Basel 3 News May 2011

8/6/2019 Basel 3 News May 2011

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Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

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Basel iii Compliance Professionals Association (BiiiCPA)1200 G Street NW Suite 800 Washington, DC 20005-6705 USA

Tel: 202-449-9750 Web: www.basel-iii-association.com

Basel III News, May 2011

Dear Members, According to Otto von Bismarck, laws are like sausages, it is better not tosee them being made.

But this is not an option for us. Basel II / III professionals must try hardto understand both, the letter and the spirit of the law.

Banks continue to lobby for revisions of the key factors that are includedin the Basel III liquidity ratios, in an effort to minimize the consequencesand... increase shareholder value (and of course pay dividends).

Citigroup and Goldman Sachs for example, try to persuade that the NSFR should be substantially re-calibrated.

Are you ready for the bad news? According to Moody’s senior vice president Alain Laurin: “While directionally positive, Basel 3 does notcure the structural challenges banks continue to face from a credit

perspective, such as illiquidity and high leverage, nor does it alleviate thetension between profit-maximizing equity holders and bank managers incontrast to risk-averse bondholders.”

This month we had another opportunity to see that Basel III is aminimum standard:

The finance commission members in Switserland voted in favor of thegovernment's proposal, which would make the UBS and Credit Suisse




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hold equity Tier 1 capital of at least 10 percent, 3 percentage points morethan required by new Basel III rules.

Credit Suisse puts on a brave face and considers the proposal "tough butdoable".

UBS, more practical, calls for a year's delay to allow more clarity oninternational regulation.

Basel iii Training

The members of the Basel iii Compliance Professionals Association(BiiiCPA) have a 20% discount for the Certified Basel iii Professional(CBiiiPro) instructor-led class.

Website: www.baseliiitraining.com

You may click “Register” after selecting the course location and date. The discount code to enter when registering for a course: biiia

http://www.baseliiitraining.com/







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We must try to understand the Basel iii framework, and to continue tolearn month after month.

Today we will study one of the new papers that explain the Basel IIIframework.

Conference on Basel III, Financial Stability Institute, 6 April 2011

Basel III: Stronger Banks and a More Resilient Financial SystemStefan Walter, Secretary General, Basel Committee on BankingSupervision

I. Introduction

Thank you for the opportunity to speak to you this morning about Basel

III.

It is has now been three and a half years since the global financial crisisbegan.

The banking sector and financial system have now been stabilised.

But this required unprecedented public sector interventions.

Despite the severity of the crisis, we are already seeing signs that itslessons are beginning to fade.

At the same time, there are still significant risks on the horizons, whilekey reforms still need to be carried through if we are to achieve a trulystable banking and financial system.

I would like to begin this morning by recalling the damaging effects of the crisis and why the Basel III reforms are central to promoting financialstability.

I will then briefly outline the key reforms that comprise Basel III.




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Finally, I will focus on what still needs to be done to ensure longer-termstability.

In particular, I will discuss the need for global and consistentimplementation of the Basel III reform package and the ongoing work toaddress the risks of systemic banking institutions.

II. Motivation for Basel III reforms

A. Damaging effects of banking crises

There is a wide body of evidence that the most severe economic crises areassociated with banking sector distress.

While there is variation in findings across studies, the Basel Committee’slong-term economic impact study found that the central estimate in theeconomics literature is that banking crises result in losses in economicoutput equal to about 60% of pre-crisis GDP.

Why are banking crises so damaging?

Banks are highly leveraged institutions and are at the centre of the creditintermediation process.

In addition, credit and maturity transformation functions are vulnerableto liquidity runs and loss of confidence.

A destabilised banking system affects the provision of credit and liquidityto the broader economy and ultimately leads to lost economic output.

[see Table 1]




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In the most recent phase of the crisis there has also been significantspillover of risk between the banking sector and sovereigns.

Governments in a number of industrialised countries had to increase theirdebt in order to stabilise their banking systems and economies.

As a result, debt-to-GDP ratios in a number of economies increased by asmuch as 10-25 percentage points.

It therefore is clear that the economic benefits of raising the resilience of the banking sector to shocks are immense.






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Many countries may not have been the cause of the current crisis, butthey have been affected by the global fall out.

Moreover, history has shown that banking crises have occurred in allregions of the world, affecting all major business lines and asset classes.

