-side mandate makes the Federal Reserve different than
most central banks.
While just about all central banks follow a flexible inflation targeting
approach, in which they seek to minimize real-side fluctuations in pursuit
of their inflation objective, most are explicitly charged only with an
inflation objective.
But for the Fed, maximum employment is an explicit part of our policy
mandate.
I strongly support the policy principles document we released in January.
But we’re still hearing questions about whether our inflation goal is
symmetric and about the specifics of how policy will be implemented
under the balanced approach articulated in this framework.
As Chairman Bernanke (2012) stated at his April press conference, the 2
percent inflation goal is a symmetric objective and not a ceiling on
inflation.
Symmetry means that inflation below 2 percent should be viewed as the
same policy miss as if inflation overran 2 percent by equal amount.
We need to take symmetry seriously.
If we disproportionately recoil at inflation a little above 2 percent versus a
little below, then we are not symmetrically weighing policy misses.
And we will not average 2 percent inflation, which is our goal.
There is some risk of this misperception taking hold. Consider the
FOMC’s latest Summary of Economic Projections (SEP), which includes
the projections of all FOMC participants, voters and non-voters alike.
_____________________________________________________________

In it, several forecasts have the funds rate rising before 2014, even though
throughout the projection period most see inflation at or below 2 percent
and unemployment well above the sustainable rate indicated by the
long-run projections.
Without further explanation, it’s difficult to see how this is consistent with
a symmetric inflation goal and a balanced approach to achieving the two
legs in our dual mandate.
I believe the FOMC can do better at describing our thinking with respect
to tolerance bands around our long-run inflation and unemployment
goals.
Clarification would increase both transparency and accountability.
Importantly, it would reassure economic agents that Fed policy would not
tighten prematurely.
To me, a symmetric inflation goal and a balanced approach to policy
mean that if we are missing our employment mandate by a large amount,
but are close to our inflation target, then we should be willing to
undertake policies that could substantially reduce the employment gap
even if they run the risk of a modest, transitory rise in inflation that
remains within a reasonable tolerance range of our target.
I believe such actions, such as the 7/3 threshold policy I have been
advocating, would produce smaller net losses relative to our dual mandate
goals than would current policy.
Conclusion: The Need for a Vibrant Economy to Cushion Risks
Finding a way to deliver more accommodation — whether it is monetary
or fiscal — is particularly important now because delays in reducing
unemployment are costly.
An unusually large percentage of the unemployed have been without
work for quite an extended period of time; their skills can become less
current or even deteriorate, leaving affected workers with permanent scars
on their lifetime earnings.

_____________________________________________________________

And any resulting lower aggregate productivity also weighs on potential
output, wages and profits for the economy as a whole.
The damage intensifies the longer that unemployment remains high.
Failure to act aggressively now could lower the capacity of the economy
for many years to come.
Such potential costs would come with the continuation of a subpar pace
of economic recovery.
The significant risks I discussed earlier – financial disruption from a
worsening of the situation in Europe or a messy resolution of U.S. fiscal
policy – raise the specter of an even more worrisome outcome.
At the moment economic growth is not much above stall speed.
Another negative shock could send the economy into recession.
And if a recessionary dynamic takes hold, it would be especially difficult
to regain momentum.
I have outlined some policy actions that I think can take us in the
direction of a more vibrant and resilient economy.
Given the risks we face, I think it is vital that we make such moves today.
I don’t think we should be in a mode where we are waiting to see what the
next few data releases bring.
We are well past the threshold for additional action; we should take that
action now.
Thank you.
Note
Charles L. Evans is the ninth president and chief executive officer of the
Federal Reserve Bank of Chicago. In that capacity, he serves on the
Federal Open Market Committee (FOMC), the Federal Reserve System's
monetary policy-making body.

_____________________________________________________________

The Federal Reserve Bank of Chicago is one of 12 regional Reserve Banks
across the country. These 12 banks — along with the Board of Governors
in Washington, D.C. — make up our nation's central bank.
As head of the Chicago Fed, Evans oversees the work of roughly 1400
employees in Chicago and Detroit who conduct economic research,
supervise financial institutions, and provide payment services to
commercial banks and the U.S. government.
Before becoming president in September of 2007, Evans served as
director of research and senior vice president, supervising the Bank's
research on monetary policy, banking, financial markets and regional
economic conditions. Prior to that, Evans was a vice president and senior
economist with responsibility for the macroeconomics research group.
His personal research has focused on measuring the effects of monetary
policy on U.S. economic activity, inflation and financial market prices. It
has been published in the Journal of Political Economy, American
Economic Review, Journal of Monetary Economics, Quarterly Journal of
Economics, and the Handbook of Macroeconomics.
Evans is active in the civic community. He is a board member at Chicago
Metropolis 2020 and the Metro Chicago Information Center, and a trustee
at Rush University Medical Center.
Evans has taught at the University of Chicago, the University of Michigan
and the University of South Carolina. He received a bachelor's degree in
economics from the University of Virginia and a doctorate in economics
from Carnegie-Mellon University in Pittsburgh.

