Monday April 1 2013 Top 10 Risk Compliance News Events

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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

Top 10 risk and compliance management related news stories and world events that (for better or for worse) shaped the

week's agenda, and what is next

Dear Member, Today I will start with the job description that made my day: Basel II/III and Solvency II risk specialist, Mandarin Speaking!!!

Basel III Risk Specialist - Mandarin Speaking Leading Global Investment Bank, London A Leading Global Investment Bank is Expanding the Regulatory Risk Function with the hire of a Basel III Risk Specialist for their London Group. - Basel III Regulatory Risk Specialist - Leading Global Investment Bank - Mandarin Speaking

- London, UK - 50,000 + Excellent Bonus Benefits As a key member of the risk group you will be communicating extensively with senior management on a global scale including direct contact with senior management in Hong Kong and Shanghai and will therefore

require Mandarin speaking skills at business A Pillar 3 Disclosure??

level proficiency.

http://www.risk-compliance-association.com/

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An expert in regulatory frameworks, you will have practical understanding of Basel II/III and knowledge of Solvency II ICAAP is also highly preferred. This is a mid-level position within the group and will require a minimum of 3 years industry experience within the London and/or International Financial Markets. It is never too late to learn Mandarin. Is looks easy!

Amazing job description… Just one slight problem with this job description: You cannot have knowledge of Solvency II ICAAP … simply because there is nothing like a Solvency II ICAAP… perhaps they mean Solvency II ORSA (Own Risk and Solvency Assessment, the Pillar 2 document). It reminds me another job description, where they required 5+ years of Basel III experience. Provided that Basel III was endorsed at the end of 2010, they could hire someone after 2015… Another development: Auditors… it is your turn to suffer the consequences of the crisis… According to the BIS, The recent financial crisis not only revealed weaknesses in risk management, control and governance processes at

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banks, but also highlighted the need to improve the quality of external audits of banks. Given the central role banks play in contributing to financial stability, and therefore the need for market confidence in the quality of external audits of banks' financial statements, the Basel Committee is issuing for consultation this guidance on external audits of banks. This document describes, through sixteen principles and explanatory guidance, supervisory expectations regarding audit quality and how that relates to the external auditor's work in a bank.

Read more at Number 1 below.

Welcome to the Top 10 list.

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External audits of banks Given the central role banks play in contributing to financial stability, and therefore the need for market confidence in the quality of external audits of banks' financial statements, the Basel Committee is issuing for consultation this guidance on external audits of banks. This document describes, through sixteen principles and explanatory guidance, supervisory expectations regarding audit quality and how that relates to the external auditor's work in a bank.

Meeting of the G20 Finance Ministers and Central Bank Governors Update by the IASB and FASB Convergence projects This report is a high-level update on the status and timeline of the remaining convergence projects.

To G20 Ministers and Central Bank Governors

Progress of Financial Regulatory Reforms

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EIOPA

The new Risk Dashboard

Focusing on Low- and Moderate-Income Working Americans

Governor Sarah Bloom Raskin Board of Governors of the Federal Reserve System At the National Community Reinvestment Coalition Annual Conference, Washington, D.C.

Islamic capital and money markets Welcoming remarks by Mr Peter Pang, Deputy Chief Executive, Hong Kong Monetary Authority, at the workshop on “Islamic capital and money markets”, Hong Kong

Interview with Gabriel Bernardino, Chairman of EIOPA, conducted by Nataša Gajski Kovačić, Svijet osiguranja (Croatia)

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Reviewing filings for smaller public companies These slides were presented at the Forums on Auditing in the Small Business Environment hosted by the PCAOB during 2012.

The Global Financial Sector—Transforming the Landscape By Christine Lagarde, Managing Director, International Monetary Fund, Frankfurt Finance Summit

Managing structural risks in the Swedish banking sector Speech by Mr Stefan Ingves, Governor of the Sveriges Riksbank and Chairman of the Basel Committee on Banking Supervision, at Affärsvärlden’s “Bank & Finans Outlook”, Stockholm

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External audits of banks The recent financial crisis not only revealed weaknesses in risk management, control and governance processes at banks, but also highlighted the need to improve the quality of external audits of banks. Given the central role banks play in contributing to financial stability, and therefore the need for market confidence in the quality of external audits of banks' financial statements, the Basel Committee is issuing for consultation this guidance on external audits of banks. This document describes, through sixteen principles and explanatory guidance, supervisory expectations regarding audit quality and how that relates to the external auditor's work in a bank. Implementation of the principles and the explanatory guidance is expected to improve the quality of bank audits and enhance the effectiveness of prudential supervision which is an important element of financial stability. This document sets out supervisory expectations of how: - external auditors can discharge their responsibilities more effectively;

- audit committees can contribute to audit quality in their oversight of

the external audit; - an effective relationship between the external auditor and the

supervisor, which allows greater mutual understanding about the respective roles and responsibilities of supervisors and external

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auditors, can lead to regular communication of mutually useful information; and

- regular and effective dialogue between the banking supervisory

authorities and relevant audit oversight bodies can enhance the quality of bank audits.

This document enhances and supersedes the Committee's guidance The relationship between banking supervisors and bank's external auditors (2002) and External audit quality and banking supervision (2008). In addition to the proposed guidance, the Committee is publishing a letter to the International Auditing and Assurance Standards Board (IAASB) on areas where it believes International Standards on Auditing could be enhanced. Serving as an observer on the Basel Committee group that developed the revised guidance, the IAASB provided helpful and meaningful input to this effort. Comments on the proposals should be submitted by Friday 21 June 2013 by e-mail to: [email protected]. Alternatively, comments may be sent by post to: Secretariat of the Basel Committee on Banking Supervision, Bank for International Settlements, CH-4002 Basel, Switzerland. All comments may be published on the website of the Bank for International Settlements unless a comment contributor specifically requests confidential treatment.

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External audits of banks 1. Executive summary 1. The recent financial crisis not only revealed weaknesses in risk management, control and governance processes at banks, but also highlighted the need to improve the quality of external audits of banks. Given the central role banks play in contributing to financial stability, and therefore the need for market confidence in the quality of external audits of banks’ financial statements, the Basel Committee on Banking Supervision (the Committee) is issuing this document on external audits of banks. It forms part of the Committee’s commitment to help improve audit quality at banks. This document enhances and replaces The relationship between banking supervisors and banks’ external auditors (January 2002) and External audit quality and banking supervision (December 2008). 2. Implementation of the 16 principles and observation of the explanatory guidance in this document are expected to improve the quality of bank audits and enhance the effectiveness of prudential supervision, which will then contribute to financial stability. Through these principles and explanatory guidance, the document describes supervisory expectations regarding audit quality and how that relates to the external auditor’s work in a bank. This document specifically sets out supervisory expectations of how: (a) external auditors can discharge their responsibilities more effectively; (b) audit committees can contribute to audit quality in their oversight of the external audit; (c) an effective relationship between the external auditor and the supervisor, which allows greater mutual understanding about the

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respective roles and responsibilities of supervisors and external auditors, can lead to regular communication of mutually useful information; and (d) regular and effective dialogue between the banking supervisory authorities and the relevant audit oversight bodies can enhance the quality of bank audits. 3. The document also notes the Committee’s continued commitment to work through international bodies to enhance audit quality.

2. Introduction, application, structure and the Committee’s international engagement Introduction 4. The banking sector is unique among sectors of the economy because it plays a central role in contributing to the financial stability of and the provision of financial resources to the economy. This sector includes major global banks that are systemically important banks (SIBs), the failure of one or more of which could trigger a global financial crisis. In addition, banks have a unique operating model. 5. Supervisors are primarily concerned with maintaining the stability of the banking system and fostering the safety and soundness of individual banks in order to maintain market confidence and protect the interests of depositors. Consequently, to enhance the effectiveness of supervision, supervisors have a keen interest in the quality with which external auditors perform bank audits. Building effective relationships with external auditors can also enhance banking supervision.

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6. An external auditor plans and performs the audit of a bank’s financial statements to obtain reasonable assurance about whether the financial statements as a whole are free from material misstatements, whether due to fraud or error, and are prepared, in all material respects, in accordance with an applicable financial reporting framework. In many ways, the supervisor and the external auditor have complementary concerns regarding the same matters. For example, the audit of financial statements may help identify weaknesses in internal controls relating to financial reporting at a bank which may, therefore, inform supervisory efforts in this area and contribute to a safe and sound banking system. 7. Although the focus of this document is on the quality of the audit performed by the external auditor, an audit in accordance with internationally accepted auditing standards is conducted on the premise that the management and, where appropriate, those charged with governance have acknowledged certain responsibilities that are fundamental to the conduct of the audit. The audit of the financial statements does not relieve management or those charged with governance of their responsibilities. 8. The Basel Committee on Banking Supervision’s Core Principles for Effective Banking Supervision (September 2012, Core Principles) provide a framework of minimum standards for sound supervisory practices and are considered universally applicable. Core Principle 27 focuses on prudential regulations and requirements for banks in relation to financial reporting and external audits. This guidance set out in this document is consistent with Core Principle 27. 9. The application and the structure of each section in this document are described below, followed by an outline of the key international

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relationships between the Committee and other groups relevant to external auditing.

Application 10. This document applies to the following entities subject to a statutory audit: - all banks, including those within a banking group;

- holding companies whose subsidiaries are predominantly banks; and

- holding companies subject to prudential supervision whose subsidiaries are predominantly banks.

All of these structures are referred to as banks or banking organisations in this document. 11. The implementation of the principles set forth in this document should be proportionate to the size, complexity, structure, economic significance and risk profile of the bank and the group (if any) to which it belongs. The Committee recognises that some countries have found it appropriate to adopt legal frameworks and standards (eg for listed firms), as well as accounting and auditing standards, which may be more extensive and prescriptive than the principles and explanatory guidance set forth herein. Such frameworks and standards tend to be particularly relevant for larger or publicly traded banks or financial institutions. 12. This document has been prepared with the full awareness that significant differences exist in national institutional, legislative and regulatory frameworks amongst jurisdictions, including accounting and auditing standards, supervisory techniques and institutional corporate governance structures. Supervisors should clearly communicate the recommendations contained herein to the banks they supervise and their respective external auditors,

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and articulate the measures banks and external auditors should undertake to meet these best practices, where possible. 13. The principles set out in this document should be applied in accordance with the national legislation and corporate governance structures applicable in each country. 14. The following terms are used in this document, with the meanings specified: - Financial statement audit – An audit of a bank’s financial statements

by an external auditor in accordance with internationally accepted auditing standards.

- Statutory audit – An audit carried out to comply with the requirements of particular legislation or regulations.

In some jurisdictions, this may include only the financial statement audit.

In other jurisdictions, this may also include extended reporting by external auditors on matters such as internal controls and regulatory returns.

- External auditor – The audit firm and the individual audit engagement team members.

Where relevant, specific references are made to the audit firm or the individual audit engagement team members in certain paragraphs.

- Banking supervisory authority – The body responsible for promoting the safety and soundness of banks and the banking system in a particular jurisdiction, including the persons who are involved with supervisory policy setting and policy issues, including policies regarding accounting and auditing.

- Supervisor – The group of supervisory personnel at a banking supervisory authority who are directly involved with the supervision/examination of a specific institution.

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- Board and senior management – The governance structure at a bank composed of a board and senior management.

The Committee recognises that there are significant differences in the legislative and regulatory frameworks across countries regarding these functions.

Some countries use a two-tier structure, where the supervisory function of the board is performed by a separate entity known as a supervisory board, which has no executive functions.

Other countries, by contrast, use a one-tier structure in which the board has a broader role.

Still other countries have moved or are moving to an approach that discourages or prohibits executives from serving on the board or limits their number and/or requires the board and board committees to be chaired only by non-executive board members.

Given these differences, this document does not advocate a specific board structure.

The terms “board” and “senior management” are only used as a way to refer to the oversight function and the management function in general and should be interpreted throughout the document in accordance with the applicable law within each jurisdiction.

- Audit committee – A specialised committee established by the board, the mandate, scope and working procedures for which are set out in a charter or other instrument.

As stated in the BCBS paper on Principles for enhancing corporate governance (October 2010), to increase efficiency and allow deeper focus in specific areas, boards in many jurisdictions establish certain specialised board committees – the audit committee being one of them.

The paper further recommends that, for large and internationally active banks, an audit committee or equivalent should be required.

It also outlines the overall responsibilities of the audit committee.

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- Those charged with governance – The person(s) or organisation(s) with responsibility for overseeing the strategic direction of the entity and obligations related to the accountability of the entity as defined by internationally accepted auditing standards.

Such person(s) or organisation(s) is (are) typically the board of directors.

Where the board of directors establishes an audit committee in a bank to assist it in meeting its responsibilities by charging the audit committee with specific tasks and responsibilities, in such circumstances the audit committee can be viewed as taking on the role of those charged with governance in relation to those specific tasks and responsibilities.

Structure The external auditor and audit quality 15. Audit quality includes delivering an appropriate, independent professional opinion on the financial statements, in compliance with internationally accepted auditing standards. Internationally accepted auditing standards require the external auditor to possess and demonstrate certain attributes while applying a rigorous audit process. 16. Given that internationally accepted auditing standards are applicable to all entities, Section 4 of this document builds upon these standards and lays out the supervisory expectations of the external auditor regarding the audit of a bank. Moreover, Section 4 highlights the key areas where significant risks of material misstatement in banks’ financial statements often arise, which therefore require the auditor’s particular attention for a quality audit.

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Engagement between the external auditor and the audit committee 17. Regular and effective engagement and communication between the external auditor and the audit committee contribute to audit quality. 18. Amongst its other responsibilities, the audit committee is responsible for overseeing the bank’s external auditor. A soundly constituted audit committee can play a key role in contributing to audit quality. Section 5 discusses the audit committee’s responsibilities in relation to the oversight of, and its relationship with, the external auditor.

Engagement between the supervisor and the external auditor 19. Effective communication between the supervisor and the external auditor enhances the effectiveness of supervision of the banking sector. This relationship will then also contribute to audit quality. 20. The supervisor and the external auditor have a mutual interest in building and maintaining an effective relationship, which fosters regular communication of useful information. Section 6 provides principles and explanatory guidance for facilitating an effective relationship between the supervisor and the external auditor at the levels of the supervised bank, the audit firm and the accounting profession as a whole.

Engagement between the banking supervisory authority and the audit oversight body 21. The banking supervisory authority and the relevant audit oversight body share a strong mutual interest in ensuring quality independent audits.

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Regular and effective dialogue between the banking supervisory authority and the audit oversight body at a national level can assist in identifying and dealing with key issues in relation to the conduct of bank audits. Section 7 sets out the principles for facilitating effective communication between these bodies. 22. Supervisors are in a unique position to identify audit quality issues at both the industry and individual audit level. Regular and effective engagement between the supervisor and the relevant audit oversight body may enable the supervisor to provide timely feedback on such issues. Additionally, the supervisor may, if necessary, take action to address issues raised by the audit oversight body.

The Committee’s international engagement on external auditing 23. Approaches for dealing with supervisory concerns about the quality of the audit of an individual bank may differ across jurisdictions, but all approaches should be designed to contribute to enhancing audit quality. In its effort to promote audit quality, the Committee engages in regular dialogue and discussion with the relevant international stakeholders on external audit matters. These stakeholders include, but are not limited to, the following: - the Financial Stability Board (FSB), whose objectives include the

enhancement of the effectiveness of banking supervision;

- the Monitoring Group, which is responsible for advancing the public interest in areas related to international audit quality;

- the Public Interest Oversight Board (PIOB), which is responsible for improving the quality and public interest focus of the international standards formulated by standard-setting boards operating under the

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auspices of the International Federation of Accountants (IFAC) in the areas of audit and assurance, education and ethics, including oversight of the public interest activities of three of the IFAC’s independent standard-setting boards and their respective consultative advisory groups;

- the consultative advisory groups of the International Auditing and Assurance Standards Board (IAASB) and the International Ethics Standards Board for Accountants (IESBA), which are responsible for developing international auditing and ethics standards respectively;

- the International Forum of Independent Audit Regulators (IFIAR),

which is responsible for improving audit quality globally, including through independent inspections of auditors and/or audit firms; and

- the Global Public Policy Committee (GPPC), which is comprised of

representatives from the six largest international accounting networks and focuses on public policy issues for the accounting profession.

24. The objective of this dialogue is to enable the Committee and the relevant international stakeholders to identify and discuss relevant issues and topics on a timely basis so that supervisors, external auditors and audit oversight bodies can take appropriate action. As such, these discussions should address not only current issues and topics, but also emerging areas and trends that raise concern.

3. Overview of the principles - Principle 1: The external auditor of a bank should have banking

industry knowledge and competence sufficient to respond appropriately to the risks of material misstatement in the bank’s financial statements and to properly meet any additional regulatory requirements that may be part of the statutory audit.

- Principle 2: The external auditor of a bank should be objective and

independent in fact and appearance with respect to the bank,

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consistent with the more stringent requirements applicable to public interest entities in internationally accepted ethical standards.

- Principle 3: The external auditor should exercise professional

scepticism when planning and performing the audit of a bank, having due regard to the specific challenges in auditing a bank.

- Principle 4: Audit firms undertaking bank audits should comply with

the more stringent requirements on quality control applicable to listed entities in internationally accepted quality control standards, having due regard to the complexity of a bank audit.

- Principle 5: The external auditor of a bank should identify and assess

the risks of material misstatement in the bank’s financial statements, taking into consideration the complexities of banking activities and the need for banks to have a strong control environment.

- Principle 6: The external auditor of a bank should respond

appropriately to the significant risks of material misstatement in the bank’s financial statements.

- Principle 7: The audit committee should have a robust process for

approving, or recommending for approval, the appointment, reappointment, removal and remuneration of the external auditor.

- Principle 8: The audit committee should monitor and assess the

independence of the external auditor. - Principle 9: The audit committee should monitor and assess the

effectiveness of the external audit. - Principle 10: The audit committee should have effective

communication with the external auditor to enable the audit committee to carry out its oversight responsibilities and to enhance the quality of the audit.

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- Principle 11: The audit committee should require the external auditor to report to it on all relevant matters to enable the audit committee to carry out its oversight responsibilities.

- Principle 12: The supervisor and the external auditor should have an

effective relationship that includes appropriate communication channels for the exchange of information relevant to carrying out their respective statutory responsibilities.

- Principle 13: The external auditor should report to the supervisor

matters that are likely to be of material significance to the functions of the supervisor.

- Principle 14: There should be open, timely and regular

communication between the banking supervisory authority, the audit firm and the accounting profession as a whole on key risks and systemic issues as well as a continuous exchange of views on appropriate accounting techniques and auditing issues.

- Principle 15: There should be regular and effective dialogue between

the banking supervisory authority and the relevant audit oversight body.

- Principle 16: The banking supervisory authority and the audit

oversight body should observe appropriate confidentiality requirements when sharing information.

4. Supervisory expectations relevant to the external auditor and the external audit of financial statements 25. External audits of financial statements performed in accordance with internationally accepted auditing standards enhance the confidence of all users, including supervisors, in the reliability of the audited financial statements and the quality of the information provided. 26. Audits of banks should be performed in accordance with internationally accepted auditing standards.

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As these standards are not industry-specific, for a quality audit supervisors expect external auditors not only to comply with internationally accepted auditing standards but also to tailor their audit work in response to the significant risks and issues applicable to banks. 27. External auditors are required to comply with applicable jurisdictional and, where relevant, internationally accepted ethical standards. However, given the complexity and systemic risks associated with banks, the external auditor of a bank should follow the most stringent rules for independence under these standards. Similarly, the external auditor of a bank should also follow the most stringent standards on quality control at the engagement level. 28. Part A of this section describes the supervisor’s expectations as a user of the bank’s financial statements, specifically with respect to the external auditor’s knowledge, competence, objectivity, independence, professional scepticism and quality control over the bank’s audit. Part B identifies areas where supervisors believe there is often a significant risk of material misstatement in a bank’s financial statements and factors to which the supervisor expects the external auditor to pay attention when auditing those areas. 29. While the primary focus in this section is on the financial statement audit, particularly in Principles 5 and 6, the external auditor may identify matters in the course of the audit that are of interest to the supervisor and therefore should be considered for communication to the supervisor. Examples of such matters have been included in Section 6. 30. In some jurisdictions, as part of the statutory audit, the external auditor may also undertake additional work to provide assurance on internal controls or other aspects of a bank’s operations. The principles set out in this section provide a relevant reference for the performance of such additional work.

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31. The principles and explanatory guidance set out in this section provide a framework for the supervisor’s interactions with the external auditor, the audit committee and the relevant audit oversight body. The outcome of these interactions will inform the supervisor’s views as to the quality of the external audit and contribute to the supervisory process. These principles and explanatory guidance also provide a framework to assist the audit committee in selecting the external auditor and in assessing the external auditor’s knowledge, competence, objectivity and independence as well as the effectiveness of the audit process.

A. The supervisor’s expectations of the external auditor of a bank Knowledge and competence Principle 1: The external auditor of a bank should have banking industry knowledge and competence sufficient to respond appropriately to the risks of material misstatement in the bank’s financial statements and to properly meet any additional regulatory requirements that may be part of the statutory audit. 32. Given the complexity and diversity of banking activities, and the legal and regulatory framework in which banks operate, the external auditor of a bank should have specialised knowledge and competence in auditing banks and should use experts as appropriate.

Knowledge 33. The resources required to perform the audit should be such that the audit engagement team, as a whole, has: - proficient knowledge and understanding of, and practical experience

with, the banking sector, associated banking industry and bank - specific risks, and the operations and activities of banks and bank audits.

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The audit engagement team may acquire this proficiency through specific training, participation in bank audits or work in the banking sector;

- proficient knowledge of applicable accounting, assurance and ethical standards, industry practice and relevant guidance such as International Auditing Practice Note (IAPN) 1000;

- proficient knowledge of relevant regulatory requirements in the areas of capital and liquidity, and a general understanding of the legal and regulatory framework applicable to banks; and

- proficient knowledge and understanding of IT relevant to bank audits.

34. In addition, the external auditor should consider whether the audit engagement team should include specialists with a high degree of technical accounting knowledge relevant to banking, particularly given the complexity of the requirements of the applicable financial reporting framework pertaining to accounting estimates, including loan loss provisions, fair value measurements, and any areas known to be subject to differing interpretation or inconsistent or developing practices.

Competence 35. Audit firms should have documented policies and procedures that set minimum competency criteria for members of a bank’s audit engagement team. 36. Supervisors may have the ability to influence the competency requirements for external auditors. Where regulations and standards in particular jurisdictions do not include specific competency requirements for banks’ external auditors, the supervisor may encourage professional and regulatory bodies to introduce requirements regarding training in, and experience with, bank auditing and accounting so that the audit engagement teams for bank audits are comprised of sufficiently competent staff.

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37. Competence is particularly important in underpinning an external auditor’s ability to exercise professional judgment and carry out key aspects of the audit, such as identifying and assessing the risks of material misstatement and designing and implementing appropriate responses to those risks.

Use of experts 38. In some instances, such as the auditing of certain complex accounting estimates, more specialised knowledge may be required to support the audit engagement team, eg additional expertise beyond that possessed by the audit engagement team’s members in a field other than accounting or auditing. Examples of such areas are valuation of complex financial instruments, commercial property valuations and evaluation of highly complex IT environments, particularly in areas subject to significant risks of material misstatement. 39. Internationally accepted auditing standards set out requirements for the nature, timing and extent of audit procedures which the external auditor should perform to assess the competence, capabilities and objectivity of the experts the external auditor may use. These are important factors in considering the reliability of the information or results produced by the expert.

Objectivity and independence

Principle 2: The external auditor of a bank should be objective and independent in fact and appearance with respect to the bank, consistent with the more stringent requirements applicable to public interest entities in internationally accepted ethical standards

Objectivity

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40. Objectivity is a fundamental ethical principle and a key element of audit quality. It requires that the external auditor’s judgment is not affected by conflicts of interest. As objectivity is a state of mind that in most cases cannot be directly observed by users of financial statements, it is important for the external auditor to be independent in both fact and appearance.

Independence 41. Independence is freedom from situations and relationships in which a reasonably informed third party would conclude that an external auditor’s objectivity is impaired. Jurisdictional and internationally accepted auditing standards and internationally accepted ethical standards lay out frameworks for external auditors to identify and respond to threats to independence. 42. The external auditor of a bank must comply with the applicable jurisdictional and internationally accepted ethical standards. Furthermore, the Committee believes that the external auditor of a bank should comply with the more stringent independence standards for public interest entities. To the extent that any of the rules within any one of these standards on ethics is more restrictive than the corresponding rule in the other standards on ethics, the external auditor must comply with the more restrictive rule. 43. Independence should be observed not only in the context of the bank that is being audited but also with respect to the bank’s related entities. 44. External auditors of a bank should comply with applicable jurisdictional requirements on the rotation of members of the audit engagement team.

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45. The audit engagement team members, the audit firm and, when applicable, network audit firms should comply with the independence requirements of both the home jurisdiction and the overseas regulatory authority (in the case where the bank is ultimately regulated by an overseas authority). 46. When assessing whether any relationship or circumstance poses a threat to an external auditor’s independence, the external auditor should evaluate not just the specific rules on independence, but also the substance of the threat to independence, and how a reasonably informed third party would perceive the threat and its effect on the external auditor’s objectivity. The provision of significant non-audit services by the audit firm and, when applicable, network audit firms to the bank being audited may particularly affect a third party’s perception of the external auditor’s independence. Such situations should be carefully evaluated for threats to the external auditor’s objectivity and perceived independence. 47. The supervisor expects the external auditor to consider actively potential threats to the auditor’s independence, specifically the threat of self-review, when discussing accounting matters with the management. For example, complex transactions may be structured to achieve a particular accounting treatment and/or regulatory outcome. When an external auditor discusses with or provides advice to management on such matters, the external auditor must exercise care so as not to take on a management role or responsibility.

Professional scepticism

Principle 3: The external auditor should exercise professional scepticism when planning and performing the audit of a bank, having due regard to the specific challenges in auditing a bank.