Moreover, there tend to be a common set of features that seem to repeatthemselves in various combinations from banking crisis to banking crisis.

These include:

1. Excess liquidity chasing yields

2. Too much credit and weak underwriting standards

3. Underpricing of risk, and

4. Excess leverage

In the current crisis, these recurring trends were magnified by:

1. Weak bank governance practices, including in the area of compensation

2. Poor transparency of the risks at financial institutions and in complex products

3. Risk management and supervision focused on individual institutionsinstead of also at the system level

4. Procyclicality of financial markets propagated through a variety of channels, and

5. Moral hazard from too-big-too-fail, interconnected financial

institutions.




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C. Benefits of tighter regulation through Basel III exceed thecosts

The objective of the Basel III reforms is to reduce the probability and

severity of future crises.

This will involve some costs arising from stronger regulatory capital andliquidity requirements and more intense and intrusive supervision.

But our analysis and that of many others has found the benefits to society well exceed the costs to individual institutions.

The Committee’s long-term economic impact analysis found that capitaland liquidity requirements could be increased – well above current

minimum levels – while still achieving positive net economic benefits.

[see Table 3]




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These findings are not surprising.

It is widely accepted that prudent fiscal and monetary policies are thecornerstones of financial stability and sustainable economic growth.

Indeed, maintaining conservative fiscal and inflation policies involve acost – they result in potentially lower short-term economic growth, whichis offset by more sustainable long-term growth.

Increasing stability of the banking and financial system involves a similartrade-off, where the costs are more than offset by the long-term gain.




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In particular, it is difficult to imagine a country that can maintainsustainable growth on the foundation of a weak banking system

III. Key features of the Basel III reform package

The Basel III framework is the cornerstone of the G20 regulatory reformagenda and the final Basel Committee rules were issued at the end of last

year.

This development is the result of an unprecedented process of coordination across 27 countries.

Compared to Basel II, it was also achieved in record time, less than two years.

The next step, which is just as critical as the policy development, isimplementation.

The full potential of Basel III will only be achieved if allCommittee-member countries and regions work within the global

process, and fully implement the minimum standards.

Some countries may choose to implement higher standards to addressrisks particular to their national contexts.

This has always been an option under Basel I and II, and it will remainthe case under Basel III.

Why is Basel III fundamentally different from Basel I and Basel II?

First, it is more comprehensive in its scope and, second, it combinesmicro- and macro-prudential reforms to address both institution andsystem level risks.

On the microprudential side, these reforms mean:




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1. A significant increase in risk coverage, with a focus on areas that weremost problematic during the crisis, that is trading book exposures,counterparty credit risk, and securitisation activities;

2. A fundamental tightening of the definition of capital, with a strongfocus on common equity.

At the same time, this represents a move away from complex hybridinstruments, which did not prove to be loss absorbing in periods of stress.

We also introduced requirements that all capital instruments must absorblosses at the point of non-viability, which was not the case in the crisis;

3. The introduction of a leverage ratio to serve as a backstop to the

risk-based framework;

4. The introduction of global liquidity standards to address short-termand long-term liquidity mismatches; and

5. Enhancements to Pillar 2’s supervisory review process and Pillar 3’smarket discipline, particularly for trading and securitisation activities.

In addition, a unique feature of Basel III is the introduction of macroprudential elements into the capital framework.

This includes:

1. Standards that promote the build-up of capital buffers in good timesthat can be drawn down in periods of stress, as well as clear capitalconservation requirements to prevent the inappropriate distribution of capital;

2. The leverage ratio also has system-wide benefits by preventing theexcessive build-up of debt across the banking system during boom times.




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To minimise the transition costs, the Basel III requirements will be phased in gradually as of 1 January 2013.

I would now like to say a few words in particular about two of the newerelements of the regulatory framework, namely the liquidity standards andthe leverage ratio. As mentioned, excess leverage and weak liquidity

profiles of banks were at the core of the crisis, and they thereforerepresent a critical part of the Basel III framework going forward.

A. The Liquidity Framework

There is broad support for the liquidity framework introduced by theCommittee.

Banks and other market participants already use methods similar to theLiquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio(NSFR).

Many of the issues that have been raised pertaining to these requirementsrevolve around the calibration of the ratios, rather than the conceptualbasis of the framework.