_____________________________________________________________

EBA, EIOPA and ESMA
Joint Consultation Paper on Draft Regulatory Technical Standards on the
uniform conditions of application of the calculation methods under
Article 6.2 of the Financial Conglomerates Directive (JC/CP/2012/02)

I. Responding to this Consultation

EBA, EIOPA and ESMA (the ESAs) invite comments on all matters in
this paper and in particular on the specific questions stated in the
attached document “Overview of questions for Consultation” at the end
of this paper.

Comments are most helpful if they:

- respond to the question stated;

- indicate the specific question to which the comment relates;

- contain a clear rationale;

- provide evidence to support the views expressed/ rationale proposed;
and

- describe any alternative regulatory choices EBA should consider.

II. Executive Summary

The CRR/CRD IV proposals (the so-called Capital Requirements
Regulation - henceforth ‘CRR’- and the so-called Capital Requirements
Directive – henceforth ‘CRD’) set out prudential requirements for banks
_____________________________________________________________

and other financial institutions which are expected to apply from 1
January 2013.

In anticipation of the finalisation of the legislative texts for the
CRR/CRD IV, the EBA, EIOPA and ESMA (hereafter the ESAs) through
the Joint Committee, have developed the draft RTS in accordance with
the mandate contained in Article 46(4) of the CRR and Article 139 of
CRDIV (amending Article 21 a (2a) of the Directive 2002/87/EC) on the
basis of the European Commission’s proposals.

This Article provides the ESAs through the Joint Committee, to develop
draft Regulatory Technical Standards (RTS) with regard to the conditions
of the application of the Article 6(2) of the Directive 2002/87/EC
(hereafter the Directive).

Further the ESAs have developed the draft RTS having regard to Article
230 in connection with Articles 220 and 228 of the Directive
2009/138/EC2.

To the extent that the texts may change before their adoption, the ESAs
shall adapt its draft RTS accordingly to reflect any developments.

The RTS included in this consultation have to be submitted to the EU
Commission by 1 January 2013.

Please note that the ESAs have developed the present draft RTS based on
the European Commission’s legislative proposals for the CRR/CRD IV.

They have also taken into account major changes subsequently proposed
by the revised texts produced by the Council of the EU and the European
Parliament, during the ordinary legislative procedure (co-decision
process).

Following the end of the consultation period, and to the extent that the
final text of the CRR/CRD IV changes before the adoption of the RTS,
the ESAs will adapt the draft RTS accordingly to reflect any
developments.
_____________________________________________________________

Main features of the RTS

This consultation paper puts forward draft RTS in order to ensure that
institutions that are part of a financial conglomerate apply the appropriate
calculation methods for the determination of required capital at the level
of the conglomerate.

They are based in particular on the following elements:

General Principles

o Elimination of multiple gearing;

o Elimination of intra-group creation of own funds;

o Transferability and availability of own funds; and

o Coverage of deficit at financial conglomerate level having regard to
definition of cross-sector capital.

Technical calculation methods

1. Method 1: “Accounting consolidation method”:
The FICOD provides in relation to Method 1 that the own funds are
calculated on the basis of the consolidated position of the group.

According to this general provision, the calculation of own funds should
be based on the relevant accounting framework for the consolidated
accounts of the conglomerate applicable to the scope of the Directive.

The use of “consolidated accounts” eliminates all own funds’ intra-group
items, in order to avoid double counting of capital instruments.

According to the Directive provisions, the eligibility rules are those
included in sectoral provisions.
_____________________________________________________________

2. Method 2: “Deduction and aggregation method”.
This method calculates the supplementary capital adequacy
requirements of a conglomerate based on the accounts of solo entities.

It aggregates the own funds, deducts the book value of the participations
in other entities of the group and specifies treatment of the proportional
share applicable to own funds and solvency requirements.