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48. Professional scepticism is defined as “an attitude that includes a questioning mind, being alert to conditions which may indicate possible misstatement due to error or fraud, and a critical assessment of evidence”. Professional scepticism should manifest itself not only through the auditor obtaining corroborating evidence for management’s assertions, but also challenging management’s assertions, actively considering whether there are alternative accounting treatments that are preferable to those selected by management, and documenting the approach, the evidence obtained, the rationale applied and the conclusions reached. Throughout the audit, the auditor should “adopt a questioning approach when considering information and forming conclusions”. 49. Exercising appropriate professional scepticism is critically important in audits of banks because of the number and significance of accounting estimates and the potential for limited objective evidence supporting those estimates. Professional scepticism is particularly important when auditing areas that: (a) involve significant management estimates and judgments because these are more prone to management bias; (b) involve significant non-recurring or unusual transactions; or (c) are more susceptible to fraud and errors being perpetuated due to weak internal controls. 50. Specific areas where professional scepticism should be exercised by the external auditor of a bank include impairment calculations, fair value measurements and going concern assessments, including assessments of solvency and liquidity. Other examples may include complex transactions structured to achieve a particular accounting treatment and/or regulatory outcome by the

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management where the audit engagement partner has or ought to have reasonable doubt that the proposed accounting treatment and/or regulatory outcome is consistent with the relevant financial reporting framework or regulatory requirements. In this context, the external auditor should actively challenge management’s assumptions and judgments and form independent views. This includes challenging evidence obtained from management that corroborates management’s view. 51. Where a bank consistently utilises valuations that are at the high or low end of a range of acceptable valuations or when there are other indications of possible management bias, the external auditor should consider this in the overall risk assessment of the bank and should inform those charged with governance, where appropriate. 52. The evidence of the extent of professional scepticism exercised should be demonstrable and understandable through audit documentation that describes how, why and what conclusions were reached by the external auditor. In this regard, internationally accepted auditing standards establish minimum requirements for audit documentation.

Quality control Principle 4: Audit firms undertaking bank audits should comply with the more stringent requirements on quality control applicable to listed entities in internationally accepted quality control standards, having due regard to the complexity of a bank audit. 53. Audit firms must comply with the applicable jurisdictional and internationally accepted standards on quality control. Furthermore, the Committee believes that the external auditor of a bank should comply with the more stringent requirements on quality control

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applicable to listed entities in internationally accepted quality control standards. To the extent that any of the rules within any one of these quality control standards is more restrictive than a corresponding rule in the other quality control standards, the external auditor must comply with the more restrictive rule. 54. The audit of a bank should be subject to an engagement quality control review (EQCR) performed internally by the audit firm prior to the issuance of the audit opinion. The engagement quality control reviewer should have the appropriate knowledge and competence to review bank audits. The reviewer should exercise professional scepticism in assessing the quality of audit evidence and whether the auditor’s judgments are appropriate. 55. EQCR should be part of a broader firm-level internal system of quality control that emphasises quality and consultation and creates a culture of compliance with auditing and ethical standards. 56. Where a network of audit firms is involved in the audit of a bank, the individual audit firms within the network should apply quality control processes that comply with this document. In such cases, the lead audit engagement partner should be responsible for the performance of a quality audit by all the teams reporting to it. In doing so, the lead partner may place reliance on the processes by which quality control is exercised within the network firms that report to it. For example, the lead audit engagement partner of a group audit may rely on the firm’s processes for (a) ensuring that each audit engagement team member

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(i) acquires the appropriate skills, knowledge and experience to perform bank audits and (ii) complies with independence rules, and (b) monitoring adherence to the audit firm’s policies and procedures on quality control. 57. The involvement of the engagement quality control reviewer throughout the audit, and the outcome of the quality control review, should be evident in the audit working papers. Any significant discussions between the engagement quality control reviewer and the audit engagement team, particularly in areas where views may have differed and as to how conclusions were reached, should be fully documented in the audit working papers. Thus in jurisdictions where the supervisor has access to the external auditor’s working papers, the quality control review would also be at the supervisor’s disposal.

B. Supervisory expectations of the audit of a bank’s financial statements Identifying and assessing significant risks of material misstatement specific to a bank’s financial statements Principle 5: The external auditor of a bank should identify and assess the risks of material misstatement in the bank’s financial statements, taking into consideration the complexities of banking activities and the need for banks to have a strong control environment.

Identifying potential risks 58. Banks are exposed to a variety of risks that can potentially affect the results of their operations or financial condition.

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These include, but are not limited to, credit risk, market risk, liquidity risk, operational risk and regulatory risk. New risks may emerge or the significance of each risk may change over time as a result of various factors that may be driven by changed circumstances or developments both internal and external to the bank. 59. In designing and performing the audit of a bank, the external auditor should assess the inherent and control risk to determine the risk of material misstatements at the financial statement and assertion levels. By doing so, the external auditor gains an understanding of internal controls that are relevant to the audit, and particularly of the control environment designed by the bank. 60. To respond to the assessed risk of material misstatement, an external auditor follows an audit strategy that includes both substantive procedures and control testing. Given the nature of bank activities, including those involving a high volume of transactions, banks implement controls designed to address risks posed to the organisation. As a result, the external auditor of a bank should perform extensive tests of controls over financial reporting to assess whether, and to what extent, the auditor can rely on them.

Materiality 61. An understanding of the concept of materiality and determination of materiality thresholds is needed in order to establish the audit strategy, and identify and assess whether a risk of material misstatement exists in the financial statements. 62. The determination of what is material to the financial statements as a whole is a matter for the external auditor’s professional judgment about misstatements that could reasonably be expected to influence economic decisions of users taken on the basis of the financial statements.

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63. The external auditor should exercise caution when evaluating identified misstatements. These misstatements could be an indicator of wider issues within the bank which could potentially lead to material misstatements in the financial statements as a whole. Therefore, individual misstatements should not be dismissed solely because they are below the level of materiality set for planning purposes. 64. For individual account balances, specific classes of transactions or disclosures, internationally accepted auditing standards require the external auditor to determine a lower level of materiality for those particular account balances, classes of transactions or disclosures, if the external auditor believes that “misstatements of lesser amounts than materiality for the financial statements as a whole could reasonably be expected to influence the economic decisions of users taken on the basis of the financial statements”. This is particularly relevant for audits of banks because certain financial statement items are used in the calculation of key metrics used by a wide range of users of the financial statements. For example, regulatory ratios such as the leverage ratio, liquidity ratio and capital adequacy ratio are calculated based on account balances in the financial statements or are derived from the financial statements.

Assessing the risks of material misstatement Internal control and its components 65. According to internationally accepted auditing standards, internal control components are the control environment, risk assessment process, information and communication systems and processes, control activities and monitoring of controls.

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66. As stated in the BCBS Principles for enhancing corporate governance, a robust internal control environment is critical to the strength of a bank’s governance system and its ability to manage risk. Consequently, when obtaining an understanding of the bank’s internal control environment, the external auditor should, amongst other considerations: - assess the “tone at the top”, ie whether management, with the

involvement of those charged with governance, is promoting a robust control environment;

- determine whether the control environment extends to all types of operations and service offerings and encompasses all subsidiaries and branches of the banking group;

- understand the bank’s approach to outsourcing/offshoring of business activities and functions and assess how internal control over these activities is maintained; and

- obtain an adequate understanding of the organisation of key control functions within the bank and its subsidiaries. At a minimum, key control functions include the internal audit, risk management, compliance and other monitoring functions.

67. Compensation arrangements at a bank may be a good indicator of the culture within the organisation because they can influence the behaviour of the bank’s personnel and the quality of corporate governance. The external auditor should pay particular attention to the risks of material misstatement in the financial statements due to fraud, particularly where banks employ compensation arrangements that may encourage excessive risk-taking or other inappropriate behaviour amongst their personnel.

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Control activities

68. Internationally accepted auditing standards require the external auditor to obtain an understanding of control activities relevant to the audit which, in the auditor’s judgment, are necessary to assess the risks of material misstatement and to establish the audit strategy. The assessment of the control activities over financial reporting is critical for the design of further audit procedures responsive to assessed risks. When identifying and assessing risks of material misstatement and assessing controls, the external auditor should take account of the following factors: - the knowledge and competence of those in charge of financial

reporting and of other control functions having an impact on financial reporting;

- the nature of hedging strategies employed by the bank which, if complex, improperly structured or inadequately monitored, can have accounting and solvency implications;

- the use of complex financial instruments involving significant estimates of fair value;

- the provision of custodial services to retail and/or institutional clients and the procedures in place to avoid co-mingling of client and proprietary assets;

- the volume of transactions by type of activity and/or presence of significant non-routine transactions;

- the use and monitoring of internal accounts;

- the structure and complexity of IT systems for conducting business and for facilitating efficient business and financial reporting, as they may lead to increased risk of fraud or error, particularly where there is potential for individual override of the control system or the potential for fraudulent transactions to go undetected due to the sophistication and complexity of the IT systems;

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- the number, scope and geographical dispersion of subsidiaries and the necessity for complex consolidation procedures;

- the existence of significant transactions with related parties; and

- the use of off-balance sheet financing arrangements, such as special purpose entities (SPEs) and other complex structures.

69. Banking supervisors and those charged with governance, such as the audit committee, need to be satisfied that the internal control is commensurate with the nature, volume and complexity of the bank’s activities and is organised in accordance with regulatory and legal requirements. The internal control of a bank must be robust and reliable in order to cope with stressed environments. Significant deficiencies in internal control which have been identified by the external auditor should be communicated in writing to those charged with governance and senior management, and other deficiencies in internal control should be communicated to the senior management at an appropriate level of responsibility on a timely basis. In addition, the Committee believes that the external auditor should communicate in writing all matters that are likely to be significant to the responsibilities of those charged with governance in overseeing the strategic direction of the entity or the entity’s obligations related to accountability. Such matters may include significant decisions or actions by management that lack appropriate authorisation.

Internal audit 70. The internal audit function is an important element of the overall internal control environment.

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It provides assurance to the board of directors and senior management on the quality and effectiveness of a bank’s internal control, risk management and governance systems and processes. The work of internal auditors can help external auditors assess the quality of the internal control processes and identify risks. 71. Whether or not the external auditor expects to use the work of a bank’s internal auditors, provided there is no reason to doubt their knowledge, competence and objectivity, the external auditor should engage with, and seek information on key internal audit findings from, the internal auditors. This may provide valuable input into the external auditor’s understanding of the entity and its environment and aid in identifying and assessing risks of material misstatement. The external auditor should consider reading relevant internal audit reports if the information obtained from engaging with the internal auditors indicates issues that may have an impact on the financial statement audit. 72. The external auditor’s observations on and, where relevant, evaluation of a bank’s internal audit function are of particular interest to the audit committee and the bank’s supervisor given the role an effective internal audit function plays in maintaining a robust control environment in a bank.

Responding to significant risks of material misstatement specific to a bank’s financial statements Principle 6: The external auditor of a bank should respond appropriately to the significant risks of material misstatement in the bank’s financial statements. 73. Having identified and assessed the risks of material misstatement, internationally accepted auditing standards require the auditor to identify any areas where there is a significant risk of material misstatement.

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Paragraphs 78-98 below set out key audit areas of a bank’s financial statements, where there is often a significant risk of material misstatement. 74. In addition to the areas set out in paragraphs 78-98, there are other items in a bank’s financial statements whose regulatory treatment could give rise to incentives for management bias in the recognition or measurement of such items. As a consequence, there is a greater risk of material misstatement of these items in the financial statements. This may lead to inappropriate application of regulatory rules to these items and a material misstatement of the bank’s capital position. Examples of such items are deferred tax assets, investments in unconsolidated entities, pension fund assets, and the classification of financial instruments. External auditors should therefore be alert to any likelihood that the treatment of such items in the financial statements is influenced by management bias towards a desired regulatory outcome and consider this in their risk assessment of the bank. External auditors should also be aware that management bias may change over time depending on, for example, the extent to which the bank is able to meet its regulatory requirements. External auditors should evaluate estimates which may be subject to this bias, and any potential audit differences otherwise identified, in the context of the impact on regulatory capital or regulatory capital ratios, consistent with paragraph 64. 75. Areas of significant risk of material misstatement particularly require an external auditor to apply professional judgment and experience. Internationally accepted auditing standards require that the external auditor obtain sufficient appropriate audit evidence51 regarding the

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assessed risks of material misstatement, through designing and implementing appropriate responses to those risks. 76. Internationally accepted auditing standards require special audit consideration for areas where significant risks of material misstatement are identified. Given that these areas are associated with issues that the external auditor identifies as highly important for the bank, these areas are worthy of discussion with those charged with governance. 77. As the categories of what may be a significant risk for a bank may change over time, the list of audit areas provided in paragraphs 78-98 of this document as areas where there is often a significant risk of material misstatement is not intended to be comprehensive.

Loan loss provisioning 78. Loan loss provisioning is generally material for a bank’s financial statements and the calculation of capital and key performance metrics. The measurement of loan loss provisions in accordance with internationally accepted accounting principles involves complex judgments about credit risk which may be subjective in nature. 79. The factors that the external auditor needs to consider in identifying and assessing the significant risks of material misstatement in relation to loan loss provisioning and the related allowance for loan losses include: (a) The estimation techniques used to compute provisions and how the techniques vary among and within banks. (b) How management has assessed the effect of estimation uncertainty on the level of provisioning, and the effect such uncertainty may have on the appropriateness of the recognised provision and the sufficiency of the related allowance for loan losses in the financial statements.

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(c) All known and relevant impairment indicators for loan exposures which include previously unexpected adverse developments in the market or economic environment, adverse movement in interest rates, restructuring, inadequate underwriting policies adopted by the bank, overdue payments, failure of the borrower to meet budgeted revenues or net income, covenant breaches and forbearance. (d) Whether the bank has sought perspectives and data from different functions within the bank, including risk management, credit and internal audit, as well as reliable sources external to the bank, including peer data and regulator perspectives so as to consider all relevant and available information in assessing impairment. (e) Accounting rules for provisioning may differ from the provisioning rules that apply for regulatory reporting or capital purposes. It may therefore be customary for banks to have different processes and systems to generate loan loss provisions for accounting purposes and for regulatory purposes. Further, there can be material differences in the application of the same set of accounting and/or regulatory rules by individual banks. Large differences between provisions for accounting purposes and for regulatory purposes may indicate a risk of material misstatement of the accounting provision. In addition, whilst for regulatory capital purposes under the Basel framework the accounting loan loss provision for internal ratings-based approach (IRB) portfolios is replaced by the regulatory expected loss provision, the level of the accounting provision may nevertheless have an impact on the level or the composition of regulatory capital, due to the treatment of the tax effect of provisions and the allocation of any excess provision to capital tiers. External auditors should be alert to any management bias in this area.

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(f) Disclosures should enable users to assess the loan loss provisioning methodology applied by the bank, regarding how it relates to credit risk for that bank, and how it compares with methodologies applied across the banking sector.

Financial instruments measured at fair value 80. A bank’s portfolio of financial instruments measured at fair value can range from “plain vanilla” financial instruments which are frequently traded in liquid markets with observable market prices, and involve less measurement uncertainty, to those which are customised, complex, and where the valuation is based on significant unobservable inputs with a substantial amount of management judgment. Financial instruments measured at fair value also include financial instruments that are subject to an impairment assessment which is a key area of judgment. 81. Where there are changes in the composition of a bank’s portfolio of financial instruments – whether due to changes in customer demand, the bank’s approach to managing risk and liquidity, or changes in prudential regulation – the bank will need to evaluate any accounting implications of the changes. 82. Accounting standards contain requirements on recognition; initial and subsequent measurement (including impairment); reclassification from fair value to amortised cost; presentation; and disclosures. Because these requirements are complex, they may be difficult to interpret and apply, and therefore the external auditor often needs to utilise more complex and wider-ranging audit procedures to obtain sufficient appropriate audit evidence to satisfy him/herself that the financial statements are not materially misstated. The classification of an individual financial instrument may be particularly important for achieving a favourable regulatory outcome.

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83. In adopting a sceptical approach to management’s assumptions regarding the valuation of financial instruments for which there are significant unobservable inputs, IAPN 1000, Special considerations in auditing financial instruments, sets out specific audit procedures that may be followed in auditing financial instruments measured at fair value.

Liabilities including contingent liabilities arising from non-compliance with laws and regulations, and contractual breaches 84. Non-compliance with, or material breaches of, the prudential framework, conduct requirements, legal requirements or contractual agreements could lead to legal or supervisory actions against a bank, thereby exposing the bank to potential litigation and/or the imposition of substantial penalties. Such events may require recognition of provisions, contingent liabilities and/or qualitative disclosures in the bank’s financial statements. Further, any adverse impact on the bank’s reputation resulting from this non-compliance could have consequences for the bank’s going concern assessment. 85. In the course of the audit, the external auditor should remain alert to actual or suspected breaches of prudential regulations, particularly those that are likely to be of material significance to the functions of the supervisor. As noted in Section 6 below,55 if the external auditor identifies any such breaches of material significance, the auditor should notify the supervisor immediately.

Disclosures 86. A number of factors have contributed to an increased demand from users for more relevant and extensive qualitative and quantitative disclosures.

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These include the increased complexity of business transactions, including off-balance sheet transactions and non-recognition of assets and liabilities, and increased use of fair value and other accounting estimates, with significant uncertainties and changes in measurement attributes. 87. While accounting standards specify disclosure objectives, the standards may not always prescribe in all circumstances specific disclosures to meet those objectives. Therefore, there may be a substantial amount of judgment in assessing whether disclosures are presented fairly in accordance with the disclosure objectives in the relevant accounting framework. 88. Increased transparency through fairly presented public disclosures enhances market confidence. It is therefore important that the bank provide disclosures which present the bank’s financial condition, the risks to which it is exposed and how they are managed, and are meaningful and responsive to changes in market conditions and perceived risks. 89. In responding to the significant risks in this area of audit, the external auditor has an important role to play in encouraging consistent and meaningful disclosures which present the bank’s financial condition in a way that is informative and understandable to users of financial statements. 90. In the course of its audit work, the external auditor should be alert to any indications that disclosures in financial statements are not consistent with the bank’s prudential information such as capital adequacy and liquidity position disclosures within the financial statements.

Going concern assessment 91. A going concern gives rise to two separate issues:

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(a) whether the going concern basis of preparation of financial statements is appropriate; and (b) the external auditor’s evaluation of the bank’s assessment of its ability to continue to meet its obligations for the foreseeable future (for at least 12 months after the date of the financial statements) and whether there are material uncertainties in this regard that should be disclosed in the applicable accounting framework. 92. The work the external auditor performs to assess the going concern status of a bank is different from that likely to be performed for a non-bank entity because of the contractual terms of bank assets and liabilities (maturity mismatch), the potential for regulatory intervention, and the impact that the signalling of any uncertainty over the bank’s ability to continue as a going concern could have on the short-term viability of the bank. 93. Examples of reasons that make the going concern assessment of a bank unique are as follows: (a) Current emerging risks and concerns specific to the bank or the banking industry as a whole may have an impact on the historical trends for the specific bank in such a manner that the historical trends may not reflect the likely trend over the next year. For example, during periods of market turmoil, normal sources of funding may no longer be available, as deposits payable on demand may run off more quickly than historical experience would contemplate and such deposits may be difficult to replace. (b) As banks are highly leveraged, a small change in asset valuation may have a substantial impact on the adequacy of a bank’s regulatory capital. Market risks may be such that financial instruments held at fair value may be subject to substantial changes in value in the short term and significant volatility over the longer term. A decrease in regulatory capital may result in a downgrade by rating agencies making funding more expensive and possibly harder to obtain.

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94. Given these and other risks, banks are required to meet liquidity requirements and capital ratios set by the bank supervisory authority. There should be equal emphasis on the evaluation of liquidity and solvency of the bank for the period over which the going concern assumption has been assessed: (a) Liquidity: Factors to assess include the reasonableness and reliability of the cash forecast for at least 12 months after the date of the financial statements, liquidity risk disclosures, regulatory or contractual restrictions on cash, loan covenants, and pension funding. (b) Solvency: Given the potential adverse impact of capital adequacy concerns on the confidence in a bank and, as a consequence, on the bank operating as a going concern, the external auditor will need to consider the robustness of the bank’s system for managing capital. In addition, the external auditor will need to consider the capital position in relation to the current and any known future capital requirements, definitions of capital resources, and challenges of raising capital. This is particularly critical where capital levels are strained, access to capital resources is restricted or where, for example, the bank’s annual report or internal capital projections include ambitious projections of improvements in capital levels. 95. In responding to the significant risks in this area of audit, and assessing management’s assertion that a bank is a going concern, factors which are necessary to consider are: (a) the robustness of the bank’s own systems and controls for managing liquidity, capital and market risk; (b) the prudential information that is reported to supervisors covering the bank’s solvency and capital; (c) any external indicators that reveal liquidity or funding concerns; and

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(d) the availability of short-term liquidity support. 96. Given the above risks and the possible systemic implications, if there are any significant doubts which may cause material uncertainty over the bank’s ability to continue as a going concern, and if the external auditor considers referring to the going concern issue in the audit report, the external auditor should promptly communicate this fact to the supervisors.

Securitisations – SPEs 97. The banking sector is involved in activities such as sponsoring (or originating) structured products/transactions that support maturity, credit and liquidity transformation risks more often than other industry sectors. The sponsoring bank does not ordinarily fund such activities. The funding is generally provided by other parties. However, the sponsoring bank may be exposed to risks such as reputational risk in the event of the sponsored entity encountering financial or operational difficulties. 98. Such activities require special consideration by the external auditor and are of interest to the supervisor for the following reasons: (a) Accounting concern – Accounting frameworks are often principles-based, which may result in different treatments of each of these complex transactions. In addition, because these are highly structured products, their accounting treatment may vary based on the facts and circumstances of each transaction, eg where SPEs are tailored to remain off the bank’s balance sheet.

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In these instances, it is necessary for the auditor to evaluate the judgments made by the management and consider whether the accounting treatment is appropriate and the disclosures are sufficient. (b) Regulatory concern – Because of the complexity of the securitisation and the chain of financial intermediation, the sponsoring bank in an “originate to distribute” model may underestimate the real risk transferred or the risk retained on its balance sheet (including reputation risk and conflicts of interest in case of defaults on the securitised assets). Even so, the originator may be able to benefit from an off-balance sheet treatment for the assets underlying these transactions and hence may not be required to hold additional regulatory capital unless specifically required by the supervisor. The external auditor should be alert to when the supervisor requires additional capital even though the off-balance sheet accounting treatment applied by the bank is appropriate. (c) Interconnectivity – Increases the correlation between banks and other non-banking sectors, which can add to the global systemic risk.

5. Supervisory expectations with regard to a bank’s audit committee and its relationship with the external auditor

99. The BCBS’s paper on the Internal audit function in banks (June 2012) and its paper on Principles for enhancing corporate governance (October 2010) describe the main responsibilities of a bank’s audit committee. The audit committee has, amongst others, a number of responsibilities with respect to the external auditor and the statutory audit. The audit committee approves, or recommends to the board of directors for approval, the appointment, reappointment, dismissal and compensation of the external auditor. The audit committee also monitors and assesses the independence of the external auditor.

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100. The audit committee oversees the bank’s statutory audit process. Key aspects of the audit committee’s work encompass the assessment of the effectiveness of the external audit process. The audit committee should require that senior management take the necessary corrective actions to address the findings and recommendations of the external auditor in a timely manner. 101. The discussion below focuses on the audit committee’s responsibilities in relation to the oversight of, and its relationship with, the external auditor to promote and support the integrity, objectivity and independence of the auditor, the quality of the external audit and the competencies that underpin that quality. To enable the audit committee to carry out its oversight responsibilities, which also contribute to the effectiveness of the audit process, the principles in this section promote effective two-way communication between the audit committee and the external auditor. It is important to note that all the discussions below stem from an important overarching principle: namely, that there should be a frank, open working relationship and a high level of mutual respect amongst all parties involved. 102. The principles and explanatory guidance in this section form the basis for the supervisor’s monitoring of the effectiveness of the audit committee in its oversight of the external auditor.

Appointment of the external auditor Principle 7: The audit committee should have a robust process for approving, or recommending for approval, the appointment, reappointment, removal and remuneration of the external auditor.

103. The audit committee has the primary responsibility for approving, or recommending to the board of directors for approval, the appointment, reappointment, removal and remuneration of the external auditor.

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In doing so, the audit committee should determine appropriate criteria for selecting the external auditor and regularly assess the knowledge, competence, independence (see Principle 8 below) of the external auditor and effectiveness (see Principle 9 below) of the external audit, having due regard to the guidance in Section 4. 104. The audit committee’s procedures for approving or recommending the approval of the external auditor should also include a risk assessment of the likelihood of the withdrawal of the external auditor from the audit, and how the bank would respond to that risk. 105. The audit committee should contribute a section to the bank’s annual report which explains the approach taken regarding the recommendation of the appointment or reappointment of the external auditor, and should include supporting information on the tenure of the incumbent auditor. 106. If the board of directors has approval responsibilities with respect to the external auditor, but does not accept the audit committee’s recommendation, it should include in the annual report, and in any papers relating to the appointment/reappointment/dismissal of the external auditor, a statement explaining the audit committee’s recommendation and the reasons why the board of directors has taken a different position. 107. The audit committee should assess the overall quality of the external auditor, prior to its first appointment and at least annually thereafter. To that end, the audit committee should request that the external auditor report on the external auditor’s own internal quality control procedures, including the audit firm’s EQCR process, and any significant matters of concerns arising from these procedures. The audit committee should also consider, where available, the external audit firm’s annual transparency report and any inspection reports on the audit firm issued by the relevant oversight body.

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108. The audit committee should maintain an understanding and knowledge of: - the structure and governance of the audit firm;

- the current nature of the audit environment, including any overseas jurisdictions where the bank operates;

- significant issues and concerns raised by the relevant audit oversight body regarding the audit firm, and the auditor’s action in addressing these concerns, to understand how these shortcomings may affect the quality of the audit of the bank;

- the nature of banking regulatory actions and conditions that could have an impact on the external auditor’s work on the bank, including any regulatory actions and conditions specific to the bank being audited, or to actions and conditions that the supervisor is imposing on all banks (for example, through newly implemented regulations and policies); and

- public lessons learned from any recent external audit failures

associated with the bank’s audit firm and how the firm has dealt with them so that similar deficiencies do not occur.

109. The audit committee should also satisfy itself that the level of the audit fees is commensurate with the scope of work undertaken. Where fee reductions are offered and accepted, the audit committee should seek assurance that these reductions do not imply an inappropriate increase in the materiality level to be applied by the external auditor, or a narrowing of the external auditor’s proposed scope of the audit, or a reduction in the attention which will be given to each business component and the significant audit risks identified. 110. The audit committee should discuss and agree to the terms of the engagement letter issued by the external auditor prior to the approval of the engagement.