It is important to emphasise the Committee’s goal in establishing theliquidity framework: to require banks to withstand more severe shocks

than they had been able to in the past, thus reducing the need for suchmassive public sector liquidity support in future episodes of stress.

The success of the framework should not be measured in terms of whether it will have zero cost.

Instead, the better measure of success is whether the framework corrects pre-crisis extremes at acceptable costs.

Banks that take on excessive liquidity risk should be penalised under thenew framework, while sound business models should continue to thrive.




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With these objectives in mind, the Committee will use the observation period to review the implications of the standards for individual banks,the banking sector, and financial markets, addressing any unintendedconsequences as necessary.

In this regard, the Committee’s focus is now on ensuring that thecalibration of the framework is appropriate.

Certain aspects of the calibration will be examined and this will involveregular data collection from banks.

Any adjustments should be based on additional information and rigorousanalyses.

Moreover, relying just on banks’ experiences from the crisis is notsufficient, as it embeds a high level of government support of banks andmarkets.

Hence, the analysis will need to include both quantitative bank experience and additional qualitative judgement.

It is worth emphasising that a number of effects of the framework areindeed intended.

For example, with regard to the pool of liquid assets, the rules are meantto promote changes in behaviour.

Contrary to popular perception, they are not about promoting thehoarding of government debt, but about creating incentives to reducerisky liquidity profiles.

This can be achieved, for example, by pushing out the average term of funding or increasing the share of stable funds.




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In other cases, banks did not price liquidity appropriately throughout thefirm, and correcting risk management deficiencies will in turn improveliquidity profiles.

In fact, the initial response we have observed in some countries that havealready implemented comparable liquidity ratios suggest that these arethe types of strategies that are being pursued.

Also contrary to what many have claimed, the new standards should help promote greater diversification of the pool of liquid assets held by banks.

Bank holdings of liquid assets continue to be dominated by exposures tosovereigns, central banks and zero percent risk-weighted public sectorentities.

These assets comprised 85% of banks’ liquid assets according to theCommittee’s most recent quantitative impact study.

By recognising high quality corporate and covered bonds – subject to alimit – the liquidity framework will help promote a further diversificationof the liquid asset pool.

B. The Leverage Ratio

Many banks entered the crisis with excessive leverage.

This increased the probability of bank failures.

It also exacerbated the effects of the crisis on broader financial markets asmany banks rushed to de-leverage once the crisis hit.

The objective of the leverage ratio is to serve as a back-stop to therisk-based measure.




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The Committee’s calibration work shows that bank leverage was a highlystatistically significant discriminator between banks that ultimately failedor required government capital injections during the crisis and those thatdid not.

Moreover, at the height of the crisis, the market gravitated towards simpleleverage based measures to compare banks. [see Table 4]

The leverage ratio also serves a macroprudential purpose.

We have seen during this and prior crises the cyclical movement of leverage at the system-wide level.

Leverage, which tends to build up prior to crisis periods, is subsequentlyunwound when a crisis occurs.

This cyclical aspect exacerbates both the upswing phase and thedownturn.




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In addition, what can appear to be very low risk assets at the institutionlevel can ultimately create incentives for the build-up of risks at thebroader system level.

The leverage ratio serves to limit excessive concentrations in such assetclasses.

[see Table 5]

As with the liquidity framework, the Committee has a process in place toassess the impact of the leverage ratio on business models.

It will take actions if necessary to make sure that the design of theleverage ratio will achieve its objectives.

As I stressed earlier, it is important that all countries and regions continueto work within this global process.




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IV. What still needs to be done to ensure longer-term bankingsector and economic stability?

Over the past three years, much has been achieved by the global

regulatory community to respond to the crisis. This policy work is now substantially complete.

But to ensure longer-term banking sector and economic stability,consistent and timely global implementation of Basel III is critical.

In addition, a key remaining area of policy development work is focusedon dealing with systemically important banks (SIBs).

Finally, we will also need to stay attuned to bank-like risks that emerge in

the shadow banking sector.

V. Implementation of Basel III

The Committee has put in place mechanisms to help ensure moreconsistent implementation of its standards.

This applies not only to Basel III but to other global standards agreed bythe Committee.

The efforts of the Committee are reinforced through additionalinstitutional arrangements introduced at the level of the FinancialStability Board (FSB) and the G20.