All intra-group creation of own funds shall be eliminated.

3. Method 3: “Combination of methods 1 and 2”.

The use of combination of accounting consolidation method 1 and
deduction and aggregation method 2 is limited to the cases where the use
of either method 1 or method 2 would not be appropriate and is subject to
the permission by the competent authorities.

III. Background and rationale

The supplementary supervision of financial entities in a financial
conglomerate is covered by the Financial Conglomerates Directive
2002/87/EC, hereafter known as the Directive.

This Directive provides for competent authorities to be able to assess at a
group-wide level the financial situation of credit institutions, insurance
undertakings and investment firms which are part of a financial
conglomerate, in particular as regards solvency (including the elimination
of multiple gearing of own funds instruments).

The nature of RTS under EU law

Draft RTS are produced in accordance with Article 10 of the ESAs
regulation.

_____________________________________________________________

According to Article 10(4) of the ESAs regulation, they shall be adopted
by means of Regulations or Decisions.

According to EU law, EU regulations are binding in their entirety and
directly applicable in all Member States.

This means that, on the date of their entry into force, they become part of
the national law of the Member States and that their implementation into
national law is not only unnecessary but also prohibited by EU law,
except in so far as this is expressly required by them.

Shaping these rules in the form of a Regulation would ensure a
level-playing field and would facilitate the cross-border provision of
services.

Background and regulatory approach followed in the draft RTS

These draft RTS are produced in accordance with CRD IV/CRR
proposals, which provide that the EBA, ESMA and EIOPA (hereafter the
ESAs), through the Joint Committee, shall develop draft regulatory
technical standards with regard to the conditions of the application of the
calculation methods with regard to Article 6(2) of the Directive and shall
submit those draft regulatory technical standards to the Commission by 1
January 2013.

The proposed draft RTS covers the uniform conditions for the use of the
methods for the determination of capital adequacy of a financial
conglomerate under the Directive.

They elaborate on Technical principles applying to all of the three
methods provided for by Directive; and also contain an Annex providing
further detail for Method 2.

The requirements contained in the draft RTS are mainly directed at
institutions, although some of them are directed at competent authorities.

_____________________________________________________________

IV. Draft Regulatory Technical Standards on the uniform
conditions of application of the calculation methods under
Article 6.2 of the Financial Conglomerates Directive

Commission Delegated Regulation (EU) No XX/2012
supplementing Directive xx/XX/EU [CRD] of the European Parliament
and of the Council of [date], Regulation (..) No xx/XXXX [CRR] of the
European Parliament and of the Council of [date] and Directive
2002/87/EC [Financial Conglomerates Directive] of the European
Parliament and of the Council of [date] with regard to regulatory
technical standards for the uniform conditions of application of the
calculation methods under Article 6.2 of the Financial Conglomerates
Directive of XX Month 2012

THE EUROPEAN COMMISSION,

Having regard to the Treaty on the Functioning of the European Union,

Having regard to the [proposal for a] Regulation (...) No xx/xxxx of the
European Parliament and of the Council of dd mm yyyy on prudential
requirements for credit institutions and investment firms Regulation
xx/xxxx [CRR] and in particular Article 46 (4) thereof.

Having regard to the [proposal for a] Directive (...) No xx/xxxx of the
European Parliament and of the Council of dd mm yyyy on the access to
the activity of credit institutions and the prudential supervision of credit
institutions and investment firms [CRDIV] and in particular Article 139
thereof.

Having regard to the Directive 2002/87/EC, as amended, of the
European Parliament and of the Council on the supplementary
supervision of credit institutions, insurance undertakings and investment
firms in a financial conglomerate (hereinafter “the Directive”) and in
particular to Article 6(2) and Annex 1 thereof.

Whereas:
_____________________________________________________________

(1) Directive 2002/87/EC provides in Chapter II, Section 2, rules on
capital adequacy of financial conglomerates, such that the elements of
own funds are available at the level of a Financial Conglomerates are
always at least equal to the capital adequacy requirements as calculated in
accordance with Annex I of the Directive.

(2) Regulation (...) No xx/xxx (‘CRR’) provides in Article 46, within Part
II, Chapter 2, Section 3, Sub-Section 2 and in the context of common
equity

Tier I rules, requirements for deduction where consolidation or
supplementary supervision are applied.