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Where relevant, the audit committee should agree to an engagement letter that has been updated to reflect changes in circumstances, such as those arising from changes in legal requirements and changes in the scope of the external auditor’s work as a result of revisions to internationally accepted auditing standards which have arisen since the previous year. 111. If the external auditor resigns or communicates an intention to resign, the audit committee should follow up on the reasons/explanations giving rise to such resignation and consider whether the audit committee needs to take any action in response to those reasons.

Independence of the external auditors Principle 8: The audit committee should monitor and assess the independence of the external auditor.

112. The independence of the external auditor is one of the main prerequisites for an adequate level of audit quality. As such, the audit committee should understand the applicable independence requirements. The audit committee should have procedures to monitor and assess the independence of the external auditor at least annually, taking into consideration relevant national laws, regulations and professional requirements. The assessment should also involve a consideration of all relationships between the bank and the audit firm (including the provision of non-audit services) and any safeguards established by the external auditor. 113. Where the audit firm has been the external auditor of the bank for many years, there may be a perception that there is a familiarity or self-interest threat to the external auditor’s objectivity and independence in its audit of the bank.

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However, when the bank changes its external auditor, there is a risk that the depth of understanding of the bank and its activities and systems will be lost. This may affect the new external auditor’s ability to identify risks of material financial statement misstatements and respond to them appropriately, and hence may detract from the quality of the audit. 114. Audit committees should have a policy in place that stipulates the frequency with which there should be a tender for the external audit contract. The policy should also call for the audit committee to consider periodically whether there should be a limit to the length of an external auditor’s tenure as the bank’s external auditor given the potential impact of audit firm rotation on independence and audit quality. 115. Audit committees should understand the audit firm’s policy on rotation of members of the audit engagement team and the audit firm’s compliance with any jurisdictional or other local regulatory requirements in this regard. 116. As described in Principle 2, the audit committee should seek assurance that the audit engagement team members and their firm and, when applicable, the network external auditors have no financial, personal, business or other relationships with the bank which could adversely affect the auditor’s actual or perceived independence and objectivity. The audit committee should seek from the external auditor, at least on an annual basis, information about the audit firm’s policies and processes for maintaining independence and monitoring compliance with the relevant independence requirements. 117. Audit committees of banks should develop a formal policy which governs the acceptance of non-audit services provided by the auditor.

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Amongst other provisions, the policy should include criteria for the types of non-audit services that the external auditor may provide or is prohibited from providing, and rules stipulating when advance approval by the audit committee is required for the auditor’s performance of non-audit services. The policy should be reviewed periodically and compliance should be monitored, taking into account the contents of Section 4 of this document. 118. Where non-audit services are provided by the external auditor, the audit committee should monitor and establish that the provision of such services does not impair the external auditor’s objectivity and independence, taking into consideration various factors including the skills and experience of the external auditor, safeguards in place to mitigate any threat to objectivity and independence, and the nature of and arrangements for non-audit fees. 119. Where the external auditor provides non-audit services to the bank, the bank’s annual report should explain to shareholders the nature of and the fee arrangements for the non-audit services received, and how auditor independence is safeguarded.

Effectiveness of the external audit Principle 9: The audit committee should monitor and assess the effectiveness of the external audit. 120. At the start of each audit, the audit committee should consider whether the audit approach is appropriate, including considerations on the audit scope, the level of materiality, areas of focus and whether planned audit procedures address the areas of significant risk for the bank, in particular those areas described in Section 4 of this document. 121. The audit committee should consider whether the proposed resources to execute the audit plan are reasonable given the scope of the audit engagement, the nature and complexity of the bank’s operations, and its structure and activities.

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The audit committee should understand the nature and extent of audit work that the external auditor intends to rely upon where the audit work is performed by network firm personnel or other audit firms. 122. The audit committee should obtain confirmation from the external auditor that there is adequate knowledge, competence and expertise within the audit engagement team and that the audit will be conducted in compliance with internationally accepted auditing standards, as well as any applicable laws and regulations. 123. The audit committee should discuss with the external auditor the findings of the latter’s work. In the course of its monitoring, the audit committee should: - Obtain an understanding of the external auditor’s view on any major

issues that arose during the audit (including those issues that were subsequently resolved as well as those that have been left unresolved), in particular the external auditor’s explanation of the significant judgments the audit engagement team made and the conclusions it reached.

This should include the discussions with management and the judgments involved, the range of possible outcomes and, where available, a comparison of the bank’s position with that of its peer group (on an anonymous basis), including a comparison with previous periods on such major issues;

- Obtain an understanding of the rationale behind the final conclusions drawn by the audit engagement partner on significant accounting and auditing matters, particularly in those circumstances where the audit engagement partner’s conclusions differed from those of the engagement quality control reviewer; and

- Review the nature and levels of misstatements identified during the audit, obtaining explanations from management and, where necessary, the external auditor as to why certain errors might remain unadjusted.

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124. The audit committee should also discuss with the external auditor the audit representation letters before signature by the board of directors/senior management and give particular consideration to matters where specific representation has been requested. The audit committee should consider whether the information provided on each of the items in the representation letters is complete and appropriate based on its own knowledge. 125. As part of the ongoing monitoring process, the audit committee should discuss with the auditor the management letter (or equivalent) and any other audit-related reports provided to the bank. In particular, the audit committee should discuss with the external auditor any significant deficiencies identified in the bank’s control environment and in its internal control over financial reporting. 126. At the end of the audit engagement period, the audit committee should: - consider whether the audit firm has followed its audit plan and

understand the reasons for any changes, including changes in perceived audit risks and the work undertaken by the external auditor to address those risks;

- obtain feedback about the conduct of the audit from key bank personnel involved, eg the heads of finance and internal audit; and

- report to the board of directors on the effectiveness of the external

audit process. 127. The audit committee should seek to obtain information from the external auditor on the main findings of audit quality reviews of the bank’s audit and the audit firm’s quality control systems by audit oversight bodies.

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Relationship between the audit committee and the external auditor Principle 10: The audit committee should have effective communication with the external auditor to enable the audit committee to carry out its oversight responsibilities and to enhance the quality of the audit. 128. The foundation for an effective relationship is regular, timely, open and honest communication between the audit committee and the external auditor. Regular dialogue between the two parties should be held throughout the reporting cycle of the bank. 129. While both cooperation and challenges are needed between the external auditor and the audit committee for the external audit to be effective, the need for cooperation should never prevent robust challenges from being made when needed. Such challenges are a key responsibility of the audit committee and are part of the productive dialogue on key judgments that can result in stronger and deeper understanding of and views on the positions of all parties. 130. In order to reinforce the audit committee’s effectiveness and enhance the quality of the audit, the audit committee should consider inviting the external auditor to attend audit committee meetings (except when discussing matters in relation to the assessment of the external auditor), even if there are no items explicitly relevant to the external audit on the agenda. The external auditor’s attendance should facilitate the exchange of views on business performance, risk and other topics. Further, to enhance audit quality, the audit committee should consider, if necessary, assisting the external auditor to gain access to any other committee meetings that the external auditor determines to be relevant for the auditor’s work.

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131. The audit committee should have the right and authority to meet regularly – in the absence of executive management – with the external auditor. This will enable the audit committee to understand and discuss all issues that may have arisen between the external auditor and bank management in the course of the external audit and how these issues have been resolved. In addition, these meetings should address any other matters that the external auditor believes the audit committee should be aware of in order to exercise its responsibilities. 132. The audit committee should discuss with the auditor any matters arising from the statutory audit that may have an impact on regulatory capital or disclosures. This may include discussion of the interaction between the accounting information and the regulatory information, eg accounting impairment charges versus regulatory expected losses, or the consistency of the bank’s Pillar 3 reporting with its annual report. 133. The audit committee should discuss with the external auditor any significant issues identified in the course of the audit, in particular in areas which could be relevant to future financial statements, to promote early discussion and planning. This includes upcoming changes in accounting standards or regulations and the consequences of material transactions. 134. The audit committee should also communicate to the external auditor matters that are likely to be of significant influence on the conduct of the statutory audit. Such matters may encompass subjects that the audit committee believes warrant particular attention, significant communications with the supervisor, or other matters that the audit committee considers may influence the audit of the financial statements.

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Reporting by the external auditor to the audit committee Principle 11: The audit committee should require the external auditor to report to it on all relevant matters to enable the audit committee to carry out its oversight responsibilities. 135. In some jurisdictions, as part of the statutory audit, the auditors are also required by law or regulations to express an opinion on the control environment of the bank and provide additional reporting of matters identified accordingly. The explanatory guidance in the following paragraphs only covers reporting to the audit committee that may be required in the context of the financial statement audit. 136. The audit committee should expect the external auditor to communicate promptly to the audit committee any significant audit findings noted in the course of the audit and any significant problems encountered in carrying out the audit. 137. Upon completion of the audit work, the external auditor should report to the audit committee on the outcome of the audit in writing. The contents of these written reports should be aligned with the requirements set by internationally accepted auditing standards for matters to be communicated to those charged with governance, the recommendations made in this document, and any additional requirements under applicable laws and regulations. 138. In addition to the above, where not already covered by the recommendations in other parts of this document and the relevant auditing standards, the audit committee should request that the external auditor report to it in writing on other significant matters, including the following: - Key areas of significant risk of material misstatement in the financial

statements, in particular on critical accounting estimates or areas of measurement uncertainty (eg loan loss provisioning and valuation

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uncertainties), including potential valuation bias and consequential effects on earnings, compensation structures and regulatory ratios.

- Areas of significant management and auditor judgment, including judgments pertaining to the recognition, de-recognition, measurement or disclosure of relevant items within the financial statements and, where relevant, judgments about material uncertainties that may cast doubt on an entity’s ability to continue as a going concern (including consideration of liquidity/funding issues of the entity).

- Outsourcing of key external audit work (eg with respect to audits of

subsidiaries) to another audit firm or use of external experts to assist with the external audit.

- Significant internal control deficiencies identified in the course of the

statutory audit.

- Matters that are likely to be significant to the responsibilities of those charged with governance in overseeing the strategic direction of the entity or the entity’s obligations related to accountability.

- Areas of financial statement disclosures, for the bank itself and

relative to its peers, which the auditor believes could be improved, including the results of discussions with management.

139. For the purposes of complying with the requirements of internationally accepted auditing standards, where significant matters are communicated to the audit committee, the external auditor should also determine if these matters need to be communicated to the board of directors.

6. The relationship between the supervisor and the external auditor 140. This section sets out the principles that promote effective relationships that will enable regular communication of mutually useful information in the context of a statutory audit between:

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- the supervisor and the external auditor at the supervised bank level, regardless of whether the communication is mandatory (Subsection A – Principles 12 and 13); and

- the banking supervisory authority and the audit firm, and the

accounting profession as a whole that is not specific to an individual bank (Subsection B – Principle 14).

141. The key objective of having effective relationships between the parties referred to above is to enhance the effectiveness of the supervision of the banking sector. This relationship will then also contribute to the quality of external audits. 142. An effective relationship should enable each party to carry out its respective statutory responsibilities while not implying that either party is responsible for or should or can perform the statutory responsibilities of the other party.

A. Effective relationship at the supervised bank level 143. The external auditor can provide the supervisor with valuable insight into various aspects of a bank’s operations and management’s attitude to the application of key accounting policies, judgments and models adopted. Conversely, the external auditor may obtain helpful insights from information originating from the supervisor where the supervisor provides an independent assessment in areas significant to the external audit and may focus attention on specific areas of supervisory concerns. In certain jurisdictions, the supervisor may also request the external auditor to perform specific assignments that go beyond the statutory audit work of the auditor. Principle 12: The supervisor and the external auditor should have an effective relationship that includes appropriate communication channels

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for the exchange of information relevant to carrying out their respective statutory responsibilities. 144. Supervisors and external auditors should have an open and constructive relationship, with confidence in each other that information exchanged will be treated appropriately and confidentially. 145. For an effective relationship to exist, the engagement between the supervisor and the external auditor should involve individuals who are knowledgeable, informed and empowered by their respective organisations to exchange information. 146. The supervisor may benefit from the results of the external auditor’s work because in many respects the two parties have complementary concerns regarding the same matters although the focus of their concerns is different. Similarly, the external auditor may benefit from insights that the supervisor can communicate. However, in order to discharge their respective statutory responsibilities, each party should not use the work of the other as a substitute for its own work and the supervised entity should remain the main source of information for their respective work. 147. The terms, nature and scope of this relationship can be determined in individual jurisdictions and should be clear to both the supervisor and the external auditor – for example, through guidance issued by the banking supervisory authority.

Access to communication with the bank 148. The external auditor’s work gives rise to the auditor’s report on the annual/consolidated financial statements which is often used for prudential supervisory purposes. When performing a financial statement audit in accordance with internationally accepted auditing standards, the external auditor

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communicates with management and/or those charged with governance about significant matters relating to financial reporting or supplementary matters, and these communications may be accessed by the supervisor. In the same manner, in certain jurisdictions, the external auditor may also have access to the supervisor’s communications to the bank. 149. Given the benefits that may ensue, when communicating with management and/or those charged with governance of the bank, both the supervisor and the external auditor should consider communicating matters that may also be of mutual interest to each other in writing so that they form part of the bank’s records to which the other party should have access.

Direct communication at the supervised bank level 150. In addition, effective communication should be established through one or a combination of direct written and oral communication channels, as dictated by the circumstances. 151. Written communication channels may include extended audit reports on the audited financial statements, which are submitted to the supervisor and are not available to the public. In certain jurisdictions, these reports may be part of the external auditor’s statutory audit work and may also cover assignments related to prudential supervisory requirements. 152. Oral communication channels may include bilateral meetings between representatives of the supervisor and the external auditor, and may be formal or ad hoc. In addition to bilateral meetings, trilateral meetings involving representatives of the supervisor, the external auditor and those charged with governance at the supervised bank can also be held.

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153. Whilst not excluding any other effective communication channels, bilateral and trilateral meetings are examples of sound practice communication channels, particularly for SIBs.

Communication of matters outside the scope of the external auditor’s duty to report/alert 154. The communication channels described in paragraphs 150-153, can be a helpful source of information for the supervisor about matters that are outside the scope of the external auditor’s duty to report/alert discussed in Principle 13 and on which the supervisors can reasonably expect the auditors to form a view in the course of their audit of the bank’s financial statements. 155. The contents of the external auditor’s communication could cover all issues that the supervisor might consider relevant in carrying out its functions. Such issues may include current, emerging and thematic issues, and entity-specific and sector-wide issues. The external auditor should remain alert to the fact that these issues may also fall within the scope of the external auditor’s duty to report/alert. 156. In addition to discussing with the supervisor areas where there is often a significant risk of material misstatement in the financial statements, Section 4 includes examples of areas where matters of interest to the supervisor may be identified by the external auditor in the course of the financial statement audit and therefore are relevant for communication to the supervisor. Examples of these matters are: - Where a bank undertakes transactions to achieve a particular

accounting or regulatory outcome such that the accounting treatment is technically acceptable, but it obscures the substance of the transaction.

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- Where a bank consistently utilises valuations which are at the extreme ends of a range of acceptable valuations or there are other indications of possible management bias.

- Significant deficiencies in internal control processes and their

observations on matters that are significant to the responsibilities of those charged with governance in overseeing the strategic direction of the entity or the entity’s obligations related to accountability.

This may include where relevant, their observations on the effectiveness of the internal audit function, the risk management function and the compliance function (where not already required by statute).

- Actual or suspected breaches of prudential regulations noted in the

course of the audit.

- Indications that disclosures in financial statements are not consistent with published prudential information.

157. Annex 1 to this document provides examples of the potential content of the extended audit reports described in paragraph 151. Annex 2 to this document provides guidance on the timing and examples of the potential content of the meetings between the supervisor and the external auditor, as circumstances may dictate. 158. Where bilateral and trilateral meetings are held, particularly in the case of SIBs, the timing and content of these meetings could be aligned with the typical phasing of the bank’s external audit and/or the supervisory assessment of the bank. Of particular importance are the planning and concluding phases of the external audit. The meetings should focus on the key issues and judgments within the scope of the external auditor’s statutory audit work.

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159. The form, frequency and content of the communication described in this document between the supervisor and the external auditor of the supervised entity will vary depending on the jurisdictional circumstances, the characteristics and circumstances of the bank, and the supervisory model adopted in the relevant jurisdiction.

Safe harbour available to external auditors 160. External auditors are required by internationally accepted ethical standards to treat much of the information received while carrying out their functions as confidential. The existence of a legal provision that protects external auditors from disciplinary proceedings, any prosecution and liabilities when making disclosure in good faith to the supervisor (safe harbour) permits auditors to share information with the supervisor without contravening their duty of confidentiality. 161. In communications on matters that fall outside the scope of the duty to report/alert discussed in Principle 13 and which may be of interest to the supervisor, where a safe harbour does not exist, it is reasonable for the supervisor to expect the external auditor to communicate these matters through the bank or directly with the bank’s consent.

Gateways available to supervisors 162. If appropriate confidentiality rules are in place, the supervisor may decide to communicate bank-specific information to the external auditor when the information-sharing will help in its supervisory work and in turn assist the external auditor in conducting a quality external audit. 163. Before disclosing any information to the external auditor, supervisors should carefully consider how sensitive the information is and the extent to which disclosing the information to the external auditor would support the supervisor discharging its duties.

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Principle 13: The external auditor should report to the supervisor matters that are likely to be of material significance to the functions of the supervisor.

Communication of matters within the scope of the external auditor’s duty to report/alert 164. When required by the legal or regulatory framework or by a formal agreement or protocol, the external auditor should promptly communicate matters of material significance to the supervisor (referred to as “duty to report/alert” matters). 165. On many occasions, the external auditor will have already identified and discussed these matters with the bank’s management and/or those charged with governance as appropriate. However, it is not sufficient for the external auditor to rely on the bank to notify the supervisor when there is a duty on the part of the external auditor to report to/alert the supervisor directly on such matters. 166. Laws or regulations provide that external auditors who make any such disclosure in good faith to the supervisor cannot be held liable for breach of a duty of confidentiality. The following are examples of matters that most jurisdictions prescribe as within the scope of the external auditor’s duty to report/alert: - information that indicates the bank’s failure to fulfil one of the

requirements for a banking licence;

- a serious conflict within the bank’s decision-making bodies or the unexpected departure of a manager in a key function;

- information that may indicate a material breach of laws and

regulations or the bank’s articles of association, charter or by-laws;

- material adverse changes in the risks of the bank’s business and possible risks going forward; and

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- a refusal to certify the financial statements or the expression of reservations in the audit report (other than a clean opinion) by the external auditor.

167. It is also usual practice for the external auditor to notify the supervisor of the external auditor’s intent to resign or the bank’s removal of the external auditor from office.

B. Effective relationship at the levels of the audit firm and the accounting profession as a whole 168. To assist in effective supervision of banks, it is important to identify system-wide, macroprudential risks which may have an impact on banks. In the course of their work, the banking supervisory authority and external audit firms obtain information which, when reviewed in its entirety, can assist in identifying changing and emerging key trends and developments that may be indicative of emerging systemic risk. 169. Audit firms may also identify emerging issues over inconsistent or inappropriate application of accounting standards which, if identified early, permit external auditors and supervisors to take timely remedial action. Principle 14: There should be open, timely and regular communication between the banking supervisory authority, the audit firm and the accounting profession as a whole on key risks and systemic issues as well as a continuous exchange of views on appropriate accounting techniques and auditing issues. 170. The banking supervisory authority and external audit firms should have regular discussions on existing and emerging key risks and systemic issues at the national level, as the exchange of such information is mutually beneficial. The communication should be open and in an environment that allows a frank exchange of views and ideas.

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If circumstances dictate, ad hoc meetings should be held to discuss matters requiring urgent action to allow each party to take appropriate action in a timely manner. 171. There should be periodic meetings at the national level between the banking supervisory authority and audit firms and professional accountancy bodies to discuss existing and emerging key risks and systemic issues. 172. Key risks may be identified from discussions on: - the appropriateness of accounting techniques for newly developed

financial instruments, other aspects of financial innovation and securitisation; and

- existing issues such as market opacity, and impairment evaluations

for a particular asset class. These discussions on key risks could be indicative of systemic issues. They could also assist in achieving banks’ adoption of the most appropriate accounting policies and their consistent application. 173. It is advisable for banking industry associations to be involved in discussions on these topics.

7. The relationship between the banking supervisory authority and audit oversight body 174. Supervisory authorities often use audited information, either directly or as a basis for regulatory information. In many jurisdictions, audit oversight bodies are responsible for independently monitoring the quality of statutory audits as well as audit firms’ policies and procedures supporting audit quality. Therefore, banking supervisory authorities and audit oversight bodies have a strong mutual interest in ensuring quality audits by the firms.

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175. To promote effective dialogue between the banking supervisory authority and the audit oversight body, their respective roles should be clearly understood. The banking supervisory authority’s focus is on the safety and soundness of the institutions under its supervision and the stability of the financial system as a whole. The audit oversight body’s main role is to monitor the quality of audits in order to protect the interests of investors or further the public interest. 176. To facilitate effective dialogue between the banking supervisory authority and the audit oversight body, it is also beneficial to have an appropriate framework (eg through a memorandum of understanding between the two parties) for cooperation and information-sharing between the two bodies, subject to the confidential obligations of both parties and the relevant laws of the jurisdiction in which they are located. This may include the form, frequency and content of the dialogue. The cooperation framework should enable the banking supervisory authority to take appropriate actions to address the identified issues or topics. Principle 15: There should be regular and effective dialogue between the banking supervisory authority and the relevant audit oversight body. 177. Where there is an audit oversight body, the banking supervisory authority should establish regular dialogue with the relevant audit oversight body to deal with relevant issues in relation to the conduct of audits of the banks under supervision. 178. Effective dialogue can be established through both formal (eg scheduled regular meetings) and informal channels (eg ad hoc discussions). There should be an open and constructive two-way dialogue between the two parties.

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179. Meetings between the banking supervisory authority and the audit oversight body should take place as frequently as deemed necessary to enable them to inform each other of topics or issues of mutual concern or interest arising from the performance of their duties that could be of relevance to the other authority, subject to relevant legal constraints. 180. Information exchanges between the two parties could include the robustness of the audit of certain areas particularly relevant to the banking supervisory authority, such as loan loss provisioning, or the auditor’s consideration of the internal controls or risk management procedures of banks. The discussions may also include any issues or topics identified by the audit oversight body in the course of its inspections relating to audits of financial institutions (including audit deficiencies), and the audit oversight body’s response to such issues, including follow-up with external audit firms and any corrective actions or other steps taken by the audit oversight body or external auditors to further strengthen external audits of financial institutions. 181. The banking supervisory authority may also discuss with the audit oversight body areas where there can be a significant risk of material misstatement, their concerns about the quality of the audit of a particular financial institution or any significant matters of concern in relation to the bank’s external auditor or audit firms in general which may be relevant to the work of the audit oversight body. 182. Although identifying audit deficiencies is not a primary focus of the banking supervisory authority’s work, on becoming aware of matters that may require action by the audit oversight body, the banking supervisory authority should consider communicating such matters to the audit oversight body. 183. The discussions should not be restricted to current issues or topics but should also include any significant thematic or emerging topics.

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184. Depending on the outcome of the dialogue between the banking supervisory authority and the audit oversight body, where permitted, actions taken by the banking supervisory authority could include: - raising issues identified by the audit oversight body with individual

banks or their external auditors and encouraging remediation of these issues where appropriate; and

- initiating a cross-sector thematic review to analyse the impact of

issues or topics identified by the audit oversight body.

Principle 16: The banking supervisory authority and the audit oversight body should observe appropriate confidentiality requirements when sharing information. 185. Information shared between the banking supervisory authority and the audit oversight body is likely to be subject to legal confidentiality requirements. 186. Where information is subject to a confidentiality requirement, the authority/body receiving the information should handle it in accordance with those requirements, and should consider: - consulting the authority/body providing the information before

disclosing the information to any third party; and - notifying the other party if it receives a request or demand to provide

the information on any basis potentially enforceable in law.

Annex 1 Guidance on the content of extended reports provided by the external auditors to supervisors In certain jurisdictions, it is a well-established practice that external auditors submit to the supervisor an extended report (the so-called

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long-form audit report) on the audited financial statements of banks. These reports form part of the statutory audit work. The following is a list of examples of the potential content of such reports, which is not meant to be exhaustive.

Contents relating to the audit of the financial statements: - description of the annual audit mandate, the audit strategy and the

audit procedures;

- description and assessment of the significant accounting and valuation methods, including structured and complex accounting activities (eg asset-backed securities transactions, sale and leaseback transactions, use of special purpose entities, and barter transactions);

- description of significant events that took place during the year

under review;

- description of material changes to the legal, financial and organisational basis of the bank (eg changes to the legal form, the capital structure, the company structure, the organisational structure, the composition of the board, the structure of banking operations and financial services provided, the lines of business, and the relations with affiliated parties);

- description of the internal controls over significant procedures and

internal control functions (eg risk management, compliance, internal audit, audit committee, and management information systems);

- assessment of business performance;

- assessment of the development of the net asset position, especially

the nature and extent of off-balance sheet assets and liabilities;

- comments and explanation on individual balance sheet items and profit and loss accounts, taking the principle of materiality into consideration;

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- comments on whether the balance sheet items have been properly valued, the valuation adjustments and provisions are appropriate and the reporting requirements have been fulfilled;

- description of material agreements and pending legal disputes where

these may have adverse effects on the net asset position;

- description of the contents and assessment of the enforceability of letters of comfort issued;

- assessment of the earnings position, including a description of the

most important sources of and factors for generating earnings;

- assessment of the risk situation, the procedures for determining risk provisioning and the adequacy of risk provisioning;

- description of major features and material risks of the lending

business, including risk concentrations and the way they are dealt with within the bank;

- description of general credit lines and noteworthy loans (eg

significant non-performing loans, loans for which sizeable loan loss provisions are necessary or were necessary in the concluded financial year, significant loans to board members, and loans for which an exceptional type of collateral has been provided);

- follow-up on serious irregularities and weaknesses observed during

previous audits; and

- summary of the key findings and results of the audit.