Going forward, the Committee’s Standards Implementation Group will play a critical role in conducting thematic peer reviews of membercountries’ implementation of standards and sound practices.

Implementation involves not only introduction of the standards in legal

form, but also rigorous and robust review and validation by supervisors.




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We therefore are also introducing processes to ensure the integrity of keyelements of the framework.

An example of this is the review of banks’ risk weightings, which shouldinclude the use of test portfolio exercises.

As we have painfully learned from the recent crisis, the failure toimplement Basel III in a globally consistent way will again lead to acompetitive race to the bottom and increase the risk of another crisisdown the road.

VI. Addressing the Too-Big-To-Fail (TBTF) problem

During the crisis, the failure or impairment of certain banks sent shocks

through the financial system.

This had an adverse knock-on effect on the real economy.

Supervisors and relevant authorities had limited options to prevent orcontain problems effecting individual firms and this led to wider financialinstability.

As a consequence, public sector intervention to restore financial stabilityduring the crisis was necessary, as was the massive scale of these

responses.

The fallout from the crisis underscores the need to put in place additionalmeasures to reduce the likelihood and severity of problems emerging atsystemic banking institutions.

The Committee, in close cooperation with the FSB is working to addressthe financial system externalities created by Systemically ImportantBanks (SIBs).

To achieve this broad objective, policy tools are being designed to:




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1. Reduce the probability as well as the impact of an SIB failure;

2. Reduce the cost to the public sector should a decision be made tointervene; and

3. Level the playing field by reducing too-big-to-fail competitiveadvantages in funding markets.

The Committee has developed a methodology that embodies the keycomponents of systemic importance.

These are size, interconnectedness, substitutability, global activity andcomplexity.

The methodology can serve as a basis for the differentiated treatment of systemic institutions without needing to specify a fixed list of suchinstitutions.

Common equity is the key when it comes to going concern capital as it isavailable to absorb losses with certainty, thus reducing the probability of failure.

The Committee also continues to study the role that going-concern

contingent capital could play in its framework for SIBs.

Strong resolution and recovery frameworks play a critical role in reducingthe impact of failure by facilitating the orderly wind-down of a globalbank.

In this context, the Committee is reviewing the role that bail-in debtcould play in complementing Tier 2 capital to provide additionalresources that can mitigate the systemic impact of banks at the point of non-viability.




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The Committee’s work on systemically important banks is part of thebroader effort of the Financial Stability Board (FSB) to address the risks

posed by SIFIs.

The Committee is working closely with the FSB through this process, andexpects to consult on proposals to address the risks of globally systemicbanks around the middle of the year.

VII. Shadow Banking

The final area where further work is needed is shadow banking.

Shadow banking was a key mechanism through which the crisis was propagated.

SIVs, money market mutual funds, the securitisation process, and bank liquidity lines to off-balance-sheet exposures all served to amplify theimpact of the crisis on banks.

While it is clearly important to address issues in the shadow bankingsector, its existence should not detract from the fundamental need tostrengthen the resilience of the banking system itself.

The banking sector remains at the centre of the credit and liquidity

intermediation process.

This is true even in economies that are more reliant on capital markets.

Moreover, significant parts of shadow banking were created, sponsoredor financed by the banking sector and these include SIVs, ABCPconduits, MMMFs, certain securitisation structures, and hedge funds.

Finally, much of the shadow banking sector depends on the financingand liquidity support of the banking sector.




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Basel III goes a long way to closing the gaps in exposure to shadow banking. It does this in several ways:

1. By addressing the capital treatment for liquidity lines to SIVs and othertypes of off-balance sheet conduits;

2. By addressing counterparty credit risk;

3. By including off-balance sheet exposures in the Basel III leverage ratio;and

4. By incorporating a range of contractual and reputational risks arisingfrom the shadow banking sector into the liquidity regulatory andsupervisory standards.

Thus, stronger, consolidated banking regulation and supervision will go asignificant way towards containing the risks of the shadow bankingsector.

In addition, to the extent that bank-like risks emerge in the shadow banking sector, they should also be addressed directly.

Supervisors should take a system-wide perspective on the creditintermediation process.

To the extent that bank-like functions are carried out in the shadow banking sector and pose broader systemic risks, they should be subject toappropriate regulation, supervision, and disclosure.