This section of the CRR provides empowerments to the European
Commission to adopt delegated acts (regulatory technical standards) in
accordance with articles 10-14 of the Regulation (EU) No 1093/2010
establishing the European Banking Authority (‘EBA’), Articles 10-14 of
the Regulation (EU) No 1094/2010 establishing the European Insurance
and Occupational Pensions Authority (‘EIOPA), and Articles 10-14 of the
Regulation (EU) No 1095/2010 (‘ESMA), establishing the European
Securities and Markets Authority.

These acts will complete the EU single rulebook for institutions in the
area of own funds.

(3) Directive (...) No xx/xxx (‘CRDIV’) provides in Article 139 that the
Directive 2002/87/EC shall be amended, such that the EBA, EIOPA and
ESMA through the Joint Committee, to develop draft Regulatory
Technical Standards (RTS) with regard to the conditions of the
application of the Article 6(2) of the Directive.

(4) For effective supervision of Financial Conglomerates, supplementary
supervision should be applied to all such conglomerates, the
cross-sectoral financial activities of which are significant, which is the
case when certain thresholds are reached, no matter how they are
structured.
_____________________________________________________________

Supplementary supervision should cover all financial activities identified
by the sectoral financial legislation and all entities principally engaged in
such activities should be included in the scope of the supplementary
supervision, including asset management companies and alternative
investment fund management companies.

(5) Without prejudice to sectoral rules, supplementary supervision of the
capital adequacy rules is necessary to bring more convergence in the
application of the calculation methods listed in Annex 1 of the Directive.

(6) For financial conglomerates which include significant banking or
investment business and insurance business, multiple use of elements
eligible for the calculation of own funds at the level of the financial
conglomerate (multiple gearing) as well as any inappropriate intra-group
creation of own funds must be eliminated.

(7) The financial conglomerate should seek an acceptable timeframe for
the transferability of funds across entities within the financial
conglomerate, which shall depend on whether the specific entity is
subject to the Directive 2009/138/EC or the CRDIV/CRR.

Moreover for an entity subject to the CRD IV/CRR this timeframe should
be expediated based on the fact that due to the nature of their activities,
they are more vulnerable to a rapid deterioration in confidence and/or
sudden resolution situation.

(8) In addition any non-sector-specific own funds, in excess of sectoral
requirements, need to originate from entities which are not subject to
transferability/availability impediments.

(9) It is important to ensure that own funds are only included at
conglomerate level if there are no impediments to the transfer of assets or
repayment of liabilities across different conglomerate entities, including
across sectors.

_____________________________________________________________

(10) If there is a deficit of own funds at the level of the financial
conglomerate, the financial conglomerate should inform the coordinator
on the measures taken to cover this deficit.

(11) Further convergence in the way that financial conglomerates apply
these rules shall ensure the robust and consistent application of the
methods of calculation.

(12) For bank-led conglomerates it is necessary to apply the most prudent
method of calculation for the treatment of insurance holdings to avoid
regulatory arbitrage.

(13) It is important that sector-specific own funds cannot cover risks
above sectoral requirements.

The financial conglomerate should first count sector-specific own funds
against their requirements (while respecting sectoral rules and limits) for
each relevant entity or group of entities. If there is an excess of
sector-specific own funds, this should not be recognised at conglomerate
level.

(14) When calculating supplementary capital adequacy of a financial
conglomerate, in respect to non-regulated financial entities within the
financial conglomerate, both a notional capital requirement and a
notional level of own funds shoud be calculated.

(15) Under Solvency II, method 1 is applied on the basis of consolidated
data which are set out at Level 2 and not on the basis of consolidated
accounts.

(16) Further changes to the capital adequacy rules may be addressed in
the European Commission’s review of Directive 2002/87/EC.

(17) It is necessary that the new regime for treatment of methods of
consolidation enters into force the soonest possible following the entry
into force of the CRR/CRD IV and Solvency II.

_____________________________________________________________

(18) This Regulation is based on the draft regulatory technical standards
submitted jointly by the EBA, EIOPA and ESMA to the Commission.

(19) The EBA, EIOPA and ESMA have conducted open public
consultations on the draft regulatory technical standards on which this
Regulation is based, analysed the potential related costs and benefits, in
accordance with Article 10 of Regulation (EU) No 1093/2010, Article 10 of
Regulation (EU) No 1094/2010, Article 10 of Regulation (EU) No
1095/2010,and requested the opinion of the Banking Stakeholder Group
established in accordance with Article 37 of Regulation (EU) No
1093/2010, Insurance Stakeholder Group and the Occupational
Stakeholder Group established in accordance with Article 37 of
Regulation (EU) No 1094/2010, and the European Securities and Markets
Stakeholder Group established in accordance with Article 37 of
Regulation (EU) No 1095/2010.