Contents relating to special prudential supervisory requirements: - assessment of the adequacy of risk management, including the

internal control system and the internal audit and compliance functions;

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- analysis of the bank’s exposure to credit risk/counterparty risk, market risk, interest rate risk, settlement risk, foreign exchange risk, liquidity risk, profitability risk and operational risk;

- analysis of the amount and composition of the bank’s own funds that

have to be reported to the supervisor;

- assessment of the appropriateness of procedures for the preparation of prudential returns;

- assessment of the appropriateness of measures taken by the bank to

determine the level of own funds, its liquidity ratio and its solvency ratio;

- assessment of the liquidity position and the liquidity management

system of the bank;

- description and assessment of the provisions for preventing money laundering and terrorist financing; and

- description and assessment of the provisions on conduct of business

rules.

Annex 2 Guidance on the timing and content of meetings between supervisors and external auditors This annex provides guidance on the timing and examples of the potential content of meetings between supervisors and external auditors, as circumstances may dictate. The examples include types of matters of supervisory interest on which external auditors can reasonably be expected to form views, but which fall outside the usual “duty to report/alert” obligations.

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Planning stage - Risk assessment and scope – assessments in light of the external

environment and the firm’s performance, business model and risk appetite.

- Recent supervisory risk assessments and other supervisory reviews if appropriate confidentiality rules are in place.

- Audit strategy/approach and views on materiality.

- Observations on internal controls (eg governance effectiveness,

control environment, application controls and monitoring controls).

- Fraud due to deficiencies in the control environment.

- Views and judgments on key risk areas based on audit/supervisory work performed to date (where confidentiality rules permit), including specific significant transactions, material valuations and impairment decisions, methodologies and assumptions.

- Assessment of risks relating to the going concern assumption.

- Accounting policy application and changes.

- Sources of potential management bias.

- Culture and tone set from the top.

- Issues from previous years and how the firm had addressed them.

- Extent of work on internal controls over regulatory reporting,

including capital.

Pre-close - Update on all areas covered in previous meetings.

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- Adequacy and reliability of disclosures in light of statutory reporting requirements and risks, transactions, judgments, and assumptions discussed in this and previous meetings.

- Critical accounting estimates and indications of management bias.

- Analysis of management’s going concern assessment.

- Content of (anticipated) reporting to those charged with governance.

- Unadjusted differences and the auditor’s evaluation in light of

materiality.

- Material control weaknesses identified in the bank’s financial and regulatory reporting processes.

- Views on the control environment around regulatory reporting and

calculation of capital resources.

- Possible modifications to the audit report.

- Additional matters arising from the audit.

Others Additional meetings may be held as appropriate during the audit phase, and after the conclusion of the audit to debrief on matters considered during the annual audit cycle and to consider any assessment of risks and anticipated issues.

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Meeting of the G20 Finance Ministers and Central Bank Governors

Update by the IASB and FASB Convergence projects This report is a high-level update on the status and timeline of the remaining convergence projects. This includes an update on the impairment phase of our joint project on financial instruments (included in the appendices to this report).

Background In the past ten years, since the US Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) (the boards) signed the Norwalk Agreement in 2002, we have made remarkable progress in improving and converging major global accounting standards. In 2006, the boards agreed a Memorandum of Understanding (MoU) that identified several short-term and longer-term convergence projects that would bring the most significant improvements to IFRS and US GAAP. The MoU was updated in 2008 and then again in 2010.

Achievements and challenges Most of the short-term projects and several of the longer-term projects have been completed or are nearing completion.

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In 2012 the boards made significant progress on the remaining joint projects and they continue to appreciate the importance of developing converged accounting standards. The boards have achieved converged solutions for Revenue Recognition accounting and will be exposing converged proposals for accounting for Leases. There have, however, been some challenges to developing completely converged solutions, especially for the Impairment and Insurance Contracts projects. For the Impairment project, it has been a challenge to bring together the different perspectives of the boards’ respective stakeholders and the different markets in which such stakeholders conduct their primary business activities. While the goal continues to be the development of a converged Standard for impairment, the extent of future convergence in this project will depend, in part, on the feedback that is received during the boards’ respective comment periods. However, it is also important to note that under both sets of proposals the provisions for loan losses continue to be based on the same information set, updated for changes in loss expectations. Developing a converged solution for the Insurance Contracts project may be more difficult. IFRS does not currently include accounting requirements for insurance contracts, so the IASB needs a final Standard urgently and will be undertaking a targeted re-exposure of its proposals. The FASB has existing models for insurance contracts but will initially be exposing proposed amendments for public comment in mid-2013.

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The difference in the scope of the questions in these exposure documents and the need for the IASB to issue timely guidance will make achieving a fully converged solution for the Insurance Contracts project challenging.

Financial instruments Classification and Measurement During 2012, the boards worked together to eliminate differences in their respective classification and measurement models and have converged decisions in the following areas: • Contractual Cash Flow Characteristics Assessment: a financial asset would be eligible for a measurement category other than fair value through profit or loss if the contractual terms of the financial asset give rise to cash flows that are solely payments of principal and interest on the principal amount outstanding, where interest is consideration for the time value of money and for credit risk. • Business Model Assessment: the assessment of the business model would apply to those financial assets that ‘pass’ the assessment of the contractual cash flow characteristics. Financial assets would qualify for amortised cost accounting if the assets are held within a business model whose objective is to hold the assets in order to collect contractual cash flows. The frequency and nature of sales would prohibit some financial assets from qualifying for amortised cost. • Fair value through other comprehensive income: financial assets would be measured at fair value through other comprehensive income if they ‘pass’ the assessment of the contractual cash flow characteristics and are held within a business model whose objective involves both holding the financial assets to collect contractual cash flows and selling financial assets.

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• Fair value through profit or loss would be the residual measurement category that would include all assets that ‘fail’ the assessment of the contractual cash flow characteristics. Given the different stages of development of the classification and measurement phases of their respective projects, (the IASB is making limited amendments to IFRS 9 Financial Instruments whereas the FASB is proposing completely new guidance), the boards’ exposure documents will not be identical. The IASB published its Exposure Draft in November 2012. These proposed amendments were intended to further align the boards’ classification models, address some of the insurance community’s concerns about the interaction with accounting for insurance contracts, and clarify the existing classification and measurement requirements for financial assets. The comment period ended on 28 March 2013. The FASB expects to issue a second Exposure Draft on classification and measurement in February 2013 and will conduct outreach with stakeholders during the exposure period. The comment period will end on 30 April 2013. The boards are planning to begin joint redeliberations about the feedback received on the proposals later this year. The timing of the issuance of final requirements will depend on the nature and extent of the feedback received.

Impairment (Loan Loss Provisioning) This is probably the most important phase of our project to overhaul the accounting for financial instruments.

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While the boards worked jointly to develop an ‘expected loss’ approach to impairment, US stakeholders raised numerous concerns about early drafts of the so-called ‘three-bucket’ approach. The most significant concerns related to the use of two different measurement approaches—a portion of the expected losses for all new or purchased financial assets and a full loss recognition approach for financial assets that have exhibited ‘more than insignificant deterioration’. The FASB believed it was necessary to address these concerns before moving to an Exposure Draft. To address these concerns, the FASB developed a different expected loss model whereby at each reporting date, an entity would recognise an allowance for credit losses for its current estimate of all expected credit losses on financial assets held at the reporting date. The same objective applies to all financial assets held in any period; however, the measure of the allowance would be commensurate with the current assessment of risk for the financial assets held. In late December 2012 the FASB published its Exposure Draft. The FASB’s comment period ends on 30 April 2013. The IASB decided to maintain the concept of the ‘three-bucket’ approach but will revise it to address concerns that had been raised about the point at which full lifetime expected losses should be recognised. The revised model will result in an initial recognition of a portion of the lifetime expected losses, with full lifetime expected losses being recognised only once a financial asset significantly deteriorates (ie to the point that an economic loss is suffered beyond the level that was originally anticipated and priced into the financial asset). The IASB is aware of the importance of publishing its proposals as soon as possible, and will publish an Exposure Draft in the first quarter of 2013.

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There will be a 120-day comment period. The boards appreciate the importance of converged requirements in this area and continue to have open lines of communication. However, as noted above, challenges to achieving a converged solution include bringing together the different needs of the respective boards’ stakeholders and the different markets in which such stakeholders conduct their primary business activities. It is also important to note, however, that under both sets of proposals the provisions for loan losses continue to be based on the same information set, updated for changes in loss expectations. The boards will continue to discuss developments as they move forward, and participate in each other’s outreach during both boards’ exposure periods. The comment periods will have some overlap and the boards will consider public comments on both approaches during redeliberations. The timing of the issuance of final requirements will depend on the nature and the extent of feedback received, but the boards expect to complete deliberations in 2013.

Hedge Accounting The objective of the IASB’s project is to improve hedge accounting by more closely aligning the accounting with a company’s risk management activities, thereby improving financial reporting. As previously discussed, the Hedge Accounting phase of the Financial Instruments project is not a joint project. However, the FASB sought comments from its stakeholders on the IASB’s Hedge Accounting Exposure Draft, and will consider these and the decisions reached during redeliberations in conjunction with

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feedback on its own proposals, when it recommences its hedge accounting deliberations.

Other projects Leases Lease obligations are widely considered to be a significant source of off balance sheet financing. The objective of the Leases project is to improve financial reporting by lessors and lessees, in particular by recognising leases on the balance sheet. The boards have completed discussions on the Leases project and have agreed to re-expose the revised proposals for identical standards on lease accounting. The boards plan to publish exposure drafts in the second quarter of 2013 with a 120-day comment period. During the comment period, the boards will conduct additional outreach with users of financial statements and with entities that undertake lease activities. The boards plan to jointly redeliberate the proposals later this year. The timing of the issuance of the final requirements will depend on the nature and extent of the feedback received.

Revenue Recognition The objective of this project is to improve financial reporting by creating identical standards on revenue recognition that clarify the principles that can be applied consistently across various transactions, industries and capital markets.

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The project applies to all contracts with customers (except leases, financial instruments and insurance contracts). In December 2012 the boards completed the substantive redeliberations of the recognition and measurement principles in the 2011 Exposure Draft. The boards plan to redeliberate the remaining topics, including the scope, disclosure, transition and effective date, in the first quarter of 2013 and issue final standards in mid-2013.

Insurance Contracts The objective of this project is to eliminate inconsistencies and weaknesses in existing practice and to provide a single principles-based Standard to account for all insurance contracts. While the boards are working together on the Insurance Contracts project they have reached different decisions on several basic matters. For example, while both boards have agreed to measure the insurance liability using a current measure of the estimated cost to fulfil the obligation, the boards have reached different decisions on several aspects of the model, including the recognition of changes in estimate, the inclusion of a risk margin in the measurement of the liability and the treatment of acquisition costs. The boards finalised their joint discussions in January 2013. The obstacles to finding a converged solution for the Insurance Contracts project may be difficult to overcome. In particular, the different decisions reached by the boards are a result of different starting points (IFRS currently does not include accounting requirements for insurance contracts so the IASB needs a final Standard urgently, whereas the FASB is proposing amendments to its long-standing insurance model).

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Due to the importance of the project and in view of the extensive debate the IASB has undertaken over the years, the IASB will only seek feedback on five key matters which have significantly changed since the 2010 Exposure Draft. The IASB hopes that this approach will avoid further undue delays in finalising this much-needed Standard for insurance contracts. The IASB plans to publish this Exposure Draft in the first half of 2013. The FASB plans to publish its first Exposure Draft in mid-2013.

Investment Entities The Investment Entity project was, in the most part, jointly deliberated. However, the FASB is addressing the accounting for investment entities more broadly than the IASB did, as the latter’s focus was solely on an exemption from consolidation. Consequently, the boards’ final requirements will be similar but not identical. The IASB issued its final requirements in October 2012. The FASB plans to finalise its redeliberations and issue a final Standard in the first half of 2013.

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To G20 Ministers and Central Bank Governors

Progress of Financial Regulatory Reforms Financial market conditions have improved over recent months. Nonetheless, medium-term downside risks remain, given weak growth prospects and high levels of public and private sector debt in many economies. The recent improvement in financial market conditions owes much to central bank actions, in particular, the accommodative monetary policy aimed at stimulating the economic recovery. As a consequence, market participants’ appetite for risk has increased, but this has not yet translated into a robust recovery in real investment. The beginning of the return of risk appetite to financial markets – while intended and welcome – raises a number of issues. First, market participants and authorities need to be on guard against mispricing of risk and valuations of assets. Second, the importance of timely completion of the reforms to over-the-counter (OTC) derivatives markets and the shadow banking system has increased. Third, historically low interest rates in many countries pose challenges for institutional investors with long-dated liabilities and may leave market participants more vulnerable to unanticipated movements in the yield curve. Financial institutions and supervisors should continue to assess the resilience of the financial system through regular stress testing, notably of

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credit and interest rate risk, and complete the process of balance-sheet repair.

1. Reports submitted for this meeting a. Regulatory factors affecting the availability of long-term finance As part of the diagnostic work you requested of the international organisations, the FSB has prepared an assessment of the effect of the G20 financial reform programme on the availability of long-term investment finance. The reforms include Basel III, OTC derivatives market reforms, and changes affecting the regulatory and accounting framework for institutional investors. The general conclusion is that, while there may be some short-term adjustment effects, the most important contribution of the financial reform programme to long-term investment finance is to rebuild confidence and resilience in the global financial system. As a result, these reforms should substantially enhance the financial system’s capacity to intermediate investment flows through the cycle at all investment horizons. Hence, the G20 regulatory reforms are unambiguously supportive of long-term investment and economic growth. The submissions of FSB members found little evidence that the regulatory reforms have had a notable impact on long-term financing to this point. This is not surprising given the fact that the reform process is still at an early stage.

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Several features of the reforms are designed to avoid major unintended consequences: the long phase-in period for reforms; the ongoing implementation monitoring; and, in certain cases, the flexibility to adjust rules during the observation period. The financial reform programme is not specific to the regulation of long-term finance. Nevertheless, the reforms will change the incentives of some financial institutions and the costs of certain transactions, which may affect the composition of long-term finance. In particular, institutional and other long-horizon investors are expected to assume a greater role in funding long-term assets and more of this investment may be intermediated via capital markets rather than the banking system. There are three areas for specific follow-up by the FSB. First, there should be ongoing monitoring to identify any regulatory factors that may disproportionately affect the provision of long-term finance so that they can be addressed. Second, the FSB could work with others to examine whether regulatory factors may constrain the ability of non-banks to expand their provision of long-term finance. Third, the FSB can contribute to the work of other international organisations to help promote the development of longer-term domestic savings and the capacity of domestic financial systems to intermediate them, particularly in emerging market and developing economies (EMDEs).

b. Update on accounting convergence The Chairs of the International Accounting Standards Board and the US Financial Accounting Standards Board have written you on their work on convergence of accounting standards.

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The two Boards expect to make progress on the two key outstanding issues of impairment of loans, where they expect to complete their deliberations in 2013, and insurance contracts, where both Boards will be holding public consultations this year. Of these two outstanding issues, the need for convergence on a new forward-looking expected loss approach to provisioning is of most immediate concern for end-users and from a financial stability perspective. We note with concern the delays in convergence to date. We therefore recommend that the G20 ask the IASB and FASB to prepare by end-2013 a roadmap for converging to a common approach for impairment and for achieving the G20 objective of a single set of high quality accounting standards.

2. Priorities and work plans a. Creating continuous markets The FSB remains fully committed to the rapid completion of the G20’s agreed reforms to OTC derivatives markets. As you are aware, these complex reforms are taking somewhat longer than originally planned. The FSB will submit for your April meeting its latest progress report on implementation, including a comprehensive stock-take of reforms as of end-2012, estimates of the extent to which transactions are being centrally cleared and reported to trade repositories, and an overview of the remaining issues to be resolved. It is important that all jurisdictions promptly complete the necessary changes to legislative and regulatory frameworks to put these reforms into practice. To maintain momentum, I have asked FSB member jurisdictions to confirm before the September Summit that the legislation and regulation

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for reporting to trade repositories are in place, and also the steps they are taking to complete the implementation of other OTC derivatives reforms. Ministers may wish to take a particular interest in progress in their jurisdictions to ensure timely compliance with these important reforms. The FSB has previously identified regulatory uncertainty as the most significant impediment to full and timely implementation of the OTC derivatives reforms. To reduce this uncertainty, regulators are working together to identify and address conflicts, duplication and gaps in the cross-border application of rules. They will provide an update in April on their progress and next steps, and a report to the Summit on how the identified cross-border issues have been resolved. International policies in remaining important areas will also be published by the Summit. These include capital requirements for exposures to central counterparties, margining standards for non-centrally cleared transactions and guidance on resolution of central counterparties. Standard setters are undertaking an assessment of the incentives to centrally clear transactions that these standards create and will adjust them as necessary to ensure a robust system. The FSB will also report at the Summit the findings of a new macroeconomic impact assessment of the OTC derivatives regulatory reforms. Standard setters are also developing international guidance on authorities’ access to trade repository data, including in such a way that it can be aggregated across trade repositories.

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This guidance, which will be issued for consultation shortly and finalised by the Summit, will be important for ensuring that authorities can use information from trade repositories in their oversight of OTC derivatives markets and assessment of systemic risk. Ministers and Governors will wish to ensure there is effective cross-border access to this information, which is vital to the monitoring of emerging financial vulnerabilities. The global Legal Entity Identifier (LEI) system will enhance the usability of the data; the Regulatory Oversight Committee as the governance body of the global LEI system was established in January 2013. Establishing the Global LEI Foundation is the key next step to launch the system in March 2013. The FSB continues to offer strong support to the LEI initiative and the FSB Secretariat will serve as ROC LEI Secretariat for the initial period.

b. Strengthening the oversight and regulation of shadow banking As you will recall, the FSB delivered to you last November an initial set of recommendations to strengthen the oversight and regulation of shadow banking. We have received useful feedback through a public consultation on the initial recommendations. The FSB is refining the recommendations relating to securities lending and repos, and those relating to the policy measures for shadow banking entities other than money market funds. The recommendations will address bank-like risks to financial stability emerging from outside the regular banking system while not inhibiting sustainable non-bank financing models that do not pose such risks. The approach is designed to be proportionate to financial stability risks

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by focusing on those activities that are material to the system, using as a starting point those that were a source of systemic risk during the crisis. We will deliver certain recommendations to the St Petersburg Summit. These measures should be viewed as the start of a broader process since they address the specific risks that arose during the crisis and we all recognise the ability of the shadow banking sector to innovate.

c. Building resilient financial institutions In January, agreement was reached by the Group of Governors and Heads of Supervision on the Liquidity Coverage Ratio (LCR) to be applied to banks. The agreement expands the range of high-quality liquid assets that can be included in the LCR and incorporates evidence-based assumptions about liquidity outflows in times of stress. The LCR will be introduced in 2015 as planned, with the minimum requirements beginning at 60% and reaching 100% by 2019 to allow the global banking system sufficient time to adjust.

d. Ending “too-big-to-fail” Progress is being made by the IAIS in developing and testing a methodology for identification of global systemically important insurers (G-SIIs), and in developing appropriate policy measures. This work should be completed in the second quarter of 2013. An identification methodology for non-bank G-SIFIs will be issued for consultation in the second half of 2013. Although implementation of the G-SIFI framework has much farther to go, we will deliver an assessment to the St. Petersburg Summit of the progress made in developing credible policies for ending too-big-to-fail (TBTF).

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3. Implementation of reforms Basel III Consistent implementation of Basel III is fundamental to strengthening the resilience of the global banking system, maintaining market confidence in the regulatory reforms and providing a level playing field for internationally active banks. The 27 member jurisdictions of the Basel Committee on Banking Supervision (BCBS) continue to make progress toward implementation; 11 had issued final regulations by 12 February 2013 and the remaining 16 jurisdictions have tabled draft regulations (see Annex to this letter). The European Union and the United States published draft regulations in 2012 and intend to finalise them over the course of 2013. The FSB and BCBS will prepare a full update on countries’ adoption of Basel III in domestic regulation for your April meeting. The countries that have missed the January 2013 start date are working to finalise their regulations and are expected to meet the 2019 timeline for full implementation. Several more members will undergo a consistency assessment of their final regulations by the BCBS in 2013. By end-2013, all jurisdictions that are the home regulator to global systemically important banks (G-SIBs) will have been subject to an assessment of their Basel III implementation. Other jurisdictions will be subject to regulatory consistency assessments shortly thereafter. The BCBS has concluded an initial examination of the international consistency in the application of the Basel III risk weighting scheme for trading book assets. A similar review is underway regarding the banking book.

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The analysis for banks’ trading books indicates that supervisory decisions and variations in banks’ models contribute to the substantial differences in banks’ calculations of market risk. (The average risk weighting of trading assets for most banks in the study varied between 15% and 45%.) The study also shows that banks’ public disclosures are insufficient for understanding how much of these variations in banks’ reported risk weightings of assets are owing to differing levels of actual risk versus that owing to other factors. This situation is unacceptable, and the study highlights three policy options which are being addressed in the Basel Committee’s ongoing work: (i) Improving banks’ public disclosures, building on the recommendations of the Enhanced Disclosure Task Force; (ii) Narrowing down modelling choices for banks; and (iii) Further harmonising supervisory practices over approval of models.

Resolution regimes and G-SIFI resolution plans An effective and credible resolution regime for SIFIs is a critical component of the policy framework for ending TBTF. Full implementation of the FSB Key Attributes of Effective Resolution Regimes will provide authorities with the powers and tools necessary for this purpose. We will shortly conclude the first peer review of FSB members’ implementation of the Key Attributes. The work under the review confirms that reforms are underway in many jurisdictions to align national statutory regimes with the FSB Key Attributes, but that significant work remains.

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We are developing an assessment methodology to assist countries with their implementation, and to provide a basis for future peer reviews and IMF and World Bank assessments. The methodology will be tested in pilot assessments by the IMF and World Bank later this year and published in the second half of 2013. The FSB and its members will also this year address the specific aspects of resolution of insurers and financial market infrastructures and the protection of client assets in resolution. By June 2013, resolution strategies and plans should be in place for all G-SIFIs designated in November 2011. To assist this process the FSB has publicly consulted on specific aspects of recovery and resolution planning and is now finalising its guidance. Progress in ending TBTF is contingent on the feasibility and credibility of putting these resolution plans into operation. We will launch in the second half of 2013 a first round of assessments under the G-SIFI Resolvability Assessment Process to evaluate the progress made.

Reducing the reliance on Credit Rating Agency (CRA) ratings The FSB has recently launched a thematic peer review to assist its members to fulfil their commitments under the roadmap for implementing the FSB principles for reducing reliance on CRA ratings. This will include a stock-take of references to CRA ratings in national authorities’ laws and regulations and of actions being taken to remove or replace these references. The findings will feed into the progress report on CRAs for the Summit, while the peer review will be completed by early 2014.

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Monitoring the impact of reforms on EMDEs The FSB will organise a workshop for EMDEs in the first half of 2013 to share lessons and experiences on implementing agreed financial reforms and on undertaking ex ante assessments of their impact. FSB members with significant experience in undertaking such assessments will be asked to present their methodologies. The FSB will report the findings of the workshop and other relevant monitoring processes at the St. Petersburg Summit.

4. FSB resources, capacity and governance Finally, I am pleased to report that the FSB has now been established with a legal personality. Alongside this, a rolling five-year agreement under which the BIS will host and provide resources for the FSB has been activated, and an institutional mechanism for the FSB’s financial and resource governance established. The FSB has also adopted Procedural Guidelines for its operational and administrative activities and practices. These are important steps towards implementation of the G20 recommendations at Cannes and Los Cabos to place the FSB on an enduring organisational footing, with strengthened governance, greater autonomy in resource use and enhanced capacity to coordinate the development and implementation of financial regulatory policies, while maintaining strong links with the BIS. The FSB will next elect new chairs for three of its Standing Committees and begin a review of the composition of their memberships.

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Following the St. Petersburg Summit, the FSB will set in train a review of the structure of its representation, which we envisage to be completed under the Australian Presidency of the G20.

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The new Risk Dashboard

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EIOPA Risk Dashboard – Background note Executive Summary EIOPA publishes a Risk Dashboard on a quarterly basis, in accordance with its obligations under the EIOPA Regulation1 and following a framework determined in cooperation with the other ESAs, the ESRB and the ECB. The Risk Dashboard is based on mechanical aggregation of indicators and additional expert judgment if deemed necessary. Besides publicly available market data, extensive use is made of company data which is reported by 30 large and important insurance groups from the EEA and Switzerland under EIOPA’s quarterly fast-track reporting. Within the common structure agreed upon by the ESAs, the ESRB and the ECB, the Risk Dashboard is designed to be flexible, so EIOPA can react quickly to upcoming risks which are deemed necessary to be covered. EIOPA expects the Dashboard to gradually evolve further, taking feedback by the addressees of this product into account.

Context As part of the new European legislation, EIOPA as well as the other ESAs and the ESRB are called upon to “develop a common set of quantitative and qualitative indicators (risk dashboard) to identify and measure systemic risk”. The legislation further stipulates that these dashboards should be constructed in cooperation between the ESAs and ESRB. In response to this requirement, the ESAs, together with the ESRB and the ECB have determined a set of general features for all dashboards to follow:

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- Each risk dashboard will be constructed based on the same set of risk categories: macro risk, credit risk, market risk, funding and liquidity risk, profitability and solvency risk and risks resulting from interlinkages and imbalances. Furthermore, each institution has the option to add categories to allow for sector specific risks (e.g. insurance risk).

- It was noted that all Risk Dashboards should be constructed on a

flexible basis in order to allow each authority to reflect the most imminent risks identified.

- Further development and implementation of the Risk Dashboards

should be taken forward individually by each of the authorities concerned. However, the ESAs and ESRB should continue to work together closely in this regard to ensure interplay regarding the underlying information presented e.g. consistency when the same indicator is used in different Risk Dashboards.

Approach Work on the EIOPA Risk Dashboard has since been brought forward by the Financial Stability Committee of EIOPA. In defining the methodology for the Risk Dashboard, the Committee has considered the approach taken by other institutions in the field of risk assessment, for instance by the IMF2. The Risk Dashboard has been created to give a structured view of risks to the insurance sector and the environment in which it operates, in order to facilitate a regular assessment of these risks and possible mitigating policy actions. In creating it, care has been taken to keep the dashboard as concise, forward-looking and flexible as possible.