In particularly this is the case where activities combine creditintermediation, maturity or liquidity transformation, and leverage.

The FSB, the Basel Committee and the Joint Forum of Banking,Securities, and Insurance Supervisors will monitor developments closely

and promote appropriate responses as circumstances dictate.




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VIII. Other Basel Committee initiatives

The Committee is also conducting a fundamental review of the tradingbook.

It is fundamental in the sense that it will help inform basic questions suchas how to address the line between the banking and the trading book andhow to improve upon the current VAR based framework for measuringtrading risks.

We will consult on this issue as the work progresses, which I expect willbe around the end of this year

Other issues on the Committee’s agenda include further work on

cross-border bank resolution issues and updating of large exposurestandards, as well as a revision of the Core Principles for EffectiveBanking Supervision.

It is critical that we incorporate the lessons of the crisis into a revised setof Core Principles, which will serve as the basis for enhanced countrylevel reviews through the IMF and World Bank.

IX. Conclusion

The policy work for developing the Basel III framework has for the most part been completed.

The reforms are significant and bring together micro and macro lessonsof the crisis.

The Committee has now moved to the next phase: implementation.

One of the regulatory lessons of the crisis is that it is critical that all

countries and regions now follow the global implementation process.




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By definition, it will be hard to predict the cause of the next crisis.Many risks are still looming on the horizon, and all countries need tocontinue the process of building their capacity to absorb shocks –

whatever the source.

The banking sector’s shock absorbing capacity must be much stronger than it has been in the past, and the implementation of our standardsmust be more globally consistent and robust.

Speech by Jean-Claude Trichet, President of the ECB,Madrid, 13 May 2011

Introduction

We are nearly four years on from the first tremors in the world’s financialsystem that started in the summer of 2007, and in a few months we willapproach three years since the dramatic intensification of the crisis in theearly autumn of 2008.

As you are all well aware, the euro area, the world’s second largest andmost open economy, was immediately and strongly affected.

And as guardians of what is generally considered the world’s second mostimportant currency, the European Central Bank (ECB) was profoundlyinvolved in the response to the crisis.

Our consistent aim in the crisis has been to protect as far as possible thereal economy from the financial distress in the system.

Over the past few years, our toolkit has featured the standard monetary policy measures of setting interest rates, as well as a range of non-standard monetary policy measures.




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The latter have included temporary measures such as full allotment of liquidity, expanded eligibility for collateral, longer-term refinancingoperations and interventions in bond markets.

The ECB has also been involved in actions focused on the long term to tryto ensure that the financial sector cannot pose such a danger to the realeconomy again.

The financial turmoil that emerged from the US housing market and which sent shockwaves across the world economy revealed deep flaws inthe way the financial system in advanced economies operates and in the

way that system is supervised and regulated.

Tackling those systemic flaws through financial reform is what I would

like to discuss today.

The ECB’s involvement in financial reform takes place through our rolein the institutional framework of the European Union as well as theinstitutional framework of the global economy – the G20, the BaselCommittee and other fora of international cooperation.

Last year several important decisions were taken on the pillars of the new supervisory and regulatory framework.

First, the adoption of Basel III.

Second, reforms of market infrastructure.

And third the establishment of macro-prudential oversight institutions,including the European Systemic Risk Board (ESRB).

Key areas where work is still in progress include the treatment of systemically important financial institutions, crisis management andresolution, oversight of the shadow banking system, and – very




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importantly – the regulation and oversight of financial markets and theirfunctioning.

* * *

Today I would like to lay out what I believe are the three main buildingblocks of the financial reconstruction that is currently in progress – tooutline what has been achieved and what remains to be done.

The first building block is banking regulation. Here, the globalcommunity has made the right diagnosis and, in the Basel III framework,drawn the appropriate lessons.

The second building block is regulation of the financial markets.

Here, reform must create greater transparency for the various marketsegments and products, ensure sufficient competition in all markets, andattenuate as far as possible the pro-cyclicality from structural featuressuch as ratings and market phenomena such as herding.

The third building block is macro-prudential oversight.

This new discipline focuses on the interactions between the various partsof the financial system and between the financial sector and the real

economy.

New institutions, including the ESRB, will pursue the task of identifyingsources of systemic risk, issuing early warnings and recommendingremedial action.