HAS ADOPTED THIS REGULATION:
TITLE I
Subject matter and definitions

Article 1
Subject matter

This Regulation lays down rules of the uniform conditions of application
of the calculation methods under Article 6.2 of the Directive.

Article 2
Definitions

1. Definitions of the CRD IV/CRR, Directive 2002/87/EC and Directive
2009/138/EC shall apply to this Regulation.

_____________________________________________________________

2. Capital instruments are those capital instruments eligible under CRR
(Regulation 2012/…./EC) and those capital instruments referred to as
“own funds” in Directive 2009/138/EC.

3. Ultimate responsible entity is the entity within the financial
conglomerate that is responsible for determining the capital for the
financial conglomerate having regard to the following minimum criteria:
control, the dominant entity from the market’s perspective (market listed
entity) and the ability to fulfill specific duties towards its subsidiaries and
its supervisor.

4. ‘indirect holding’ as defined under definition 17 of Article 22 of CRR [to
be added if not in final CRR text].

5. Insurance-led financial conglomerate is a financial conglomerate
whose most important sector is insurance as defined under Article 3(2) of
the Directive.

6. Bank-led financial conglomerate is a financial conglomerate whose
most important sector is banking as defined under Article 3(2) of the
Directive.

7. Investment firm-led financial conglomerate is a financial conglomerate
whose most important sector is investment services as defined under
Article 3(2) of the Directive.

TITLE II
Technical Principles

Article 3
Elimination of multiple gearing and the intra-group creation of
own funds

The ultimate responsible entity shall ensure that own funds, which have
been created by intra-group transactions, be it direct or indirect, shall be

_____________________________________________________________

eliminated for the purpose of determining the required capital on a
consolidated basis.

Article 4
Transferability and availability of own funds

1. For all entities of a financial conglomerate, own funds, in excess of
sectoral solvency requirements, shall be considered available to absorb
losses elsewhere in the financial conglomerate provided that all of the
following conditions are fulfilled:

(a) There are no practical, legal, regulatory, contractual or statutory
impediments to the transfer of funds or repayment of liabilities across
conglomerate entities in due course.

This is the case when the transfer of own funds from one conglomerate
entity to another is not barred by a restriction of any kind and there are no
claims of any kind from third parties on these assets.

The ultimate responsible entity of the financial conglomerate shall
confirm to the satisfaction of the coordinator that the conditions set out in
this point are met.

(b) For the purpose of assessing the transferability of funds to entities
subject to 2009/138/EC, “in due course” shall mean no later than 9
months;

for the purpose of assessing the transferability of funds to entities
subjected to CRR, “in due course” shall mean no later than, three
calendar days with no impediments on the coordinator requiring a faster
transfer if necessary.

2. Own funds, in excess of sectoral solvency requirements, which do not
meet the criteria under point 1 shall be excluded from the conglomerate’s
own funds.

_____________________________________________________________

3. The financial conglomerate shall demonstrate that measures have been
taken to mitigate the risk that transfer of funds would have a material
effect on the transferor’s solvency.

EXPLANATORY TEXT for consultation purposes

This text is consistent with Annex 1 of the Directive which states “when
calculating own funds at the level of the financial conglomerate,
competent authorities shall also take into account the effectiveness of the
transferability and availability of the own funds across the different legal
entities in the group, given the objectives of the capital adequacy rules”.

Point 1(a) aims to ensure that own funds are only included at
conglomerate level if there are not impediments to the transfer of assets or
repayment of liabilities across different conglomerate entities, including
across sectors.

If the conglomerate cannot confirm to the satisfaction of the coordinator
that there are no inherent impediments in relation to a given entity, that
entity’s own funds in excess of its sectoral requirements cannot be
included at conglomerate level.

The impediments to be considered include practical, regulatory,
contractual or statutory ones.

Point 1(b) establishes an acceptable timeframe for the transferability of
funds across conglomerate entities.

There is a differentiation based on the fact that entities subject to CRR,
due to the nature of their activities, are more vulnerable to a rapid
deterioration in confidence and/or sudden resolution situation.

Article 5
Deficit of own funds at the financial conglomerate level

_____________________________________________________________

Risk Compliance News September 2012

Risk Compliance News September 2012

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