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Furthermore, it is worth noting that the dashboard is designed as a high-level tool showing the most relevant trends and risks on a macro level. As significant differences between individual institutions exist, the findings presented are not always applicable to all EU insurers.

Methodology Indicators A set of currently 40 quantitative indicators forms the basis of the risk assessment presented. These indicators, which signal potential risks and vulnerabilities for the European insurance sector as well as its resilience, are generated using both supervisory and publicly available data. This data is used – and in some cases combined – as the basis of the risk assessment for each indicator. Given that the distribution of risks and vulnerabilities is at least as important as its central tendency, the risk indicators are, where possible, assessed by taking both the median and outliers (e.g. 10th or 90th percentiles) of the underlying sample into account. Based on this information an initial risk score for each indicator is derived. These scores basically serve as proxies when combining various risk indicators to an assessment for the overarching risk category.

Risk categories The indicators are mapped to aggregated categories of (1) macro risk,

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(2) credit risk, (3) market risk, (4) funding & liquidity risk, (5) profitability & solvency, (6) interlinkages & imbalances and (7) insurance risk. Based on the individual risk scores for each underlying indicator an aggregated risk score for each category is generated by either - an unweighted average (for categories 4, 6 and 7);

- a weighted average referring to a long-term average of actual

portfolio holdings (for categories 2 and 3);

- a sub-aggregation within some indicators of a risk category and an aggregation of these “sub-risk scores” by using the simple average o for category 1 with a split in (1a) real-economy risks and (1b) the riskiness of the insurance sector as perceived by financial market participants, o for category 3 with a split in (3a) asset side risks and (3b) ALM matching risks, o for category 5 with a split in (5a) life business, (5b) non-life business and (5c) total business.

For a quick and comprehensive interpretation the overall risk score are visualized through four color codes in the Risk Dashboard. Quarterly changes are represented through arrows.

Risk assessment The mechanically estimated risk scores per category form the basis of the risk assessment in the Risk Dashboard.

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These scores are complemented by other information available on risks, e.g. from stress test results, topical risk analyses or other available data. If necessary, this information is used to adjust the scores. This way, it is ensured that all available information is used for the risk assessment and the most complete picture is generated. However, decisions to change the mechanically aggregated scores (i.e. expert judgment) are documented to ensure transparency of this process. To ensure flexibility, the Risk Dashboard contains space to elaborate further on the most prominent risks in a ‘user-defined’ non-mechanical way. Additional dimensions of each risk (e.g. the potential impact as well as timing aspects) have been derived partially on expert judgment as well.

Expert judgment Expert judgment is considered crucial for complementing or substituting the mechanical process of the risk assessments and for making forward-looking statements about the expected evolution of risks. The process for adjusting the initial risk scores (both upward and downward adjustment) by expert judgment is intended to be transparent and used consistently over time. Any uncertainty in the assessment and/or element of judgment that will influence the final assessment, such as risk mitigating factors will be made explicit and will be documented. The transparency and documentation requirements should ensure a sufficient level of confidence in the expert judgment. This confidence in expert judgment is important in order to produce credible risk assessments.

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This confidence should be further maintained by tracking the adjusted assessments against actual experience or new information that becomes available. Such “reality checking” is especially important where the expert judgment leads to significant deviations from the mechanical assessment or where it has a material impact on the overall assessment output.

Data sources Data for the Risk Dashboard is obtained from both public sources (market data) and the quarterly supervisory reporting of 30 large European insurance groups to EIOPA (fast-track reporting). Data availability for Risk Dashboard purposes is expected to improve substantially with the introduction of Solvency II reporting.

Indicators used Macro risk As macro risks are obviously the major domain of the ESRB’s Risk Dashboard, EIOPA’s contribution focuses mainly on insurance-linked aspects. Besides consensus forecasts of GDP growth, development of consumer prices and unemployment rates, this section therefore encompasses the financial markets’ perception of the healthiness and profitability of the European insurance sector. For this purpose, relative stock market performances of European insurance indices against the total market are assessed, as well as fundamental valuations of insurance stocks (price/earnings ratio, price/book-value ratio), CDS spreads and ratings/rating outlooks.

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Market risk Market risk is, for most asset classes, assessed by analysing both the investment exposure of the insurance sector and an underlying risk metric. The holdings give a picture of the vulnerability of the sector to adverse developments; the risk metric gives a picture of the current level of riskiness. For equity investments, the relevant risk metrics are the implied volatility as a short-term indicator and the price/book-value ratio as medium-term indicator. Also for property investments the valuation comes in as a risk metric, via the current yield of commercial real estate investments. In addition, the current level of long-term interest rates and some asset-liability matching indicators are assessed, e.g. by comparing the duration of the bond portfolio (including the effect of derivative holdings) with the duration of technical provisions. The difference between guaranteed interest rates and investment returns completes the assessment in this risk category.

Credit risk For measuring credit risk the holdings of credit asset classes are combined with risk metrics applicable for these asset classes. For instance, the holdings of government securities are combined with the credit spreads on European sovereigns. Such indicators are also constructed for the holdings of bank bonds (secured and unsecured) and non-financial corporate bonds.

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Liquidity and funding risk Generally speaking, insurers are less prone to liquidity risk than banks. As indicators, the lapse rate of the life insurance sector has been used with a high lapse rate signaling a potential risk. Furthermore, holdings of cash & deposits are used as a measure of the liquidity buffer available, both in absolute terms and as a share of less liquid assets. The last indicator used is the issuance of catastrophe bonds, where a very low volume of issuance and/or high spreads signal a reduction in demand which could form a risk.

Profitability and Solvency Nine risk indicators were considered in the determination of the risk score for this category. While the return on equity provides an overall assessment of the profitability in the whole sector, a more detailed breakdown of profitability trends is available by analysing the combined ratio and the return to premiums for non-life business and the return on assets for life insurers. Solvency ratios for both life and non-life insurers complete the picture in this risk category as well as the year-on-year change in capital&reserves.

Interlinkages and Imbalances Under this section various kinds of interlinkages are assessed, both within the insurance sector, namely between primary insurers and reinsurers, between the insurance sector and the banking sector, as well as via derivative holdings.

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In addition, as an indicator on imbalances the debt/equity ratio of the insurance sector has been included.

Insurance Risks As indicators for insurance risks gross written premiums of both life and non-life business are an important input. Both significant expansion and contraction are taken as indicators of risks in the sector; the former due to concerns over sustainability and the latter as an indicator of widespread contraction of insurance markets. Premiums are also analysed in comparison to insurers’ capital&reserves (insurance leverage). Information on insurance losses due to natural catastrophes rounds up this risk category.

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Governor Sarah Bloom Raskin Board of Governors of the Federal Reserve System At the National Community Reinvestment Coalition Annual Conference, Washington, D.C.

Focusing on Low- and Moderate-Income Working Americans I am delighted to be here at the National Community Reinvestment Coalition (NCRC) Annual Conference today, and to be gathered with so many people who have been working for decades to strengthen communities and the integrity of our nation's economic institutions and financial practices. Those of you involved in community development and community reinvestment know all too well the trauma and hardship experienced by low-income communities over the last several years. You know it in a way that is lost on people whose communities have not been so badly battered by these economic storms. That's why I'm looking forward this morning to sharing with you my perspective on the importance of focusing on the situation and prospects of low- and moderate-income working Americans. In my remarks, I will start by discussing the types of jobs being generated in the current recovery. Certainly, the pace of recovery in employment has improved, but it's important to look at the types of jobs that are being created because those jobs will directly affect the fortunes and challenges of households and neighborhoods as well as the course of the recovery. I will then suggest that we think about how the absence of a substantial number of new high-paying jobs, when combined with changes in the

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landscape for financial services, affects access generally to affordable, sustainable credit. Finally, I will explore some of the monetary, supervisory, and regulatory touchpoints in which the situation and prospects of low- and moderate-income working Americans can be addressed.

Challenges Posed by Labor Market Conditions The Great Recession stands out for the magnitude of job losses we experienced throughout the downturn. These factors have hit low- and moderate-income Americans the hardest. The poverty rate has risen sharply since the onset of the recession, after a decade of relative stability, and it now stands at 15 percent--significantly higher than the average over the past three decades. And those who are fortunate enough to have held onto their jobs have seen their hourly compensation barely keep pace with the cost of living over the past three years. While today's 7.7 percent unemployment rate is a marked improvement from the 10 percent rate we reached in late 2009, it is still higher than the unemployment rate for the 24 years before the Great Recession, a span of time over which the rate averaged about 6 percent. Moreover, the government's current estimate of 12 million unemployed does not include nearly a million discouraged workers who say they have given up looking for work and 8 million people who say that they are working part time even though they would prefer a full-time job. A broader measure of underemployment that includes these and other potential workers stands at 14.3 percent. About two-thirds of all job losses resulting from the recession were in moderate-wage occupations, such as manufacturing, skilled construction, and office administration jobs.

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However, these occupations have accounted for less than one-quarter of subsequent job gains. The declines in lower-wage occupations--such as retail sales and food service--accounted for about one-fifth of job loss, but a bit more than one-half of subsequent job gains. Indeed, recent job gains have been largely concentrated in lower-wage occupations such as retail sales, food preparation, manual labor, home health care, and customer service. Furthermore, wage growth has remained more muted than is typical during an economic recovery. To some extent, the rebound is being driven by the low-paying nature of the jobs that have been created. The slow rebound also reflects the severe nature of the crisis, as the slow wage growth especially affects those workers who have become recently re-employed following long spells of unemployment. In fact, while average wages have continued to increase steadily for persons who have remained employed all along, the average wage for new hires have actually declined since 2010. The faces of low-wage Americans are diverse. They include people of varying employment status, race, gender, immigration status, and other characteristics. Many such Americans are attached to the workforce and are deeply committed to both personal success and to making a contribution to society. For purposes of reference, in 2011, low wage was defined as $23,005 per year or $11.06 per hour. Today, about one-quarter of all workers are considered "low wage."

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They are sanitation workers, office receptionists, and nursing assistants; they are single mothers of three who worry: How will I be able to send my children to college? What if my landlord raises the rent this year? Tens of millions of Americans are the people who ask themselves these questions every day. This diverse group of workers faces numerous barriers when trying to access the labor market or advance in their current positions. Many of these barriers were identified in an initiative that the Federal Reserve's Community Development function launched in 2011. Over the course of a year, Reserve Banks across the country hosted a series of 32 regional discussions aimed at examining the complex factors creating chronic unemployment conditions and identifying promising workforce development solutions. The kinds of problems faced by low-wage workers are familiar to all of you and have long been part of the structural conditions of poverty and near-poverty in America. We know, for example, that location presents thorny challenges for many low-wage workers. Within metropolitan areas, jobs are not spread out evenly and job creation tends to be depressed in low-income communities. As a result, many low-wage workers face long commutes and serious commuting difficulties due to less reliable transportation and an inadequate transportation infrastructure. Moreover, a number of low-wage employees work non-standard hours, exacerbating both transportation and childcare issues, as well as personal health problems.

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Traditionally, many workers find jobs through social networks and through personal connections that they have to the labor market. But, because low-income individuals are typically less mobile, more isolated, and less socially connected than other people, they are often left out of the social networks that, in practice, lead to jobs for most Americans.

Addressing These Challenges Among those responding to these challenges are innovative local practitioners who are implementing programs designed to expand job opportunities for low-wage workers. Consider Impact Services in Philadelphia, an organization that builds relationships with the local business community to better understand their hiring needs and then devises programs that supply those firms with appropriately skilled workers from the community. The National Fund for Workforce Solutions is another example. This organization works with local communities to organize funding collaboratives to support regional industries.

More Recent Challenges for Low-Wage Workers So progress is being made, thanks to coalitions like these across the country that are working for practical changes at the community level. But the 21st century labor market is increasingly complex; it continues to generate new challenges. For example, growth in sectors such as green industries and advanced manufacturing is creating jobs, but these jobs may demand different skills. Access to reliable information becomes critical for workers who are considering a new job, and must carefully weigh the skills and credentials required by potential employers with the cost of training and the likelihood of gaining employment.

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And, more and more, employers are requiring post-secondary credentials. Today, a high school diploma alone is less likely to qualify an individual for a job with a path toward meaningful advancement. And, as demand for more credentials increases, workers who lack those credentials will find it increasingly difficult to gain upward mobility in the job market.

Contingent Work Many employers are looking to make the employment relationship more flexible, and so are increasingly relying on part-time work and a variety of arrangements popularly known as "contingent work." This trend toward a more flexible workforce will likely continue. For example, while temporary work accounted for 10 percent of job losses during the recession, these jobs have accounted for more than 25 percent of net employment gains since the recession ended.10 In fact, temporary help is rapidly approaching a new record, and businesses' use of staffing services continues to increase. Contingent employment is arguably a sensible response to today's competitive marketplace. Contingent arrangements allow firms to maximize workforce flexibility in the face of seasonal and cyclical forces. The flexibility may be beneficial for workers who want or need time to address their family needs. However, workers in these jobs often receive less pay and fewer benefits than traditional full-time or "permanent" workers, are much less likely to benefit from the protections of labor and employment laws, and often have no real pathway to upward mobility in the workplace. Many workers who hold contingent positions do so involuntarily. Department of Labor statistics tell us that 8 million Americans say they are working part-time jobs but would like full-time jobs.

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These are the people in our communities who are "part time by necessity." As businesses increase their reliance on independent contractors and part-time, temporary, and seasonal positions, workers today bear far more of the responsibility and risk for managing their careers and financial security. Indeed, the expansion of contingent work has contributed to the increasing gap between high- and low-wage workers and to the increasing sense of insecurity among workers. Flexible and part-time arrangements can present great opportunities to some workers, but the substantial increase in part-time workers does raise a number of concerns. Part-time workers are particularly vulnerable to personal shocks due to lower levels of compensation, the absence of meaningful benefits, and even a lack of paid sick or personal days. Not surprisingly, turnover is high in these part-time jobs.

Access to Credit The economic marginalization that comes with the growth of part-time and low-paying jobs is exacerbated by inadequate access to credit for many working Americans. Ideally, people chronically short of cash would have access to safe and sound financial institutions that could provide reliable and affordable access to credit as well as good savings plans. Unfortunately, many working Americans have no practical access to reasonably priced financial products with safe features, much less the kind of safe and fair credit that is available to wealthier consumers. Working Americans have several core financial needs.

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They need a safe, accessible, and affordable method to deposit or cash checks, receive deposits, pay bills, and accrue savings. They may also need access to credit to tide them over until their next cash infusion arrives. They may be coming up short on paying their rent, their mortgage, an emergency medical expense, or an unexpected car repair. They may want access to a savings vehicle that, down the road, will help them pay for these items and for education or further training, or start a business. And many want some form of non-cash payment method to conduct transactions that are difficult or impossible to conduct using cash. Products and services that serve these core financial needs are not consistently available at competitive rates to working Americans. Those with low and moderate incomes may have insufficient income or assets to meet the relatively high requirements needed to establish a credit history. Others may have problems in their credit history that inhibit their ability to borrow on competitive terms. Many workers simply may not have banks in their communities, or may not have access to banks that actually compete with each other in terms of pricing or customer service. There is a growing trend toward greater concentration of financial assets at fewer banks. In my mind, this raises doubts about whether banking services will continue to be provided at competitive rates to all income levels of customers wherever they may live. According to a study of bank branch locations published by NCRC in 2007, there are more persons per branch in low- and moderate-income census tracts than in moderate- and upper-income census tracts.

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While branch-building has been on the rise, indications are that the increase in the number of bank offices has not occurred evenly across neighborhoods of varying income. In fact, a significant number of low- and moderate-income families have become--or are at risk of becoming--financially marginalized. The percentage of families earning $15,000 per year or less who reported that they have no bank account increased between 2007 and 2009 such that more than one in four families was unbanked. Families slightly further up the income distribution, earning between $25,000 and $30,000 per year, are also financially marginalized: 13 percent report being unbanked and almost 24 percent report being underbanked. This combination of economic insecurity and financial marginalization has incentivized more low- and moderate-income families to seek out alternative financial service providers to meet their financial needs. Some of the providers they find, such as check-cashers and outfits furnishing advance loans on paychecks, can lead unwary workers into very deep financial holes. In light of these challenges, I ask questions that have been asked before: What can economic policy do to reduce unemployment, economic marginalization, and the financial vulnerability of millions of lower-income working Americans? There is no simple cure to these conditions, but government policymakers need to focus seriously on the problems, not simply because of notions of fairness and justice, but because the economy's ability to produce a stable quality of living for millions of people is at stake. Our country cannot achieve prosperity without addressing the powerful undertow created by flat wages and tenuous financial security for so many millions of Americans.

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The Role of Monetary Policy So how can the Federal Reserve address these challenges? Let me start with monetary policy. Congress has directed the Federal Reserve to use monetary policy to promote maximum employment and price stability. The Federal Reserve's primary monetary policy tool is its ability to influence the level of interest rates. Federal Reserve policymakers pushed short-term interest rates down nearly to zero as the financial crisis spread and the recession worsened in 2007 and 2008. By late 2008, it was clear that still more policy stimulus was necessary to turn the recession around. The Federal Reserve could not push short-term interest rates down further, but it could--and did--use the unconventional policy tools to bring longer-term interest rates such as mortgage rates down further. Fed policymakers intend to keep interest rates low for a considerable time to promote a stronger economic recovery, a substantial improvement in labor market conditions, and greater progress toward maximum employment in a context of price stability. Both anecdotal evidence and a wide range of economic indicators show that these attempts are working to strengthen the recovery and that the labor market is improving. Nonetheless, and again, the millions of people who would prefer to work full time can find only part-time work. While the Federal Reserve's monetary policy tools can be effective in promoting stronger economic recovery and job gains, they have little effect on the types of jobs that are created, particularly over the longer term.

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So, while monetary policy can help, it does not address all of the challenges that low- and moderate-income workers are confronting. That said, the existing mandate regarding maximum employment requires policymakers on the Federal Open Market Committee (FOMC) to understand labor market dynamics, which obviously must include an understanding of low- and moderate-income workers.

Regulatory and Supervisory Touchpoints In addition to monetary policy, the Federal Reserve's regulatory and supervisory policies have the potential to address some of the challenges faced by low-income communities and consumers. The Federal Reserve is required by law--by virtue of the Bank Holding Company Act--to approve various applications, such as mergers, acquisitions, and proposals to conduct new activities. This statutory review requires an explicit consideration of public benefits and the effects of the proposed transaction on the convenience and needs of the communities to be served. This assessment is, as many of you know, a critical opportunity for community input and analysis. Indeed, as people with their feet firmly planted on the ground in communities across America, you probably remember James Q. Wilson's theory of "broken windows" in community policing: Move in quickly when vandalism and disorder first start to appear--even if it is only a broken window or graffiti on a stop sign--or else face losing the whole neighborhood as disrespect for the law rapidly spreads. The "broken windows" strategy is every bit as compelling when it comes to addressing the disorder that comes from sloppy practices by financial institutions. If banking practices are undermining the ability of the economically marginalized to become financially included and to access the credit they

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need in an affordable way, regulators must move in quickly to stop the disorder and repair the broken windows of financial intermediation. Bank supervisors should be prepared to respond to the earliest signs of trouble by requiring operationally challenged banks to address problems quickly and completely. If corrections are made, then the regulators can move on. If not, then the regulators need to escalate enforcement. Swift and decisive corrective action is not always how federal bank regulators have responded to broken windows in the past. In my view, for example, regulators' response to the rampant, long-running problems in loan-servicing practices at large financial institutions was not swift and was not decisive. The point is that federal regulators must listen carefully to community input and analysis in order to keep track of where windows are breaking and how they are being broken. And they must carefully study and take responsibility for analyzing comments provided by organizations such as the NCRC when considering the public benefit of an application. Both the exam process and the application process must be strengthened as key venues for federal regulators to incorporate the voices of affected communities; I'd like to see us revise and strengthen these processes to include the analysis in these voices.

The Role of Business Now let's shift back to the private sector. In particular, to the question of whether businesses can be competitive in the current marketplace and still provide a pathway out of poverty for their employees.

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The Hitachi Foundation recently set out to answer this question by identifying firms that provided upward job mobility for their employees. They found that the identified employers showed noteworthy consistency in how they train and educate workers, develop career ladders, and craft supportive human resources policies and other motivators. They also found some evidence to indicate that the companies benefited from strategic and financial returns while their lower-wage workers also benefited from increased earnings and career advancement. "Anchor institutions," such as hospitals and universities, which are firmly rooted in their locales, can also be powerful engines for job creation in their communities. Anchors may include cultural institutions, health care facilities, community foundations, faith-based institutions, public utilities, and municipal governments. These institutions have the potential to generate local jobs through targeted procurement purchases of food, energy, supplies, and services from local businesses. This can be a substantial, positive development in the local economy. The Evergreen Cooperative in Cleveland, Ohio, is an example of a network of worker-owned businesses, launched in low-income neighborhoods, to support local anchor institutions. The cooperatives were initially established to provide services to local hospitals and universities that had agreed to make their purchases locally. This model is effective because it capitalizes on local production, and because it forges a local business development strategy that effectively meets many of the anchor institutions' own needs.

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Role for Community-Based Organizations Clearly, the challenges facing low-wage workers are multi-faceted and complex. In addition to the challenges that workforce development and community organizations have addressed for years, structural changes in the economy heighten obstacles, make the stakes higher if we fail to conquer them, and, therefore, require new levels of openness and creativity by policymakers. You are the ideal audience for this message because you know how to link federal policymaking with economic empowerment. NCRC has grown to an association of more than 600 community-based organizations that promote access to basic banking services to create and sustain affordable housing, jobs, and vibrant communities for America's working families. Community-based organizations like many of those represented in this room will need to consider how to work with low-wage workers to bridge information gaps by expanding workers' networks, providing legitimate information, and identifying new job opportunities. But finally, the pressure that community-based organizations exert on financial regulators must continue. Access to credit is an enduring challenge, and the obstacles and problems--all the "broken windows" you see on the block--must be reported and explained. They must be understood by the federal policymakers who are responsible for enforcing our country's laws and regulations in the realm of access to credit; by the federal policymakers who engage in the conduct of monetary policy; and by the federal policymakers whose actions contribute to the shaping of the landscape for financial services in this country.

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Your voices--whether you are reporting, documenting, monitoring, analyzing, proposing, or even protesting--must be heard. Your voices are crucial to alerting policymakers to the significant developments and emerging trends in the nation's communities that must be confronted--and confronted in a swift and decisive way--if we are to make prosperity a national agenda that touches every American. Thank you.

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Islamic capital and money markets Welcoming remarks by Mr Peter Pang, Deputy Chief Executive, Hong Kong Monetary Authority, at the workshop on “Islamic capital and money markets”, Hong Kong Distinguished guests, ladies and gentlemen, 1. It is my great pleasure to welcome you to this Islamic finance workshop. We are particularly grateful to Mr. Mohd. Radzuan, Mr. Azidy and Mr. Azahari, the experts from Malaysia, who have flown all the way to Hong Kong to share with us their knowledge on Islamic capital and money markets and their valuable experience in developing these critical components of Islamic finance. I would also like to thank Mr. Najmuddin of Bank Negara Malaysia for bringing the Malaysian delegation here.

Two fast developing asset classes in the global markets 2. This workshop comes at a very opportune time as Hong Kong is looking to develop Islamic finance as a way to diversify our financial platform and further enhance our capability as an international financial centre. In my view, to be a truly international financial centre, one needs to develop a conducive platform for the two fast developing asset classes in the global markets – Islamic financial products and RMB-denominated investment assets.

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3. The development of Islamic financial markets has been phenomenal in the past two decades. The size of global Islamic finance assets made a quantum leap from only US$150 billion in the mid-1990s to US$1.3 trillion at the end of 2011. Although the investment climate has been clouded by the US sub-prime crisis and the European sovereign debt problems in recent years, the global sukuk market is powering ahead. Indeed, last year was the best year for the global sukuk market on record, with sukuk issuances growing by more than 60% year-on-year, taking the outstanding sukuk amount to a new height of US$240 billion. According to some market estimates, the size of the global Islamic finance industry has the potential to increase five-fold from the current level to some US$6.5 trillion by 2020.3 4. The development of RMB-denominated investment products is equally impressive. In a short space of 6 years, the size of the RMB dim sum bond market in Hong Kong has grown from a modest amount of 10 billion yuan in 2007 to 237 billion yuan at the end of 2012. Offshore RMB financial products have also become more diversified, expanding from only RMB bonds to RMB equities, RMB investment funds, RMB A-share exchange-traded funds (ETFs) as well as RMB insurance products. The growth momentum of the offshore RMB financial markets is expected to pick up further, as more and more financing and investment activities can now be conducted in RMB, especially following the introduction by the Mainland authorities of the arrangements for inward and outward direct investments in RMB and the RMB Qualified Foreign Institutional Investors (i.e. RQFII) scheme.

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5. Hong Kong is fortunate to have made a good start in offshore RMB business. Since the introduction of offshore RMB business in 2004, we have developed a wide variety of RMB denominated financial products. In particular, the offshore RMB bond market in Hong Kong is by far the largest in the world. We also possess the largest RMB liquidity pool outside of Mainland China. As at the end of 2012, the aggregate amount of RMB customer deposits and certificates of deposits has reached a high of 720 billion yuan. Notwithstanding these, when it comes to Islamic finance, Hong Kong is a relative newcomer and would need to catch up in this area.

Legislative exercise to promote the development of sukuk market 6. In developing Islamic finance, we are taking a step by step approach. As a first step, our current focus is to put in place the supporting legal infrastructure. Specifically, the HKSAR Government is set to change the tax laws in Hong Kong to facilitate the development of the sukuk market. In terms of economic substance, sukuk are no different from conventional bonds. However, since Islamic law prohibits the payment and receipt of interest, sukuk are often structured with the use of special purpose vehicles and multiple transfers of underlying assets.

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This may result in additional tax liabilities and hence higher issuance costs for sukuk when compared with conventional bonds under the existing tax regime. 7. It is therefore necessary to refine our tax laws to provide a tax framework for sukuk that is comparable to the one applying to conventional bonds. But this does not mean that we are going to confer special tax favours on the Islamic finance sector; rather, our aim is to level the playing field so that financial instruments of similar economic substance will be given similar tax treatments. 8. On this, I am very pleased to see that an amendment bill has been introduced into the Legislative Council earlier this year. The bill adopts a prescriptive and religion-neutral approach, and covers five of the most common types of sukuk globally. Products that can meet the key features and qualifying conditions specified in the bill will be given tax treatments similar to those currently afforded to conventional bonds. This means that sukuk issuers and investors alike will no longer be subject to additional tax and stamp duty charges over and above what they would need to pay for conventional bonds. So, passage of the bill will be a very positive step forward in furthering the development of Islamic finance in Hong Kong.