The birth date of macro-prudential oversight in Europe will probably beidentified as the start of this year but it was originally conceived in 2009through the work of the Committee presided over by Jacques deLarosière.




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The fact that it took little more than a year and a half from policy designto institutional establishment was made possible by thoroughgroundwork by the European Commission and very rapid decisions bythe European Parliament and the European Council.

I feel very honoured to chair this new body, the ESRB, together withMervyn King and Andrea Enria.

Let me discuss each of these three building blocks, focusing on both progress to date and the challenges that lie ahead.

1. Banking regulation and Basel III

First, banking regulation, where the Basel III framework represents the

cornerstone of the newly revised international regulatory architecture.

This framework envisages higher minimum capital requirements, betterrisk capture, stricter definition of eligible capital elements and moretransparency.

It introduces entirely new concepts, such as non-risk-based leverageratios and mandatory liquidity requirements.

Beyond the micro-prudential dimension of regulation – typically

represented by institution-specific solvency requirements – Basel III alsointroduces macro-prudential elements, most prominently the capitalbuffer regime based on aggregate credit growth.

From both a macroeconomic and financial stability perspective, theimplementation of Basel III should bring substantial long-term benefits.

As painfully experienced in recent years, financial crises imposeenormous costs on society.




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The main benefit of the reform will stem from the reduced frequency of future crises.

The new standards aim at improving banks’ capital base and the sector’sresilience to a crisis.

Financially sounder banks will, in turn, help foster financial stability as well as mitigating systemic risk.

The prevention and mitigation of downside tail risks for the economyimplies a sizeable reduction in the expected output losses associated withsystemic events, contributing to more sustainable growth.

Although the net benefits from Basel III are difficult to quantify precisely,

the Committee’s analysis indicates that the potentially negative impact of the new framework on long-term output is considerably lower than thegrowth benefits associated with the reduced frequency of crises.

Additional benefits include lower funding costs for banks and a decline inrisk premia.

At the same time, it is acknowledged that implementation of the new framework will impose some transitional costs on the sector as banksneed to meet the more stringent regulatory requirements.

Banks can adjust their capital ratios through a combination of severalmeasures, for example, by raising capital or reducing dividends for sometime.

The length of the implementation period matters crucially for thetransition costs.

The Basel Committee has designed relatively long phase-in arrangementsto mitigate adjustment costs.




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If the new framework had been implemented hastily, banks would haveneeded to reorganise their balance sheet structure quickly, which couldhave had adverse impacts on credit intermediation in the short term.

Implementation over the time frame 2013-2019 has been agreed to providethe sector sufficient time to adjust to the new requirements.

The gradual implementation should prevent disruptions in credit flowsand bring enough clarity and scope for banks to absorb the necessaryadjustments smoothly over time.

Looking forward, the introduction of the new standards presents theinternational regulatory and supervisory community with two majorchallenges.

The first is to ensure proper implementation of Basel III at the globallevel.

In line with the G-20 recommendations, all national authorities shouldhonour their commitment to implement the framework without anyundue postponement.

The second challenge relates to thorough assessment of the new regulatory concepts and measures.

Some of the new concepts, such as liquidity standards and leverage ratios,have sparked controversy and delayed final agreement.

To alleviate concerns about potential unintended consequences, anobservation period has been agreed to serve as a basis for the final designand calibration.

Work in progress on systemically important financial institutions, crisisresolution and shadow banking




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Let me turn to some issues of banking regulation on which it is importantthat work continues.

The first is systemically important financial institutions, which the G20and the Group of Governors and Heads of Supervision have stated shouldsatisfy additional solvency requirements beyond the levels agreed in BaselIII.

The main goal here is to reduce the externalities related to the financialdistress of such institutions, and ultimately avoid a repetition of the crisis.

The Financial Stability Board (FSB) has been working on identifyingsystemically important financial institutions and evaluating the desirablemagnitude of additional capital with which they should comply.

Its recommendations will be delivered to the G20 summit in November.

The FSB’s work is a fundamental step towards an internationalframework that fully reflects the greater risks posed by these largeinstitutions.

Looking forward, it is crucial that effective peer reviews of finalimplementation are set up, ensuring consistency across jurisdictions.

Enforcing a level global playing field remains a priority for the regulatoryagenda, to prevent regulatory arbitrage to parts of the financial sector

with less supervision and weaker regulation.