Synergy between Hong Kong and Malaysia 9. With the legal infrastructure to be in place soon, the next important step will be to develop the Islamic financial markets here. We definitely have a lot to learn from Malaysia in respect of product development and market operation.

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As I see it, Hong Kong and Malaysia each has different edges in the financial services industry, and the potential synergy between the two places in developing the Islamic financial markets is tremendous. 10. Malaysia is undoubtedly an important leading centre in the global Islamic finance industry that has accumulated vast experiences and invaluable expertise over the past three decades. It has developed a well-diversified Islamic financial market, offering a full suite of products covering sukuk, Islamic equities, Islamic funds, Islamic ETFs, etc. Its sukuk market is by far the largest in the world, accounting for more than 70% of global sukuk issuances last year. It has also put in place well-developed financial infrastructure which can facilitate local and overseas market players alike in conducting Islamic financial transactions. 11. On the other hand, Hong Kong as an international financial centre has developed a deep and highly liquid capital market with a diverse base of investors coming from all around the world. More importantly, with Hong Kong’s unique role as a gateway to Mainland China and a leading hub for offshore RMB business, Hong Kong can offer an ideal platform to link Islamic and RMB financing together by developing financial products that are Shariah-compliant and, at the same time, denominated in RMB. Through Hong Kong’s platform, international investors in the Islamic world can easily tap the appealing growth story of the Mainland. This is especially given the fact that many investors are now actively looking for investment opportunities in Asia, particularly Mainland China, to diversify their investment portfolios. At the same time, Mainland issuers can also make use of our platform to reach out to the increasingly wealthy investor base in the Islamic world.

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12. Clearly, there is a strong foundation for both sides to work together to complement each other, grow the pie bigger and achieve a win-win proposition in developing Islamic finance. For this important reason, the HKMA entered into a Memorandum of Understanding (MoU) with Bank Negara Malaysia in 2009 to strengthen mutual co-operation in the area of Islamic finance. We are very pleased to have worked closely with Bank Negara Malaysia to put together and bring this workshop to Hong Kong under the framework of the MoU. Building a deep talent pool is crucial for further development of the Islamic finance industry. Workshops of this kind will undoubtedly help to promote market awareness and knowledge of Islamic finance, while also providing an excellent forum for market players to exchange views and business contacts. We will continue to work closely with the Treasury Markets Association to raise the expertise in Islamic finance in Hong Kong. 13. Apart from our continuous efforts to put in place a conducive platform, it is also crucial for market players to maximize their readiness to grasp the opportunities brought by the development of Islamic finance in Hong Kong. After all, market players will be the ones who drive the growth of the market ultimately. So, I highly encourage you all to gear up for the new opportunities ahead of us. On this, I am pleased to note that some financial institutions have already started to get ready by mobilizing their staff in the Middle East or Malaysia to Hong Kong, as well as providing training to their staff in Hong Kong.

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The fact that you are here today is also a good indication that you are keen to prepare yourselves. I hope you would take the most out of this workshop. 14. Thank you.

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Interview with Gabriel Bernardino, Chairman of EIOPA, conducted

by Nataša Gajski Kovačić, Svijet osiguranja (Croatia)

In the best scenario, the beginning of Solvency II implementation should be either in 2015 or 2016, as Mr. Bernardino has recently said. He added that the date depends on the length of the legal and political process. Previously it was announced that full implementation of Solvency II will happen at the beginning of 2014? What is the reason of the delay of Solvency II? First of all let me give you an overview of the EU legal process that precedes the implementation of Solvency II. We have a Level 1 text – the Solvency II Directive, which was adopted in 2009, it is a principles based document. The Level 2 text will contain detailed rules of the Solvency II regime. This document is called Implementing Measures and will be prepared by the European Commission. Finally we have Level 3 & Technical Standards, which concerns purely technical matters and require supervisory expertise rather than strategic

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decisions or policy choices. The Technical Standards are to be prepared by EIOPA and then adopted by the European Commission. The EU trilogue parties (the European Commission, the European Parliament and the Council of the EU) still need to decide the scope and the legal basis for the Technical Standards that EIOPA has to draft. This decision will be introduced in the so called Omnibus II Directive. Only after the finalization of the Omnibus II Directive, the Commission will come up with the Implementing Measures and EIOPA – with Technical Standards. Last year the trilogue parties agreed that a final decision on the Omnibus II Directive can be taken only after EIOPA conducts the Long Term Guarantee Assessment (LTGA). EIOPA supports this approach because before moving forward with Solvency II we indeed need to agree on a sound and prudent regime for the valuation of long term guarantees. On 28 January 2013 we launched this study and hope to present its findings and our conclusions in June 2013. Afterwards we expect that the Omnibus II Directive will be finalized. Some insurance companies complain that the Solvency II scheme favors bigger insurers who have the resources to easily adjust to the new regime. They complain that the cost of preparation are too big already. How do you comment that? No, Solvency II is a neutral framework.

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Already the level 1 text states that the Directive should not be too burdensome for small and medium sized insurance companies. And one of the means to achieve this objective is the proper application of the proportionality principle. In our work related to the drafting of Technical Standards, we always take into account proportionality aspects that are related to the size, complexity or risk profile of insurance companies. As regards the costs of preparation, let’s ask ourselves: do we want to keep the existing Solvency I regime? No, because Solvency I is not risk sensitive, it contains very few qualitative requirements regarding risk management and governance and does not provide supervisors with adequate information on the undertaking’s risks. Comparing to the current regime, Solvency II has a clear benefit – it is a risk& based regime, it helps companies to better understand and manage their risks. Solvency II is a huge step in terms of transparency as it will bring harmonized reporting framework and reliable disclosure. I am convinced that Solvency II will provide an appropriate basis for increased policyholder protection and will contribute to reinforcing financial stability in general. The costs of preparation will be higher for the companies that want to use internal models for the calculations of their capital requirement. That will not be the case for the vast majority of companies in the EU. Do you think that European insurers are prepared for the transition to Solvency II? Where do you expect the biggest problems to occur?

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We are confident about the preparation level of insurance undertakings. At the same time we want to use the delay in Solvency II implementation for tackling possible problems in a consistent and convergent way and here I would like to mention EIOPA Opinion on interim measures related to Solvency II, which we issued in December last year. In this document we indicated that we see a great necessity in such interim measures because there is a risk that due to the delay of a final agreement on Solvency II, a number of European supervisors may decide to develop national solutions in order to ensure sound risk sensitive supervision. So instead of reaching consistent and convergent supervision in the EU, different national solutions may emerge to the detriment of a good functioning internal market. EIOPA will develop Guidelines that are addressed to the national competent authorities and that are related to such stable elements of Solvency II that are unlikely to be influenced by the finalized Omnibus II Directive. These Guidelines will cover the system of governance, including risk management, ORSA, pre application of internal models, and reporting to supervisors. I must say that our initiative to develop the Guidelines was approved by EIOPA Board of Supervisors (BoS), which consists of all the national supervisory authorities of the European Economic Area and also received a very positive feedback from the European Commission. In April we hope to have the first draft Guidelines ready. Afterwards we will put them out for a public consultation. After the public consultation the Guidelines will be finalized and will be tabled to EIOPA Board of Supervisors in Autumn 2013.

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As of 2014 the Guidelines are supposed to start to be implemented, however we are fully aware that it will not be possible for the supervisors to comply with everything as of 1 January 2014. So here again we take into account the proportionality principle: while preparing the Guidelines we are considering their gradual implementation. The Guidelines are focused on the preparation for Solvency II. With this step we will ensure a smoother transition to the new regime, both by undertakings and supervisors. Croatia is about to join the EU thus July – what big changes can we expect in insurance world? As all the other EU members, Croatia will have to comply with the EU legislation and, thus, for example with EIOPA Guidelines related to the interim measures for the Solvency II implementation or with the Guidelines on complaints handling by insurance undertakings that we issued in 2012. I am confident that the membership in the EU will open to Croatian insurance market the possibilities for future growth, while the European System of Financial Supervision will contribute to preserving the financial stability and enhancing consumer protection in the Croatian insurance market. Are you familiar with the work of insurers in Croatia? How do you cooperate with our national supervisory authority Hanfa? Yes, the information exchange among competent supervisors and EIOPA is one of the purposes for which the European System of Financial Supervision (ESFS) was created. As regards the cooperation, EIOPA started to prepare the ground

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for welcoming the Croatian Financial Services Supervisory Agency (HANFA) to our Board of Supervisors already in 2011. In 2012 HANFA became an observer of the BoS and started the preparatory work in order to comply with all the necessary requirements. The members of the HANFA Board and its staff members already actively participate in EIOPA activities such as the meetings of EIOPA Board of Supervisors, various committees and working groups and EIOPA trainings and seminars. Soon the HANFA will become a voting member of EIOPA Board of Supervisors. The tasks of our BoS are wide ranging. The BoS is the main decision making body of EIOPA, it adopts all the opinions, recommendations and decisions issued by our Authority; approves our budget, annual and multi annual work programmes and annual reports. So National Supervisory Authorities closely participate in the work of EIOPA and are aware of all our initiatives and achievements. Is there some kind of special treatment towards new members in EIOPA, do they have some period of adjustment? No, the preparation started well in advance and no special transition period for the CFSSA will be needed. When Croatia becomes part of the EU, what will your authorities in insurance politics in Croatia be? EIOPA is responsible to develop technical standards, that will become mandatory and guidelines that HANFA will need to comply or explain. So the regulatory framework will be influenced by EIOPA.

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Furthermore, EIOPA has the power to investigate possible breaches of the EU Legislation in EIOPA’s scope of activities. If EIOPA makes a conclusion that the Breach of the EU indeed took place, the Authority will issue a recommendation addressed to the respective national supervisor. In some limited cases EIOPA action can be applied to the individual companies. But this might happen only in case the national authority does not comply with actions recommended by EIOPA or the European Commission. In this case the Chairman of EIOPA has a right to propose to the Board of Supervisors an individual decision addressed to a financial institution in which requiring the necessary action to comply with its obligations under the Union law. Such a decision may require the cessation of any practice. Many insurers operate on the European and global level so they are sometimes confronted with different supervisory regimes or practices ; how can that be resolved? The first step is to build up a harmonized prudential framework in the EU. That is the purpose of the Solvency II. Secondly we need to assure that day to day supervision of financial institutions is done within a consistent framework. EIOPA will develop a Supervisory Handbook that would work as a guidebook for supervision in Solvency II, setting out good practices in all the relevant areas of supervision. This handbook will foster the implementation of a more consistent framework for the conduct of supervision.

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Furthermore, there is a strong role for the colleges of supervisors. In the end of 2012, 91 insurance groups with cross&border activity were identified in the European Economic Area (EEA). Colleges represent a very important tool of group supervision because they provide necessary platform for the gathering and dissemination of information especially in case of concerns or emergency situations that occur. Colleges help to develop a common understanding of the risk profile of the groups, to achieve coordination of supervisory review and risk assessment at a group level as well as to establish supervisory plans for the mitigation of risks at a Group level. The Regulation establishing EIOPA empowered our Authority to participate in the colleges with a view to streamlining the functioning and the information exchange within colleges. The strategic goal of our college work is to set up consistent, coherent and effective EEA-wide supervision of cross-border insurance groups for the benefit of both group and solo supervision. Every year we set a yearly action plan for colleges and also publish our annual reports on the functioning of colleges. In the course of 2012, EIOPA attended almost all college meetings for 75 insurance groups. We contributed to the work of colleges by developing a catalogue for regular information exchange and by providing specific presentations in colleges about EIOPA’s regular assessment of risks faced by the EEA insurance industry. How will Solvency II apply to pension funds? What can pension funds expect out of Solvency II?

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Right now & nothing. The review of the IORP Directive is a different process and is in a different stage. We believe that occupational pension funds also need to have a much more risk based regulation. As part of the process to advise the European Commission on the review of the IORP Directive,, we conducted the first Quantitative Impact Study for occupational pensions. But sufficient time needs to be taken to get the right approach. At the moment we have three main conclusions. First, is that the requirements and principles that we have in Solvency II on the governance side should also be applied to occupational pension funds. The principles, especially the requirements about risk management, are very much relevant for occupational pension funds, too. But of course they should be applied using a proportionality principle. The second conclusion is about transparency. Solvency II improves information not only for supervisors but also for all the externals parties. We recommended the Commission for example that in case of defined contribution schemes a key information document should be given to the potential and already existing members of the pension plan. This document should outline costs, charges, commissions and risks. The third conclusion is that also in the occupational pension funds you should have an economic valuation of assets and liabilities.

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We need to prevent the situation when a problem is faced, but it is too late to solve it. At the same time I used to repeat that we are very much against a copy&paste exercise from Solvency II to IORP Directive. We do realize the differences between insurance companies and IORPs and these differences should necessarily be taken into account. Your opinion on the role that insurance companies dealing with life insurance have in providing for wellbeing of elderly people? Insurance companies can and do play a particularly relevant role in prioritizing security and long term savings. Life insurers are experts in risk management, they are used to deal with demographic, biometric and investment risks. They are very well placed to offer good solutions for retirement savings. Due to this important role, regulation and supervision are much relevant to ensure that insurance undertakings have robust solvency and that they provide policyholders with transparent information about the products and their risks.

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Interview with Carlos Montalvo, Executive Director of EIOPA

Conducted by Victoria Tozer Pennington, the Risk Universe (the United Kingdom) The recently announced further delay to Omnibus II have been greeted with dismay by firms eager to see the final rules to Solvency II. How do you account for the delays and what is your advice to firms? Carlos Montalvo Rebuelta: A credible timeline for the implementation of Solvency II is a must have. Regardless of these uncertainties, there is a strong need for risk-based supervision. This need has been only reinforced by the lessons taken from the current crisis. In order words, the idea and the principles of Solvency II are more actual and valid than ever. Our advice to the firms is not to wait until the political discussions are over, but to use the time in order to better prepare for Solvency II internally: to make sure that the Boards of firms keep considering Solvency II a priority; and to take advantage of the information that they are already collecting, as part of such exercise, in terms of better understanding the risks they face, and how to address them. In the absence of a final agreement on Solvency II in the scheduled timeline, EIOPA has expressed an opinion in order to ensure and enhance sound risk based supervision and prepare the industry for the final Solvency II Directive. Instead of reaching consistent and convergent supervision in the EU, different national solutions may emerge to the detriment of a good functioning internal market. In order to avoid this scenario EIOPA decided to develop guidelines and

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to take a lead in the preparatory process aimed at a consistent and convergent approach with respect to the preparation of Solvency II. EIOPA Guidelines will allow supervisors and undertakings to be better prepared for the application of the new regulatory framework. To cut a long story short, the guidelines are an excellent way for all parties to use the extra time of the delay as a way to be better prepared for implementation. How have the individual Member States of the European Union progressed with their adoption of Solvency II and are you confident all will be able to implement the final rules on time? Montalvo: The Member States can and must successfully implement Solvency II and they have already started to make necessary preparations for it. Some steps in the right direction have already been taken, there is a good work already in progress, but there are still challenges with regards to the whole implementation process both for companies and supervisors. Ignoring them would be irresponsible. In your opinion how will Solvency II serve to reduce cost, complexity and risk for insurance firms? Montalvo: First of all, it is not possible to eliminate or even reduce risks. The insurance business is a risk-related business that by its nature is based on taking, managing risks and making profit out of those risks. The objective of Solvency II is not to reduce risks, but to allow companies to properly understand, price and manage the risks they face. Solvency II will enhance better understanding of the risks, and such understanding will help companies to better manage the risks and therefore, to make better decisions.

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This will create an immediate benefit to the undertakings. As regards complexity, complexity is particularly challenging for small and medium-sized enterprises. Solvency II is more complex than it was originally foreseen. Beyond the principle of proportionality and its application, we have currently on our table such initiatives as looking for the calculation of the Solvency capital requirements (SCR) and developing an IT tool to facilitate it, or a toolkit to convert data required into XBRL. We acknowledge the problem and together with industry we want to find ways to tackle the excess of complexity of the framework, because complexity should never be an obstacle to the clear benefits of Solvency II. Why are insurers having such difficulty communicating the impact of Solvency II to the business? Montalvo: Solvency II provides firms with a lot of relevant information for them to run their business, and to do so in a more sound manner. But this also implies changes and it is always challenging to explain the benefits of change, to send the message that we may have to change our approach to certain risks, products… that are embedded in the normal functioning of the company, simply because they can threaten the firm itself. Compliance with the rulebook is certainly not the driver towards Solvency II, as it only brings the downside of it, costs and complexity, but not the upside, namely quality information, understanding of risks and the subsequent opportunities. Therefore, a change of approach, in terms of both action and communication, should take place to deal with the described situation.

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There are significant data management issues connected with Solvency II; do you recognise the challenges firms face and what advice do you have in this area? Montalvo: We are aware of the challenges originated by reporting requirements and we are working in order to minimize this burden for companies. The data challenges come from two sources: the valuation of the activity using a harmonised market consistent approach and the detailed requirements for public disclosure and supervisory reporting. The market consistent valuation is a high_level principle, which was set early on in the process (Article 75 of the Solvency II Directive). EIOPA recognised from the start the data challenge that undertaking will face and has expended maximum effort to allow undertakings to start preparing themselves, by consulting on the detailed expectations regarding public disclosure and supervisory reporting. The implied advice remains the same: continue (or urgently start for the late comers) to prepare your internal systems to be ready on time. EIOPA has also recently launched an IT development project (Tool for Undertaking) to make sure that all undertakings will have access to at least one costless possibility to create the Solvency II reporting submissions expected by supervisors. The ORSA [Own Risk and Solvency Assessment] remains a challenge for many insurers, which has not been helped by a lack of detailed guidance from the regulators. Given how much firms are struggling with this, do you expect to offer more guidance once the final rules are published? If so, when and on which areas? Montalvo: The ORSA process must be owned by the company.

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We indicate the aim of ORSA but cannot provide very detailed guidance because we don’t want to intervene in the management processes of companies and to tell them how exactly they should conduct the ORSA. At the same time we understand the concerns of industry and precisely because of this, we already conducted public consultation on our preliminary views on the ORSA. And this is not the end of our work on ORSA, but a link to the work we are doing in terms of supervisory review process and other areas. We plan to continue involving the industry on how to enhance understanding and how to make the ORSA an operative toolkit for the companies, a toolkit that would allow them to understand their solvency position, their risk challenges and the continuity of their business, beyond a one year time horizon. In terms of supervision, the ORSA should be brought to a qualitative level and that is what EIOPA is also working on. A final point I think appropriate to raise on ORSA is its use as a way to impose add-ons by supervisors. If we would do so, it would be a one and done exercise, we would never realistically be able to pretend that undertakings would perform, for their own internal purposes, a serious ORSA exercise, but a compliance box ticking one. A recent survey showed that although firms (in the UK specifically) are well on their well to implementing their internal models, sources say that the bigger issue of passing the use test could be a problem. Do you have any advice on preparing for the use test? Montalvo: Internal models go beyond a simple toolkit to calculate capital requirements because they are a fundamental management toolkit.

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On the basis of this, since day one, the use test became a cornerstone of the whole process. As part of the use test, undertakings need to demonstrate that the internal model is widely used in terms of decision making and plays an important role in their system of governance, and that the model at all times reflects the risk profile of the undertaking. EIOPA is developing guidelines that will clarify the requirements related to the use test. These guidelines have already been pre-consulted with selected stakeholders. One of the most crucial points is that national supervisory authorities (NSAs) should asses individually the compliance with the use test for each undertaking individually according to the requirements. Although there are minimum requirements for the use test, there is no detailed and complete list of uses that the undertakings have to abide with. EIOPA recognises that the uses of the internal model will vary from undertaking to undertaking. NSAs will assess compliance with requirements based on proportionality. Some uses may not be materially important to the undertaking given the nature of their business. Does EIOPA have any information on the preferred blend of scenarios and loss data from a modelling perspective? Montalvo: Internal models by definition are tailored to the specific needs of individual companies.

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On that basis EIOPA cannot have any concrete preferred approach when it comes to blend of scenarios and loss data and in general to internal models as they are specific to companies. It is up to the undertaking to justify its own approach and methodology to the supervisory authority as part of the approval process of the use of an internal model for the calculation of the solvency capital requirement. This justification includes demonstrating both that the approach is adequate taking into account the specific risk profile of the undertaking, and that the internal models requirements related to test and standards are fulfilled. From an operational risk loss data point of view, firms are coping with a dearth of data and scaling issues using external loss data. Has EIOPA done any work on this area or can you offer some advice to firms on the issue of the preferred use of internal and external loss data, sources of loss data, and scaling problems? Montalvo: EIOPA or more precisely, its predecessor CEIOPS has performed several studies in order to calibrate the Operational Risk Capital Charge. The studies were based on different sample sizes (number and size of undertakings) in different Member States. The final calibration was based on the analysis of larger sample of data. It is important to note that the results are not far different from those produced by other analyses.

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Reviewing filings for smaller public companies These slides were presented at the Forums on Auditing in the Small Business Environment hosted by the PCAOB during 2012. Participants were auditors from smaller registered public accounting firms. The slides are intended to provide a sampling of issues that the Staff of the Division of Corporation Finance (“CF” or the “Division”) frequently encounters when reviewing filings for smaller public companies as well as an overview of developments within the Division. Comments issued by the CF Staff may be different from those included here based upon individual facts and circumstances. The slides are accompanied by detailed notes that provide additional context.

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The Division assists the Securities and Exchange Commission (the “Commission”) in executing its responsibility to oversee corporate disclosures to the investing public. Companies are required to comply with regulations pertaining to disclosure that must be made when securities are publicly sold and then on a continuing and periodic basis. The Division Staff reviews the disclosure documents, provides companies with assistance interpreting the Commission's rules, and recommends to the Commission new or revised rules for adoption. The Division reviews documents that publicly-held companies are required to file with the Commission. These documents disclose information about the companies' financial condition and business practices to help investors make investment decisions. Through the Division's review process, the Staff checks to see if publicly-held companies are meeting their disclosure requirements in an effort to improve the quality of the disclosure.

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The Division provides administrative interpretations of the Securities Act of 1933, the Securities Exchange Act of 1934, and the Trust Indenture Act of 1939, and related rules and regulations. The Staff provides interpretative guidance to registrants, prospective registrants, and the public to help them comply with the law and related regulations. For example, a company might ask whether the offering of a particular security requires registration with the SEC. The Division may communicate its guidance orally, or the Division uses no-action letters and interpretive letters to provide guidance on the regulations in a more formal manner.

Additional information about the Commission’s implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act can be found at http://www.sec.gov/spotlight/dodd-frank.shtml.The Jumpstart Our Business Startups (JOBS) Act, which was enacted on April 5, 2012, made several significant changes to the securities laws. Title I of the JOBS Act, which was effective immediately upon enactment, creates a new category of company called an “emerging growth

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company,” which is defined as a company with total annual gross revenues of less than $1 billion during its most recently completed fiscal year and has either (1) not yet had or (2) had after December 8, 2011, its first sale of common equity securities pursuant to an effective registration statement under the Securities Act of 1933. A company retains its status as an emerging growth company until the earliest of the following: •The last day of the fiscal year of the issuer during which it had total annual gross revenues of $1 billion or more (the Commission is required to index this amount for inflation every five years); •The date it is deemed to be a large accelerated filer under Commission rules (including a public float of $700 million or more); •The date on which it has issued more than $1 billion in non-convertible debt in the previous three years; or •The last day of the fiscal year following the fifth anniversary of the first registered sale of common equity securities of the issuer. Accommodations available to EGCs include the following, depending on their facts and circumstances: •Confidential submission •Financial reporting accommodations related to: •Number of years of financial statements presented •MD&A •Selected financial data

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•Delay in adoption of new or revised accounting standards until the date that a non-issuer would be required to comply with such standards •Exemption from auditor attestation on internal controls over financial reporting (SOX 404(b)) •Other Additional information about the JOBS Act can be found at http://www.sec.gov/divisions/corpfin/cfjobsact.shtml. Additional information about the Commission Statement in Support of Convergence and Global Accounting Standards can be found at http://www.sec.gov/spotlight/globalaccountingstandards.shtml. The Final Staff Report on the Work Plan for the Consideration of Incorporating International Financial Reporting Standards into the Financial Reporting System for U.S. Issuers can be found at http://www.sec.gov/spotlight/globalaccountingstandards/ifrs-work-plan-final-report.pdf.

The Division of Corporation Finance Financial Reporting Manual can be found at: http://www.sec.gov/divisions/corpfin/cffinancialreportingmanual.shtml.

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The summary of updates can be found at http://www.sec.gov/divisions/corpfin/cffinancialreportingmanual.pdf#changes. The Corporation Finance Compliance and Disclosure Interpretations can be found at http://www.sec.gov/divisions/corpfin/cfguidance.shtml. CF Disclosure Guidance Topics can be found at http://www.sec.gov/divisions/corpfin/cfdisclosure.shtml#cfguidancetopics. SEC CF Staff Review of Common Financial Reporting Issues Facing Smaller Issuers (Dec. 2011) slides can be found at http://www.sec.gov/news/speech/2012/spch020912co.pdf.

As required by the Sarbanes-Oxley Act of 2002, the Division undertakes some level of review of each reporting company at least once every three years and reviews a significant number of companies more frequently. In addition, the Division selectively reviews transactional filings – documents companies file when they engage in public offerings, business combination transactions, and proxy solicitations.

http://www.sec.gov/news/speech/2012/spch020912co.pdf

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To preserve the integrity of the selective review process, the Division does not publicly disclose its review criteria. This Division continues to exceed the Sarbanes-Oxley review mandate. CF Staff conducted over 5,000 company reviews last year.

The Division’s comments are in response to a company’s disclosure and other public information and are based on the CF Staff’s understanding of that company’s facts and circumstances. Make sure you understand the type of response we are looking for. We usually issue three types of comments: (1) request for additional information; (2) request for additional or clarifying disclosure in a future filings; or (3) request for amendment of the filing to revise financial statements or disclosure. If you do not understand which type of comment we issued, give us a call.

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A company is generally expected to respond in writing to each comment in a letter from the CF Staff. A company’s explanation or analysis of an issue will often satisfactorily resolve a comment. Depending on the nature of the issue, the CF Staff’s concern, and the company’s response, the CF Staff may issue additional comments following its review of the company’s response to its prior comments. This comment and response process continues until the CF Staff and the company resolve the comments. In some cases, it may be necessary to amend a previously filed report or other filings as the result of comments. Once we complete our review, we typically send the company a letter indicating we have completed our review and have no further comments. The SEC publicly releases comment letters and response letters no earlier than 20 business days following the completion of the review of the filing. In the event that a company does not respond to a comment letter or staff inquiries, we will consider what additional actions may be necessary in order to resolve the issues raised in our comment letter. If we are unable to satisfactorily communicate with the company, we may eventually issue a “review termination letter” that includes a ten day deadline for response. This letter explains that, in the event the company does not provide a response, the staff will consider how to resolve any outstanding issues. Among other things, we may decide to release publically comment letters and response letters relating to disclosure files it has reviewed to ensure that we fulfill our investor protection responsibilities.

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All correspondence must be filed on EDGAR. If you do not want certain parts of your response to be released publicly after completion of the review process, consider discussing with your legal counsel how to request confidential treatment of a portion of your response under Rule 83. Companies are allowed to request that certain information receive confidential treatment, but you can not request that too much or all of your response be provided to us confidentially. Check our website, which includes helpful information about requesting confidential treatment. It may be easier to respond to comments if you have documented your significant accounting decisions along with the literature you relied upon, the alternatives considered, and the basis for your conclusions, contemporaneously with the transaction. Going through this process at the time of the transaction will allow you to respond more efficiently and effectively to CF Staff comments.

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Our comment letters request that you respond to the letter within ten business days. If you are unable to respond within this timeframe, please call us to discuss a potential extension. In some circumstances we may ask to have the extension request in writing and submitted to EDGAR. Companies should respond to all comments in the letter, including all parts of the comment. We sometimes send a follow up letter since some portions of our original comment letter were not fully addressed. If you do not understand what is being asked in the comment letter, pick up the phone and call us. Our phone numbers are located in the last paragraph of our comment letters. We generally appreciate if you could schedule a conference call in advance. It allows us time to prepare for the call - so we can make the call as productive as possible. We also encourage you to invite all interested parties to the first call to eliminate the need to repeat information in any subsequent calls.

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This is not a pre-determined list of staff focus. When we review a registrant’s filings we are literally “reviewing that registrant.” Any comments that result are specific to the registrant, including its current circumstances, what is happening in its industry and any other relevant factors.

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Reverse mergers refers to a private operating company merging with a public shell company. This method of registration is reported on a Form 8-K rather than a 1933 Act registration statement. There are several accounting and reporting complexities with these transactions. They can be problematic in the review process because at the time the CF Staff reviews these transactions, the Form 8-K has already been filed and the transaction has been consummated. In certain circumstances, the due date or filing date of the Form 8-K, whichever is earlier, occurs after the end of the private company’s most recently completed annual or quarterly period, but before financial statements for that annual or quarterly period would be required to be presented in a Form 10. In these circumstances the financial statements of the private operating company required by Items 2.01(f) and 9.01 of Form 8-K may not include the private company’s most recently completed annual or quarterly period. The registrant, however, remains subject to Exchange Act Rules 13a-1 and 13a-13, or 15d-1 and 15d-13, requiring annual and quarterly reports, respectively. The registrant must file its applicable annual and quarterly reports. Additionally, the registrant must file an amended Form 8-K with the financial statements of the private operating company’s most recently completed annual or quarterly period prior to the date of the reverse recapitalization, as applicable, within the number of days applicable based on the shell company’s filing status (60, 75, and 90 days for annual periods and 40, 40, and 45 days for interim periods for large accelerated, accelerated, and non-accelerated filers, respectively) after the private operating company’s period end.

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Unless the same audit firm audited both the registrant and the accounting acquirer, a reverse merger always results in change of accountants for purposes of Item 4.01 of Form 8-K. While the historical financial reporting for pre-transaction periods may change to that of the private operating company once the transaction has occurred, the registrant has not changed in this transaction. It is still the public shell company, and therefore is not a newly public company for purposes of SOX 404. However, CF Staff has issued a CDI to provide guidance to companies that find themselves in this situation. It acknowledges that it might not always be possible to conduct an assessment of the private operating company or accounting acquirer’s internal control over financial reporting in the period between the consummation date of a reverse acquisition and the date of management’s assessment of internal control over financial reporting required by Item 308(a) of Regulation S-K. It also recognizes that in many of these transactions, such as those in which the legal acquirer is a non-operating public shell company, the internal controls of the legal acquirer may no longer exist as of the assessment date or the assets, liabilities, and operations may be insignificant when compared to the consolidated entity. Therefore, CF Staff does not object if the registrant excludes management’s assessment of internal controls over financial reporting (“ICFR”) in the Form 10-K covering the fiscal year in which the transaction was consummated. However, this CDI would not apply if the company had to file an amended Form 8-K under the Rule 13a-1 interpretation discussed above .

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This slide provides an example of the reporting under the CF Staff Interpretation of Rule 13a-1 discussed on the prior slide. In SEC Release No. 33-8587, the SEC determined that investors in operating businesses newly merged with shell companies should obtain the same level of information as provided for reporting companies that did not originate as shell companies. Therefore, they are required to include equivalent information as if they were registering under the Exchange Act. Accordingly, the CF Staff looks to the accounting acquirer's eligibility as a smaller reporting company at the time of the reverse acquisition for purposes of the disclosures to be provided in the Form 8-K.

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Under current accounting literature, the acquisition of a private operating company by a non-operating public shell company is considered by the CF Staff to be a capital transaction in substance rather than a business combination (it is outside the scope of FASB ASC Topic 805). That is, the transaction may be viewed as a reverse recapitalization — issuance of stock by the private operating company for the net monetary assets of the public shell company accompanied by a recapitalization. In order to reflect the change in capitalization, earnings per share should be recast for all historical periods to reflect the exchange ratio. The common stock account of the public shell continues post-merger, while the retained earnings of the shell company should be eliminated as the historical operations are deemed to be those of the private operating company. Where the registrant is a public shell company requiring the Form 10-level disclosure in the Form 8-K, the private operating company’s financial statements must be audited by a PCAOB-registered firm and audited in accordance with PCAOB standards.

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Slides 18 through 20 provide a summarized example of reporting for a “back door” registration statement accounted for as a recapitalization.

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CF Staff continues to issue comments on the evaluation of disclosure controls and procedures in quarterly and annual reporting. Item 307 requires companies to “disclose the conclusions of the registrant’s principal executive and principal financial officers…regarding the effectiveness of the registrant’s disclosure controls and procedures…”

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Registrants should be aware that the definition of disclosure controls and procedures is broader than the definition of internal control over financial reporting (internal control over financial reporting is generally subsumed in disclosure controls and procedures) so it is possible that disclosure controls and procedures can be ineffective even while internal control over financial reporting is effective. However, the CF Staff may ask the company to support a conclusion that disclosure controls and procedures are effective when internal control over financial reporting is ineffective.

While there is significant overlap between the definition of disclosure controls and procedures and internal control over financial reporting, the conclusions related to internal control over financial reporting are separate and distinct from the conclusions regarding the effectiveness of disclosure controls and procedures. In this regard, the rules require that registrants explicitly state whether internal control over financial reporting is effective or ineffective with no qualifying language or scope limitations. The CF Staff generally asks companies to amend their filings when it appears they have not completed an assessment, they have not disclosed their conclusion on effectiveness, or they have concluded that internal

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control over financial reporting is effective when material weaknesses exist. From a compliance perspective, companies that are subject to the auditor attestation requirement or voluntarily comply must disclose all four elements required by Item 308(a) of Regulation S-K (non-accelerated filers and EGCs must only disclose the elements relevant for their purposes). As it relates to the framework, the Commission specified the characteristics of a suitable control framework and identified the “Internal Control – Integrated Framework (1992)” created by COSO as an example of a suitable framework. The Commission Guidance Regarding Management's Report on Internal Control Over Financial Reporting Under Section 13(a) or 15(d) of the SecuritiesExchange Act of 1934 or “Management’s Guidance” highlights two other frameworks that meet the characteristics outlined in the adopting release and encourages companies to examine and select a framework that may be useful in their own circumstances.

The CF Staff continues to comment on and observe areas where disclosures of material weaknesses can be improved.

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Disclosures of material weaknesses are most useful if they provide some transparency into the pervasiveness and impact a particular material weakness could have on the financial statements. The CF Staff often sees material weaknesses that are narrowly focused on one particular financial statement line item in which an error was discovered. For example, a company may disclose that it has material weaknesses related to its accounts receivable. Not only does this disclosure not specifically address the internal controls in which there are weaknesses, it does not consider the impact that the weakness could have on other financial statement line items. Similar questions may also arise through a review of remediation disclosures. For example, the remediation disclosures may indicate that the registrant is improving internal controls that go well beyond and impact more areas than the narrow material weakness disclosed. The disclosures required by Item 308(c) of Regulation S-K pertaining to changes in internal control over financial reporting are intended to alert investors to circumstances that may create risk through their effect on registrants’ internal control. Since these disclosures are required on a quarterly basis, they are helpful in providing timely information that may speak to the quality of a company’s financial reporting in any given period and provide an update from the company’s most recent annual evaluation of internal control over financial reporting. The CF Staff may issue comments when there is “boilerplate” disclosure that there have been no material changes in the period in situations where conclusions have changed from one year to the next or other identifiable events exist, such as layoffs, change in an outsourcing arrangement, or changes in accounting policy.

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If a company’s conclusion on effectiveness changes from ineffective to effective, the company shouldconsider disclosing the reasons for those changes.

There are a number of registrants that conduct all, or substantially all, of their operations in foreign countries. These registrants include domestic companies that are required to prepare their financial statements in accordance with U.S. GAAP and foreign private issuers that elect to prepare their financial statements in accordance with U.S. GAAP. In certain situations, we have issued comments to understand how these companies have prepared their financial statements and assessed their internal control over financial reporting. In certain cases, companies have had to amend their filings to disclose the lack of U.S. GAAP knowledge within the company as a material weakness. Our comments focus on such issues as: the existence and extent of education and ongoing training relating to U.S. GAAP; professional qualifications of members of the accounting staff, such as a U.S. CPA

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license; and professional experience of members of the accounting staff, either as an auditor or preparer of U.S. GAAP financial statements. If the company uses an outside consultant to assist it, the staff may ask about that relationship and the consultant’s qualifications.

We sometimes see audit reports in EDGAR filings that do NOT contain the auditing firm’s signature. The Staff believes that readers should be able to easily determine the name of the firm that audited a registrant’s financial statements and therefore, we will request amendments for any filings that do not comply with the requirements of Regulation S-X, which requires a signature. As a result of Regulation S-T, such signature should be in typed form. We have noticed a fair number of audit reports referring to “auditing standards of the PCAOB” instead of “the standards of the PCAOB.” Use of the word “auditing” implies that the auditor did not comply with other standards, such as the PCAOB’s professional practice standards and the SEC’s independence standards.

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The PCAOB requires an issuer’s auditor to refer to the “standards of the PCAOB.” However, the PCAOB does not preclude an auditor of a non-issuer from issuing an opinion in accordance with “the auditing standards of the PCAOB,” unless the issuer’s principal auditor makes reference to the audit report covering the non-issuer. Auditor association with cumulative amounts from inception included in a registrant’s or its predecessor’s annual financial statements is required as long as the registrant or its predecessor is in the development stage. This is premised on the fact that U.S. GAAP identifies these amounts as “additional information,” rather than supplemental information that is not required to be audited. Where an auditor assumes responsibility for the audit of the entirety of the cumulative amounts from inception, the current auditor’s report would not refer to the work of a predecessor auditor. Alternatively, a current auditor may rely on the work of a predecessor auditor (or predecessor auditors) with respect to discrete reporting periods that are part of the cumulative amounts since inception, in which case the current auditor’s report must include a reference to the predecessor auditor(s) and identify the periods audited by the predecessor auditor(s) in the introductory paragraph of the audit report, and refer to the report of the other auditor in expressing the current auditor’s opinion. When a current auditor refers to a predecessor auditor (or predecessor auditors) the filing must include the predecessor auditors’ report(s) and, where applicable, consent(s). If the PCAOB revokes the registration of an audit firm, audit reports issued by that firm may no longer be included in a registrant’s filings made on or after the date the firm’s registration is revoked, even if the report was issued before the date of revocation.

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Financial statements previously audited by a firm whose registration has been revoked would need to be reaudited by a PCAOB registered firm prior to inclusion in future filings or if included in a registration statement that has not yet been declared effective.

The test for SRC status is: -Public float < $75 million on last business day of Q2, or -If public float = $0, <$50 million annual revenues If an issuer fails to qualify as an SRC, it is not eligible for SRC status until: -Public float < $50 million on last business day of Q2, or - If public float = $0, < $40 million annual revenues If a company newly qualifies as a smaller reporting company based upon its second quarter public float, it may elect to provide the scaled disclosure starting with its next quarterly report on Form 10-Q. While the company can provide the scaled disclosure immediately, it is still considered an accelerated filer through the end of the fiscal year, at which time it becomes a nonaccelerated filer.

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SRC Status in Transition to Other Reporting Company Status - Public float > $75 million on last business day of Q2

- If public float = $0, > $50 million annual revenues

While the thresholds may align with the thresholds for filer status (i.e., nonaccelerated or accelerated), the test is for different purposes and there may be circumstances where a smaller reporting company is an accelerated filer or where a larger reporting company is a nonaccelerated filer. If a company is required to exit smaller reporting company status, it may continue to report as a smaller reporting company through the filing of the annual report on Form 10-K for that year. However, while this company may still provide scaled disclosure in the Form 10-K, if the company is an accelerated or large accelerated filer it must follow those deadlines for the Form 10-K for that year and include the attestation report on internal control over financial reporting required by Section 404(b) of the Sarbanes-Oxley Act.

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The Global Financial Sector—Transforming the Landscape By Christine Lagarde, Managing Director, International Monetary Fund, Frankfurt Finance Summit Bonjour! Guten Tag ! Good day. It is a pleasure to be back in Germany and to be a part of this year’s Frankfurt Finance Summit. I would like to thank Dr. Lutz Raettig, the Chairman of the Board of Frankfurt Main Finance, for inviting me to participate. Let me also thank Jens Weidmann for his very kind words of introduction. It is indeed an honor to speak today about financial sector reform, here in Frankfurt—for centuries the center of commerce and finance in the heart of Europe. This year’s Summit examines “how regulation and crisis management will change the world’s financial landscape”. This is exactly what we are all working towards: a new financial landscape. History shows that financial crises often alter the financial sector landscape. The terrain that emerges usually features restructured balance sheets, a stronger regulatory framework, and often a different population of banks. We can point to examples such as those in the Nordic and Asian countries after crises in the 1990s.

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But there are also examples where there was little fundamental change, or where improvements weakened over time as the architecture failed to keep up with innovation. Take the United States ─ barely 20 years had elapsed between the resolution of the Savings and Loan crisis and the sub-prime debacle. While these were vastly different crises, as were their spillovers (unfortunately), real estate lending and the failure of regulation and supervision were common denominators. The industry did not learn the right lesson. Here we are, more than five years into this crisis; has the “landscape” been transformed? In other words, have we built a stronger system? Not yet. We have made progress, but there is more to do. Our job today as policymakers and regulators is to bring about change that is more effective and permanent; that results in a robust set of banks and also reduces the frequency and severity of systemic busts. I would like to focus today on what we believe is needed to bring this about. Each is a necessary, but on its own, not sufficient condition for successful transformation. 1) Global regulatory reform─how close are we to a solid set of rules? 2) Balance sheet repair and banking union ─necessary and worthwhile

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1. Global Regulation: Reform and Reinforce

Policymakers and regulators around the world and in Europe have laid out a comprehensive reform agenda.

Many long nights were spent burning the midnight oil to negotiate agreements on regulation.

I participated in just a few of those “nuits blanches”.

I can tell you, what Otto Von Bismarck said is true: “Laws are like sausages, it is better not to see them being made.”

But the sausage-making did happen, and has produced some historic achievements.

Agreements on global bank capital and liquidity regimes, and FSB standards on Effective Banking Supervision and Resolution Regimes are major steps forward.

Here in Europe, deeper policy commitments have greatly reduced near-term stability risks.

My main concern is that progress is uneven.

This risks un-doing some of our achievements.

The pace of implementation has been adjusted intentionally to support banks on the mend, but delays also reflect difficulties in agreeing on the way forward, and pushback from industry averse to changing outmoded and dangerous business models.

Let me address some of the key regulatory issues, beginning with bank capital and liquidity:

Capital and liquidity

Much has been done both on capital rules and liquidity standards as well as setting capital surcharges for globally systemically important banks.

We are, however, worried about uneven implementation of these rules, particularly the delay of Basel III in major jurisdictions.

Different rates of implementation could contribute to dilution of overall minimum standards.

These delays affect longer term business decisions, straining credit markets and spilling over to the real economy.

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The IMF is also worried about national differences in the calculation of the riskiness of assets—the very basis for determining the capital needs of all banks, and the success of the new rules.

Recent studies by the U.K. authorities, the Basel Committee, and the European Banking Authority have found a wide variation in bank risk weights with similar risk profiles.

In an interconnected world, the lowest common denominator is connected to all.

Accounting

Progress with accounting standards is also mixed.

For example, on this same issue of risk measurement, the two main accounting bodies, the International Accounting Standards Board and U.S. Financial Accounting Standards Board, have not reached agreement on a common approach for asset impairment, that is, whether to base it on expected or incurred losses.

This is not just an academic exercise.

As you know, it materially affects the assessment of asset quality and valuation, which of course informs investors and regulators about an institution’s financial strength.

Too big to fail and resolution

What about resolution and the big banks?

The FSB led the initial progress, and the United States and the United Kingdom recently moved forward on coordinating contingency plans when winding down failing cross border banks.

But some banks are still considered “too-important-to-fail,” due to their size, complexity, and interconnectedness.

This is unacceptable.

The IMF estimates the implicit subsidy available to big banks in terms of lower borrowing costs at about 0.8 percentage points.

Others have used this to derive a dollar figure for the five largest banks in the U.S. of about $64 billion, roughly equivalent to their typical annual profits — a gift from the taxpayer.

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While this may be a simplistic approach, it highlights the social dimension of the issue.

Pressure to address the moral hazard from this problem and facilitate resolution has fostered the development of regional initiatives to legislate banking activities or ring-fence operations, such as the Liikanen, Vickers and Volcker proposals, and the soon-to-be legislated German and French reforms.

While well-intentioned, these separate plans could undermine common goals of harmonizing global standards if they are not well coordinated.

The bottom line is that we have yet to fix “too-big-to-fail”.

We need to forge ahead on three fronts to address the root cause of this problem:

(1) regulation, like systemic surcharges;

(2) intensive supervision; and

(3) frameworks for orderly failure and resolution, nationally and across borders.

In the coming months, jurisdictions need to spell out plans to resolve each systemic institution, regardless of its size, inter-connectedness and complexity.

In addition to cross-border collaboration arrangements, this requires an ability to impose discipline on the managers, shareholders and junior debt holders of large failed banks, using bridge banks or other resolution tools to preserve the liquidity of borrowers, depositors and other counterparties.

Over the counter derivatives

Progress on reform of derivative markets is too slow.

We all agree that wider use of clearing houses —central counterparties — will raise transparency of over-the-counter markets and make the system safer.

However, no authorities have met the deadlines to implement reforms.

First, available data shows that the increase in the value of centrally cleared contracts has been modest.

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For example, as of September 2012, only 10 percent of all credit default swaps were contracted through central counterparties.

Second, data is limited, and almost nonexistent for commodity, equity and foreign exchange asset classes.

This is a problem we need to address.

Recent headlines suggest that banks’ internal risk management systems are not keeping up with derivative innovation.

For example, the loss by JP Morgan Chase of over $6 billion in the so-called London Whale case demonstrates the daunting complexity of assessing risks in these big institutions, and the glaring failure of risk managers and policymakers in this area.

Shadow banking

Back in 2009, when I was with the G-20 Finance Ministers, we made the point that regulation needed to cover “all markets, all products, and all operators”

On shadow banking, however, I am afraid there is not much progress to report.

This is worrisome since regulators were largely in the dark before the crisis hit and since then, I suspect that funds have been migrating to new unregulated activities.

For example, we have anecdotal evidence—because there is no official data—that trading is moving to unregulated hedge funds.

While “Guidance” on the monitoring and regulation of money market funds has been published, there is little consensus on actual implementation.

There is other work in the pipeline at the FSB, but we need to see more concrete progress.

Compensation

Compensation? This has been in the headlines lately, particularly in Europe.

Mark Carney stressed recently that “an important lesson from the crisis was that compensation schemes encouraged individuals to take on too much long-term risk and tail risk”.

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From a financial stability perspective, the level and structure of compensation must align incentives with risk profiles, and ultimately with performance.

The common goal here is to make sure that the structure of compensation curbs incentives for excessive risk taking.

The financial sector has a duty to live up to the highest ethical standards. To that end, the FSB forged consensus on compensation practices some time ago.

We fully support these principles and encourage all jurisdictions to implement them.

Impact in Europe

Together with Outright Monetary Transactions and other liquidity support from the ECB, these reforms have helped to calm markets, particularly in Europe.

Borrowers, however, particularly small business and households, have not yet felt the impact, and rates of lending to the real economy have not yet incorporated this framework of stronger discipline, nor the path towards banking union.

Some financial systems are still facing pressure and negative feedback loops between sovereigns and the real economy continue.

To fix this, troubled banks need to be recapitalized or wound down.

This brings me to the second aspect of a new landscape—balance sheets.

2. Balance Sheet Repair and Banking Union – Necessary and Worthwhile

Balance Sheet Repair: The Missing Link in the Quest for Recovery

It is possible that delays in agreement on regulatory reforms reduced the drive to deal with needed balance sheet repair and bank resolution.

Or has insufficient balance sheet repair acted as a brake on reform progress?

Either way, we need to move beyond this chicken and egg question and tackle both balance sheet repair and regulatory reform simultaneously.

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Further progress on the regulatory reform agenda is essential, but to get credit flowing in support of a recovery, banks have to be in a financial position to respond.

Again we can point to some progress: U.S. and European banks have substantially increased their capital ratios.

During 2007-2012, the number of credit institutions in Europe declined by about 5 percent (20 banks were resolved and 60 banks have undergone deep restructuring).

But more needs to be done.

Many banks are still shackled by the leftover effects of the crisis.

This is the weak link in the chain of recovery.

We still see fragmentation in funding conditions—a direct result of concerns about the quality of bank assets—which is impairing the credit transmission to the real economy.

In addition, peripheral euro area banking systems remain relatively weak, with capital buffers still low relative to impaired assets.

These banks are less able to absorb losses, which worsens the drag on new lending.

This chokes off credit to viable firms and reinforces weaknesses in corporate sectors, perpetuating “zombie” companies as well as zombie banks.

There is a way out of this adverse spiral: clean up balance sheets and use a common backstop—the European Stability Mechanism (ESM)— for systemic cases.

Enhanced disclosure and credible asset quality reviews will help restore confidence and banks should be urged to deleverage by raising equity and cutting business lines that are no longer viable.

Country authorities and the Single Supervisory Mechanism (SSM) should undertake selective asset quality reviews.

For direct recapitalization by the ESM, modalities and governance arrangements should be established as soon as possible.

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Banking Union in Europe—Necessary and Worthwhile

Of course this is part of the bigger picture ─ full banking union in Europe.

What exactly do we mean by “banking union”?

We mean a single supervisory and regulatory framework, a single resolution mechanism and resolution authority, and a common safety net that includes deposit insurance and lender of last resort capabilities.

This integrated oversight framework is the logical extension of an integrated banking system, but it also plays a central role in the global process of transformation.

In many ways it represents a microcosm of the aims of the global regulatory reform agenda.

Banking union will move responsibility for supervision and potential financial support to a shared level which would help contain systemic risks and curb moral hazard.

This would remove destructive incentives for deposit flight and fragmentation, and weaken the vicious loop of rising sovereign and bank borrowing costs.

The IMF recently released two important papers on these issues, including last week the inaugural Financial System Stability Assessment for the European Union.

And I would encourage you to take a look at them.

Let me first recognize the considerable progress on banking union so far: agreement on the Single Supervisory Mechanism; proposals by the EC to harmonize regulations on capital (CRR ─ the Capital Requirements Regulation, and CRD-IV, the Fourth Capital Requirements Directive), on resolution regimes, and for national deposit insurance schemes; agreement to draw on the ESM to recapitalize banks, with ECB supervision; and finally, commitment to a Single Resolution Mechanism with backstop arrangements to recoup taxpayer support over time.

“To do” list

Policymakers need to plow ahead with their “to do” list.

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Recent agreements are major steps towards a new landscape, but follow through will be critical.

This means swift adoption of the various directives, and ensuring that they are in full compliance with global accords, namely Basel III and the FSB “Key Attributes”.

Other priorities include endowing the single supervisor with requisite resources and authority; implementing the common resolution and safety nets with a coherent, credible backstop; and setting up the resolution authority and insurance fund with access to common backstops.

Full embrace of this Union-wide architecture is needed to ensure durable financial stability, but also to sustain the currency union and the single market for financial services in Europe.

This includes severing the link between weak sovereigns and future banking sector risks, otherwise, the impact of new rules and institutions on economic growth, and on the citizens of Europe, will be limited.

Conclusion: enlightened stewards of the financial system

Let me conclude: I asked earlier if the financial landscape been transformed?

I would say not yet.

I believe that we are making progress, but it is mostly in the wiring and the plumbing—essential elements of a solid structure, but under the surface.

The structure is still half-built and not safe.

Weak banks are still a drag on growth.

Balance sheet repair needs to be tackled at the same time as regulatory reform, in a mutually reinforcing manner.

Finishing the business in both areas is necessary to reap the fruits of hard-won gains in regulatory reform and to restore the full functioning of the financial sector so that it can do its job of intermediating funds to borrowers and support growth.