In parallel with higher solvency requirements for systemically importantfinancial institutions, important initiatives are underway – both in Europeand globally – to improve the capacity of authorities to resolve financialinstitutions, especially in a cross-border context.




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An effective resolution regime should consist of a comprehensive toolkitof gradually increasing powers, complemented by credible financingarrangements that reduce the reliance on government budgets.

It is essential to make significant progress in the coming years to ensurethat all systemically important financial institutions can be resolved in anorderly manner and without taxpayers’ support.

The FSB is identifying the key elements of effective resolution regimes.

At the same time, the reform of national (or in the case of the EU,supra-national) resolution frameworks is already underway in the majorjurisdictions, including the Dodd Frank Act in the United States.

Here, the European Commission has published a public consultationdocument on the planned EU framework, for which legislative proposalsare expected in June.

Let me briefly mention shadow banking.

The introduction of more stringent capital requirements for creditinstitutions may provide further incentives for banks to shift part of theiractivities outside the regulatory perimeter.

Against this background, the FSB is developing recommendations tostrengthen oversight of the shadow banking system in collaboration withother international standard setting bodies.

Work on the shadow banking system should aim to develop a betterunderstanding of the interconnections between regulated banks andunregulated entities that are conducting credit intermediation, eitherdirectly or as part of a complex chain of intermediation activity, as well asthe channels for possible contagion.




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In this context, it is crucial to understand the functioning of the repomarket. It is also vital to identify entities or activities within the shadow banking system that may be sources of systemic risk.

2. Market regulation

Let me turn to the second building block, namely regulation of financialmarkets.

One of the key lessons from the crisis is that the risks to market returnsdid not come mainly from shocks to the real economy.

The risks came from the financial sector itself.

The financial structures that we thought were in place to assess, absorband neutralise risk were either dysfunctional or worked to magnify

volatility.

Key factors in creating this risk were opaque financial structures and pro-cyclicality in financial markets.

The lack of transparency in many financial instruments meant that somemarket players could exploit – for their own, private benefit – informationthat was not generally available.

Pro-cyclicality acts as a formidable accelerator of financial trends.

Two important factors that drive such amplification are distortedincentives and herd behaviour.

The role of distortions in economic incentives is widely understood, butherd behaviour as a driver of pro-cyclical patterns in financial markets stillneeds a thorough explanation.




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One explanation lies in the significance of market players’ evaluation of their performance relative to the rest of the market.

This is reminiscent of Keynes’ famous beauty contest analogy.

To be successful in this environment, individual participants do not formtheir own opinions, but follow the general mood.

Everybody seeks to ride the wave, hoping to step off before the moodturns.

A second complementary explanation is that global markets are in factless atomistic than we think. Derivatives activity in the US bankingsystem, for example, is dominated by a small group of large institutions.

And, of course, the market for credit ratings is famously dominated bythree signatures, which act as standard-setters for an enormous volume of transactions.

Many regulatory initiatives are underway to remedy these issues,including work on OTC derivatives, which comprise 80% of tradedderivatives.

The near-collapse of Bear Stearns in March 2008, the default of Lehman

Brothers in September 2008 and the bail-out of AIG the same monthhighlighted shortcomings in the functioning of the OTC derivativesmarket, and underlined the need for appropriate action to increasetransparency and address concerns about financial stability.

To this end, there is now a regulation underway in Europe aimed atbringing more safety and more transparency to the derivatives market.

According to the draft regulation, information on OTC derivativecontracts should be reported to trade repositories and be accessible to

supervisory authorities.




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Furthermore, standard OTC derivative contracts should be clearedthrough central counterparties, thus reducing the risk that one party tothe contract defaults.

Any possible concentration risk involved in the set-up of the CCPs couldbe assessed at the macro-prudential level.

Of course, financial market infrastructures can only help to foster thestability of markets to the extent that they are safe and sound.

To this end, the Committee on Payment and Settlement Systems and the Technical Committee of the International Organization of SecuritiesCommission are reviewing the relevant regulatory and oversightstandards.

A consultative report published in March 2011 outlines principles that will provide greater consistency in the oversight of financial marketinfrastructures worldwide.

3. Macro-prudential supervision and the ESRB

Let me come to the final building block: macro-prudential oversight.

As my earlier remarks suggested, the financial crisis has been revealing in

many respects.