I am an optimist, drawing inspiration from Martin Luther, who said “Everything that is done in the world is done by hope.”

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…. But I am also a realist.

Immanuel Kant, one of the greatest German philosophers, said that “using reason without applying it to experience only leads to theoretical illusions”.

The free exercise of reason by the individual was a theme of the Enlightenment.

Hopefully, we are moving toward an “Enlightened” era in global finance and regulation, one based on experience and reason.

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Managing structural risks in the Swedish banking sector Speech by Mr Stefan Ingves, Governor of the Sveriges Riksbank and Chairman of the Basel Committee on Banking Supervision, at Affärsvärlden’s “Bank & Finans Outlook”, Stockholm

Today I intend to speak about the Riksbank’s view of the structural risks in the Swedish banking sector and how they can be managed. As so often in recent years, I will take the crisis of 2007–2009, and the risk reassessments that banks, investors, researchers and decision-makers all over the world were forced to make as a result of the crisis, as my starting point. I will begin by saying a few words about the international work on regulations that arose as a consequence of the crisis. Then I will go into a little more detail about the structure and special characteristics of the Swedish banks. On the basis of this, I will present my view of the possible implications of the implementation and follow-up of the Basel III regulations for the Swedish banks.

The risks associated with banking operations need to be limited First, however, I would like to give you a small example of the risks we are talking about. The US mortgage crisis became acute in 2007 and marked the start of the global financial crisis.

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At that time, the capital adequacy ratio, that is the amount of capital in relation to risk weighted assets, in the major Swedish banks averaged around 7 per cent. This means that for every SEK 1 000 in risk-weighted assets, the banks funded their operations with SEK 70 of their own money and with SEK 930 in borrowed money. This is in fact a rather generous calculation and includes capital that turned out be of dubious quality. Decisions had also been made at that time that allowed the banks to use their own internal risk models to a greater extent to calculate their capital adequacy requirements. The banks were thus able to substantially reduce the risk weights of their assets, including mortgages, in the long term. The major banks’ internal risk models indicated that the risks associated with mortgage lending were extremely low. In several cases this meant that the risk weight of a typical mortgage could easily be as low as 6 per cent, which meant that only 6 per cent of the mortgage would need to be covered. With a capital adequacy ratio of 7 per cent and a risk weight for mortgages of 6 per cent, this meant that a bank could fund each SEK 1 000 of a mortgage loan with SEK 996 in borrowed money and SEK 4 in its own money. The risk the bank itself took when it lent SEK 2 million for the purchase of a house thus corresponded to SEK 8 000 of its own capital. There were in fact transitional regulations that initially meant that the banks were not able to calculate so liberally, but these were the regulations that would apply in the longer term and thus those that the banks and investors, and often the authorities, primarily focused on.

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Given that the banks, in Sweden and in other countries, only needed a small amount of capital, and given that it was often assumed that they were backed by government guarantees, it was highly profitable for them to take substantial risks. The banks themselves carried only a small part of these risks, while it turned out that the banks’ customers and the taxpayers had to carry the major part. In several countries – Spain, Ireland and Denmark for example, in addition to the United States – we have seen how substantial falls in the prices of the banks' assets, mainly in the form of mortgages, have led to major economic problems. The point is that the risk capital that the banks and their shareholders provide is limited to the value of the share capital. But society’s risks are greater than this. A mainstream assessment in economic research is that a national crisis in the financial system costs the economy around 60 per cent of GDP. In Sweden, this would be equivalent to over SEK 2 000 billion, or more than SEK 200 000 per Swede. This is more than two and a half times the joint stock market value of the four major Swedish banks at the turn of the year 2012/2013. In Sweden, we succeeded in managing the acute phase of the financial crisis in 2008 and 2009 in a way that made it possible to limit the costs to society. One contributing factor was probably that the crisis of the 1990s was fresh in the minds of the banks and they thus limited their risk-taking more than might otherwise have been the case, at least with regard to their operations in Sweden. As we know, not all countries were as lucky.

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The negative effects of the crisis are still in evidence in large parts of the world – not least in several countries in central and southern Europe – and will probably remain so for some time to come. In retrospect, it is easy to note that the combination of shortcomings in the regulations and the profit motives of the participants on the financial markets contributed to one of the worst financial crises of the modern era. The details regarding the build-up of risk and the course of the crisis have been described several times and I will not repeat them here. It is enough this time to note that banks with a limited amount of capital and banks with a high degree of market funding proved to be vulnerable when the storm broke. These insights from the crisis lie behind the regulatory work that is now underway in Sweden and abroad today. There is broad agreement that risk-taking in the banking sector must be limited and that its costs must be taken into account by the banks and their investors to a greater extent. Important steps have been taken in this direction in the global agreement on future standards for regulations in the banking sectors referred to as the Basel III Accord. The worlds’ banks will be safer when this is implemented, which will benefit everyone.

Basel III increases the safety margins in the system The Basel III regulations represent the introduction of much-needed standards that will require the banks to hold more and better capital. The minimum requirement for CET 1 capital, that is share capital and retained earnings, will be raised to 4.5 per cent of the risk weighted assets.

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In addition to the minimum requirements there will be a capital conservation buffer, a countercyclical capital buffer and a buffer for systemically-important banks, which all sharpen the requirements for the level of CET 1 capital. In total, the Basel III Accord will represent a capital-adequacy requirement of 7 to 12 per cent of CET 1 capital depending on how important the bank is in a global systemic perspective and where the country's economy is in the credit cycle. This is a much higher level than previously. The countercyclical capital buffer is particularly interesting. This will be built up in good times, when credit growth is higher than normal, with the aim of creating airbags to protect the banking sector in troubled times. So far, this is the instrument on which international agreement has been reached in the field of macroprudential policy, that is a policy that comprises measures to prevent financial crises that are directed at the system as a whole. A leverage ratio requirement will also be introduced under which, irrespective of risk weights, a bank's assets may not exceed 33 times its own capital. A leverage ratio requirement represents an extra safety measure that also limits the banks’ possibilities to use internal risk models to actually keep risk weights down. Basel III also sets quantitative standards for the banks’ liquidity, a short-term (Liquidity Coverage Ratio, LCR) and a long-term (Net Stable Funding Ratio, NSFR). The short-term measure means that every bank should have sufficient liquid assets to survive for at least 30 days in a stressed scenario.

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The long-term measure, in principle, limits the gap between the maturity of a bank’s assets and the maturity of its liabilities. The standards stipulated in the Basel III Accord will be implemented in national legislation during the 2010s and should be implemented in their entirety by 2019, with several interim targets along the way. Establishing better regulations on the banks’ capital and liquidity represents a major step forward. However, in a wider perspective we can note that even in the future the worlds’ banks will have capital that only amounts to a few per cent of their assets. This is almost within the margin of error for a valuation of the total assets. The equity/assets ratio in the banking sector is only one fifth, or even one tenth, of that for companies in other sectors. However, a central element of the Basel III Accord is that the standards are minimum regulations – countries that want to impose stricter requirements may and should do so. We have already seen cases of this – for example in the United States, the United Kingdom and Switzerland. Decisions have also been made in both the United States and the United Kingdom on more structural measures to protect the central functions of the financial sector, for example through the Dodd-Frank Act and the follow-up of the Vickers Report. In the EU, the Liikanen Report has taken up the issue of ring-fencing, that is separating the different operations of the banks from each other. The reason is that the financial systems are different in different parts of the world.

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It is therefore important to design regulations that are tailored to the banking system that has to comply with them. We also need to maintain a respectable distance to the minimum regulations. Considering what we know about the Swedish banking system, there are good reasons for ensuring that Swedish banks comply with the global standards by a broad margin.

The Swedish banking system is special It is thus important to put the Swedish banking system into perspective. The total domestic and foreign assets of the four major banking groups amount to 400 per cent of Sweden's GDP. In other words, out banking system is huge. Relatively speaking, it is on a par with the banking system in the United Kingdom, for example. The Swedish banking system is also highly integrated, which means that problems in one bank can easily lead to a crisis of confidence for the entire system. If we were hit by a financial crisis, the costs to society could thus be very high. With this in mind, I intend to focus in more detail on two vulnerabilities in the Swedish financial system that are interlinked. The first is the indebtedness of the Swedish households. The second is the banks’ funding in foreign currencies and their dependence on the currency-swap market.

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The Swedish mortgage market has structural weaknesses An issue that has been widely discussed recently is the indebtedness of the Swedish households and the risk of a fall in housing prices. Experience in several countries has shown that indebtedness and the development of housing prices are the main explanations of why some countries are hit harder than others during economic crises. Similarly, crises that are preceded by a credit and housing boom tend to be longer and more severe than other economic crises. A fall in housing prices may lead households to save rather than consume in order to compensate for the fact that the value of their homes has fallen. If many households behave in this way, this may weaken economic activity, increase unemployment and create loan losses in the banks' lending to companies. This, for example, is what has happened in our neighbouring country Denmark in recent years. What we can note is that the credit conditions for mortgages changed in the early 2000s. Interest-only mortgages became increasingly common at the same time as the loan-to-value ratios increased. The banks also began to fund mortgages by issuing so-called covered bonds on the financial markets to an increasing extent. Easy access to inexpensive funding in combination with a high demand for mortgages led to rapid credit growth. Now, the debts of the Swedish households are high in both historical and international terms.

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Although the rate of credit growth has slowed down and loan-to-value ratios have fallen – the mortgage cap introduced in 2010 has probably contributed to this – there are still structural weaknesses on the Swedish mortgage market. For instance, the mortgage survey recently published by Finansinspektionen identifies one such weakness: approximately half of all new mortgages are interest-only loans. This increases the scope for the households to take larger loans, which in turn increases the debt stock. Figure 1 shows household debt in relation to disposable income. It also illustrates how indebtedness in the household sector grows under different assumptions about amortisation. This raises a number of questions about the future. For example, how will the average loan-to-value ratio in the banks' mortgage stocks develop when older mortgages are paid off and new interest-only mortgages are paid out? What will the long-term consequences of a weak or non-existent amortisation culture be for peoples' private finances, the national economy and expectations of economic policy? These are questions that we are considering and that we will analyse further together with Finansinspektionen.

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The banks’ extensive market funding in foreign currencies makes the system vulnerable Another structural weakness in the Swedish banking system is that the degree of market funding is high. We can see this, for example, by looking at lending in relation to deposits. Lending is significantly higher in the Swedish banking system than in many other European countries (see Figure 2). This is partly because Swedes to a large extent save in funds rather than in bank accounts. Another reason is that Swedish banks retain their mortgage loans on

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their balance sheets, while banks in many other countries “sell” them or securitise them.

Swedish banks are thus highly dependent on the capital markets to fund their lending. A large proportion, almost 45 per cent, of the funding from the capital markets is in foreign currencies. This borrowing funds assets in both Swedish kronor and foreign currencies. This dependence on market borrowing in foreign currencies gives rise to two risks.

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The first relates to the extent to which participants are prepared to buy the banks’ mortgage bonds and when necessary convert borrowing in foreign currencies to Swedish kronor. The second lies in the fact that the maturities for assets and liabilities in foreign currency differ. Few counterparties fund the long-term lending in Swedish kronor The borrowing in foreign currencies also funds lending in Swedish kronor to some extent, for example for housing purposes. The Swedish banks typically fund their mortgage loans by issuing covered bonds for which the mortgages act as collateral. A large proportion of these bonds are issued in foreign currencies, mainly euro and US dollars. The reason that the banks have chosen to get funding on the foreign markets is probably that they want to spread their sources of funding across different markets. This is also something that the credit-rating agencies encourage. It has also often proved to be an inexpensive method of funding mortgage loans. However, broadening the investor base may also mean that it consists of a larger percentage of volatile investors. Problems on the Swedish housing market may therefore lead to the banks finding it difficult to refinance their mortgage loans. We actually believe that the banks can manage rather substantial falls in the market value of housing, but if the investors' assessment is that the risk have increased they may choose not to buy the Swedish banks' bonds, despite the fact that they only entail a minor credit risk.

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Such concerns may also make other types of market funding more expensive and more inaccessible if the investors choose to reduce their exposures to the Swedish banking sector. We saw examples of this in the autumn of 2008, when foreign investors wished to offload Swedish mortgage securities and the market demand for more liquid instruments, particularly Swedish government securities, increased. The Swedish National Debt Office then carried out extra issues of treasury bills and provided loans through reverse repos in covered mortgage bonds. At the same time, the Riksbank expanded its list of approved forms of collateral. All in all, this meant that in principle the government assumed the risk that lay in the outstanding stock of Swedish mortgage loans. In order to convert borrowing in foreign currencies to lending in Swedish kronor without taking a currency risk, the banks usually conduct currency swaps. In simple terms, this is done like this: A Swedish bank borrows euros in Germany at a maturity of five years. However, as the bank does not really need the euros but needs kronor to fund mortgage loans to Swedish households, the bank has to exchange the euros for kronor. To protect itself against the currency risk, the bank enters into a currency swap in which the euros are exchanged for kronor today under an agreement to exchange the kronor back to euro at a predetermined rate in five years’ time. In this way the bank matches the currencies of its assets (the mortgages) and its liabilities and thereby eliminates the currency risk.

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The Swedish banks are thus dependent on acquiring kronor in the long-term from a counterparty in a currency swap. They can in principle do this in three ways: through a foreign bank, another Swedish bank or an insurance company. Today, it is often a foreign bank that acts as the counterparty in these swaps. The foreign banks do not themselves usually have any natural access to Swedish kronor. They therefore fund part of their lending in kronor by borrowing kronor in the short-term from other Swedish banks. However, the risk is that foreign investors will leave the Swedish market if problems arise, as the Swedish krona is a small currency. There are also reasons for believing that the number of foreign banks that act as counterparties to the Swedish banks is limited. Moreover, participating in the swap market is often not a central part of the operations of the foreign banks. This in turn has consequences for liquidity and pricing on the swap market. We saw an example of this when the last extraordinary loan that the Riksbank had offered the banks during the crisis matured in the autumn of 2010. Uncertainty then arose on the money market, and consequently swap counterparties abroad who had acquired short-term funding in kronor through Swedish banks became less willing to enter into swap agreements with Swedish banks. It thus became both more expensive and more difficult for Swedish banks to convert foreign currency into Swedish kronor at long maturities.

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To a certain extent, Swedish banks also act as counterparties to each other in the swaps. However, from the perspective of the Swedish banking system this is really only a matter of redistributing the maturity risk. The fact that the banks act as counterparties to each other also forges the links within the Swedish banking system even tighter. A natural counterparty for the Swedish banks could be the Swedish life insurance and pension companies. These companies have long-term liabilities in kronor in the form of pension savings that they partly invest in assets abroad. At present, these companies are not active on the long-term currency swap markets to any great extent. The Swedish banks are therefore dependent on a tight circle of counterparties on the currency swap markets. A small and concentrated market means in turn that there is a considerable risk of disruptions and contagion effects. Long-term assets and short-term funding in foreign currencies create risks Swedish banks have substantial assets in foreign currencies and also have a deposit deficit, that is they are dependent on market funding. As a large part of this market funding is short term, a liquidity risk in foreign currency also arises. The US dollar is a currency for which this risk is clear. Following the collapse of Lehman Brothers, when the dollar market was practically closed for a while, the Riksbank needed to lend the equivalent of almost 250 billion kronor in US dollars to the banking system to prevent the liquidity risk spreading to the real economy.

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However, as the Riksbank cannot create liquidity in foreign currencies in the same way as it can in Swedish kronor, there are limits on the size of the liquidity risks the banks can take in foreign currencies without posing risks to financial stability. There are therefore good reasons for the banks to examine the matching of the maturities of their assets and liabilities in foreign currencies. The market for bank certificates in kronor has shrunk. It is not only long-term funding that takes place in foreign currencies. A large part of the banks’ short-term funding also takes place in foreign currencies, mainly US dollars and euros. The Swedish banks are, for example, important counterparties for US money-market funds. Sweden is the second-largest European market for the money-market funds – larger than the United Kingdom or Germany. Although this indicates a high level of confidence in the Swedish banks, it also entails risks. During the crisis, we saw that the money-market funds were among the more volatile investors. A high degree of funding from the money market funds also makes the banks dependent on US regulatory frameworks and legislative processes. For short-term funding in Swedish kronor there is a market for bank certificates. However, this market has shrunk (see Figure 3). We may wonder why this market has declined so dramatically when it seems that there should be incentives to maintain it.

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A thriving domestic market for bank certificates in kronor would increase the banks' scope for diversification. Their dependence on markets in foreign currencies and on the swap market would be reduced. Although these markets usually work well and Swedish banks currently have a good reputation among investors this does not always need to be the case, as we saw in 2008 and 2009. We should of course think about how to create a liquid market for bank certificates in kronor. One problem is that the benefits of such a market fall to the banks collectively while the costs in the form of higher borrowing costs fall to each bank individually. In this perspective it may be necessary to investigate whether the costs that each individual bank pays for its shortterm funding in foreign currencies reflects the true costs to the Swedish financial system and Swedish society.

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Swedish conditions require a complement to the reform agenda The Swedish banking system is thus marked by a number of characteristics that make it somewhat special in an international perspective – characteristics that either increase the risk of problems or the economic costs to society if problems arise in the banking sector. There are therefore good reasons for establishing a safe margin – a respectable distance – to the minimum regulations in the Basel III Accord. As you know, we have already taken several steps to strengthen the Swedish banking system, over and above the commitments that Basel III entails. In November 2011, the Riksbank, the Ministry of Finance and Finansinspektionen announced that the four major Swedish banks would

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meet the capital adequacy requirements of 10 per cent of the risk-weighted assets from 1 January this year and of 12 per cent from 1 January 2015. All of the four major banks now have CET 1 ratios that are higher than 10 per cent according to the definition in Basel III. Three of the banks are also above 12 per cent. The Swedish authorities have also said that the banks should meet the short-term liquidity measure in Basel III (the LCR) both in total and separately for the euro and the US dollar. This requirement has been compulsory for the eight largest Swedish banks since 1 January this year. The Riksbank has also recommended the banks to improve their public information on liquidity risks and the degree of encumbered assets. This is because greater transparency increases both confidence and market discipline. I am pleased to say that the banks’ public reporting has improved in line with the Riksbank's recommendations, although some work still remains to be done (see Table 1).

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These measures have contributed to the relative stability of the Swedish banks. But I don’t think we have finished yet. The financial system is important, and the risks in the system must be constantly reviewed. Let me give you some examples of areas that I believe will need to be investigated. As I mentioned earlier, the Swedish banks’ high dependence on market funding entails an increased risk that they will suffer liquidity problems in a stressed situation. It is of course always possible for the Riksbank to lend Swedish kronor, but it is unreasonable for the banks to take liquidity risks based on the

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expectation that the Riksbank will provide extraordinary loans if things do not go according to plan. The ability of the banks to comply with the Liquidity Coverage Ratio in the Basel III Accord should therefore be investigated. The differences in the maturities of the banks’ assets and liabilities in foreign currencies that I described above are also a potential source of concern in more troubling times. The Riksbank cannot after all offer unlimited liquidity in any other currency than our own. As you know, the Riksbank has therefore recently strengthened its foreign-exchange reserve so that in a situation in which the foreign-exchange market is seriously disrupted the Riksbank will be able to provide extraordinary loans in US dollars and euros. The aim of course is to strengthen the Riksbank’s preparedness to safeguard the basic workings of the financial system and thereby help us to avoid major economic costs. Given that all the Swedish banks benefit from the Riksbank’s foreign-exchange reserve, it would not be unreasonable for them to share the costs of maintaining it. If we can price this in an effective way it will also give the banks an incentive to reduce their own currency risks. This would reduce the risks to financial stability in the Swedish economy. It is of course no secret that we are also looking at mortgage loans from the asset side in the banks’ balance sheets. As I have already pointed out, the banks’ risk weights are very low. Finansinspektionen intends to begin applying a risk-weight floor of 15 per cent for the banks’ portfolios of Swedish mortgage loans.

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The Riksbank supports the proposal for a risk-weight floor of 15 per cent. We also believe that there are good reasons for analysing whether this floor needs to be raised even further. One important reason is that the public sector and non-financial companies would have to bear a large part of the risk if the debt-servicing ability of the households were to weaken. I have also spoken about the risks arising from the fact that a large proportion of the mortgage loans are interest-only loans. In this context, the Swedish Bankers’ Association’s recommendation that all mortgages that exceed a loan-to-value ratio of 75 per cent should be amortised is of course welcome, although one may ask whether this is enough. Mortgages were amortised to a greater extent a few decades ago, at the same time as inflation automatically reduced the real debt ratio. I believe that more amortisation may be needed, especially in the current situation with low and stable inflation. However, before the authorities impose amortisation requirements it may be worth reviewing other aspects of the provision of loans. One example may be how different amortisation alternatives are presented to the borrowers. Another may be to demand that the borrowers have the financial scope to amortise their loans at a certain rate. The important thing is to restore an amortisation culture so that the households’ margins are safeguarded and the economy is protected. The Riksbank focuses on these issues because we wish to safeguard the Swedish financial system.

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All our analysis and all our measures aim to reduce the risk of Sweden incurring major economic costs when the banking sector gets into trouble. As a complement, Sweden also needs to put a clear framework for macroprudential policy in place. The global financial crisis demonstrated the need to complement traditional financial supervision – micro supervision – which focuses on risks in individual institutions, with supervision that focuses on the risks in the financial system as a whole. In January, the Financial Crisis Commission presented an interim report which proposed how responsibility for macroprudential policy could be allocated in Sweden. We will therefore need to consider the Riksbank's stance on this issue. A guiding principle for us is that the body that is given responsibility for macroprudential policy needs a clear mandate with both the right and obligation to take action against risks that arise and appropriate tools that can be used to limit the risks. The discussion of macroprudential policy also comprises the issue of the Riksbank’s balance sheet, and particularly the foreign-exchange reserve. As you know, the inquiry conducted by Harry Flam recently presented its proposals. Here too, the Riksbank is in the process of formulating its stance.

The public are entitled to expect that the authorities act to prevent and manage financial crises in the best possible way All of the things I have talked about here are measures that aim to reduce the risk of a financial crisis recurring, or to limit the damage if a financial crisis nevertheless breaks out.

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The international process that has come to expression in the Basel III Accord is creating better regulations for the banks in all countries. This also benefits us here in Sweden. Over and above this, however, we have to manage the Swedish banking system and its special characteristics. Sweden is a small open economy with its own currency and large banks. We need special regulations. This means that we, like a number of other countries, want to proceed more quickly and impose stricter requirements than those in the Basel III Accord. However, the measures we have taken so far have already clearly strengthened the Swedish banks. The financial sector is central in every modern society. We cannot afford recurring crises that threaten the basic functions of the financial sector. The public are entitled to expect that the authorities act to prevent and manage financial crises in the best possible way. Regulations that cover the special characteristics and structural risks of the Swedish banking sector are central instruments in the work to promote financial stability.

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Disclaimer The Association tries to enhance public access to information about risk and compliance management. Our goal is to keep this information timely and accurate. If errors are brought to our attention, we will try to correct them. This information: - is of a general nature only and is not intended to address the specific circumstances of any particular individual or entity; - should not be relied on in the particular context of enforcement or similar regulatory action; - is not necessarily comprehensive, complete, or up to date; - is sometimes linked to external sites over which the Association has no control and for which the Association assumes no responsibility; - is not professional or legal advice (if you need specific advice, you should always consult a suitably qualified professional); - is in no way constitutive of an interpretative document; - does not prejudge the position that the relevant authorities might decide to take on the same matters if developments, including Court rulings, were to lead it to revise some of the views expressed here; - does not prejudge the interpretation that the Courts might place on the matters at issue. Please note that it cannot be guaranteed that these information and documents exactly reproduce officially adopted texts. It is our goal to minimize disruption caused by technical errors. However some data or information may have been created or structured in files or formats that are not error-free and we cannot guarantee that our service will not be interrupted or otherwise affected by such problems. The Association accepts no responsibility with regard to such problems incurred as a result of using this site or any linked external sites.

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Certified Risk and Compliance Management Professional (CRCMP) distance learning and online certification program. Companies like IBM, Accenture etc. consider the CRCMP a preferred certificate. You may find more if you search (CRCMP preferred certificate) using any search engine.

The all-inclusive cost is $297. What is included in the price: A. The official presentations we use in our instructor-led classes (3285 slides) The 2309 slides are needed for the exam, as all the questions are based on these slides. The remaining 976 slides are for reference. You can find the course synopsis at: www.risk-compliance-association.com/Certified_Risk_Compliance_Training.htm B. Up to 3 Online Exams You have to pass one exam. If you fail, you must study the official presentations and try again, but you do not need to spend money. Up to 3 exams are included in the price. To learn more you may visit: www.risk-compliance-association.com/Questions_About_The_Certification_And_The_Exams_1.pdf www.risk-compliance-association.com/CRCMP_Certification_Steps_1.pdf C. Personalized Certificate printed in full color Processing, printing, packing and posting to your office or home.

http://www.risk-compliance-association.com/Certified_Risk_Compliance_Training.htm

http://www.risk-compliance-association.com/Certified_Risk_Compliance_Training.htm

http://www.risk-compliance-association.com/Questions_About_The_Certification_And_The_Exams_1.pdf

http://www.risk-compliance-association.com/Questions_About_The_Certification_And_The_Exams_1.pdf

http://www.risk-compliance-association.com/CRCMP_Certification_Steps_1.pdf

http://www.risk-compliance-association.com/CRCMP_Certification_Steps_1.pdf

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D. The Dodd Frank Act and the new Risk Management Standards (976 slides, included in the 3285 slides) The US Dodd-Frank Wall Street Reform and Consumer Protection Act is the most significant piece of legislation concerning the financial services industry in about 80 years. What does it mean for risk and compliance management professionals? It means new challenges, new jobs, new careers, and new opportunities. The bill establishes new risk management and corporate governance principles, sets up an early warning system to protect the economy from future threats, and brings more transparency and accountability. It also amends important sections of the Sarbanes Oxley Act. For example, it significantly expands whistleblower protections under the Sarbanes Oxley Act and creates additional anti-retaliation requirements. You will find more information at: www.risk-compliance-association.com/Distance_Learning_and_Certification.htm

http://www.risk-compliance-association.com/Distance_Learning_and_Certification.htm

http://www.risk-compliance-association.com/Distance_Learning_and_Certification.htm

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Monday April 1 2013 Top 10 Risk Compliance News Events

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