It has revealed the fallout from the failure of large financial institutions.

It has revealed the fragility of the financial system to features and trendsthat cut across institutions, markets and infrastructures.

And it has illustrated the amplitude of the consequences of the adversefeedback loop between the financial system and the real economy.




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All these three elements are key features of systemic risk: first, contagion;second, the build-up of financial imbalances and unsustainable trends

within and across the financial system; and third, the close links with thereal economy and the potential for strong feedback effects.

The strengthening of macro-prudential oversight – with theestablishment of institutions devoted to that task such as the ESRB, theUS Financial Stability Oversight Council and the UK’s Financial PolicyCommittee – should enhance our ability to identify and address systemicrisk.

How can these new bodies reach their full potential?

The first precondition is that they have an adequate infrastructure to

identify and analyse systemic risks.

This demands a state-of-the-art analytical toolkit, which can provide asolid basis for systemic risk analysis and the ensuing formulation of

policy responses.

In the field of systemic risk assessment, great attention is currentlydevoted to macro stress testing as a tool to evaluate the impact of shockson the financial sector and the real economy.

This complements micro stress tests relating to individual financialinstitutions.

A key challenge is modelling feedback effects between the financialsystem and the real economy.

Another promising area relates to network analysis, which aims toidentify systemic inter-linkages across firms, sectors and countries.

This type of analysis, which is well established in other domains, is still at

its infancy for the financial sector.




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A key point in this context is that the effectiveness of the analytical toolkitis strongly dependent on the availability and quality of data.

There are several data gaps, which make it difficult to assess the sourcesand magnitude of systemic risks and the very complex network of inter-linkages in the financial system.

The second precondition for the success of the new bodies is a coherentframework for macro-prudential oversight and policy development.

In this context, it is important to note that the institutions do not havedirect control over policy tools.

In the case of the ESRB it may issue risk warnings and recommendations

to other authorities, which should comply with them or give reasons fornon-compliance.

Since existing policy tools that can be used for macro-prudential purposesfall in other policy domains (e.g. micro-financial supervision, monetary

policy or fiscal policy), it is essential that effective coordinationmechanisms should be developed between the responsible authorities.

In particular, close cooperation between macro- and micro-supervisoryauthorities is essential as most of the macro-prudential tools are

micro-prudential in nature.

It is therefore of utmost importance that the mandate of macro-prudentialauthorities as well as the role of supervisory authorities inmacro-prudential surveillance are clearly defined.

Conclusion

Let me conclude. I believe we are now about halfway through thecomprehensive financial reforms that the crisis has demanded.




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We have achieved a blueprint of more stringent bank regulations thatincludes more loss-absorbing capital, better risk coverage and limitationsfor undue leverage. The oversight of financial institutions as well asmarkets and market infrastructure are being strengthened.

And the organisational structure of financial supervision is beingoverhauled.

But much remains to be done.

The key aspect is implementation of the reforms.

Moreover, the issue of systemically important financial institutionsrequires further reflection.

And oversight of the proper functioning of financial markets in a way thatavoids undue volatility, excessive influence of dominant players andoligopolistic market structures, while reinforcing transparency, needs tobe addressed resolutely.

Thanks, in particular, to prompt and resolute action by central banks andby governments, the international community avoided a great depression,after the intensification of the crisis in mid-September 2008.

With the global recovery being confirmed, numerous voices in thefinancial sector are arguing that we are now back to business as usual.

Achieving an ambitious programme of reforms of rules, regulations andoversight of the financial sector is considered by some as unnecessary andcounterproductive.

I do not at all share those views. It is an absolute obligation, for all of us,to do all what is necessary to reinforce the resilience of the financialsystem and ensure its sustainable contribution to growth.




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We must be sure that the excessive fragility that was revealed in 2008 and2009 is eliminated.

Not only because the costs of financial crises in terms of growth is alwaysconsiderable but, even more, because it is extremely likely that ourdemocracies would not be ready to provide once again the financialcommitments to avoid a great depression in case of a new crisis of thesame nature.

Our people would not permit, for a second time, that governmentsmobilize 27% of GDP of tax payer risk, on both sides of the Atlantic, toavoid the collapse of the financial sector.

For these reasons public authorities must pursue and implement their

G20 programme with inflexible determination, and it is essential that the private sector fully implements this programme.

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