With a $2 billion loss by JPMorgan Chase in London serving as a reminder that risky trading has not gone away, European Union finance ministers broke an impasse Tuesday and agreed on a plan to force banks to hold more capital as a buffer against the unexpected

The unanimous move came after a compromise that allowed Britain — which held up passage of the package last week during a 16-hour marathon meeting — to impose tougher standards than the international minimum.

The British government, which was forced to partially nationalize the Royal Bank of Scotland and Lloyds Banking Group during the financial crisis, called the deal “an important step towards a safer and stronger banking system in Europe, and one that will help protect the taxpayer from picking up the bill when things go wrong in the way they have had to do over the past few years.”

The agreement was required for Europe to implement new global rules on banking standards known as Basel III, which were endorsed by the Group of 20 largest economies in 2010 and are meant to force banks to sock away more cash for bad times.

The draft approved by ministers means negotiations can begin on a final text with the European Parliament, where a committee passed its own version late Monday. The Parliament’s version includes an additional measure that would forbid banks from awarding bonuses that are higher than an employee’s annual base salary — a response to continued public anger over outsized pay in the financial sector.

The Swedish finance minister, Anders Borg, suggested Tuesday that governments may have to accept tougher bonus rules in the final agreement, Bloomberg News reported.

But his German counterpart, Wolfgang Schäuble, said he did not think the issue would hold up implementation of the Basel III rules.

Mr. Schäuble warned, however, that “throughout human history” people have found ways around rules “to make more money, faster.” He pointed to the $2 billion loss revealed last week by the biggest American bank, JPMorgan, in its London trading office — a disclosure that came as policy makers in Washington were putting the finishing touches on new industry regulations there.

“As you’ve just seen, even with the top market experts in the United States, that it could happen again,” Mr. Schäuble said at a news conference, shaking his head. “In English or German it’s a lot of money.”

Britain, home to one of the world’s biggest financial centers, the City of London, wanted to avoid being prevented from applying tougher rules as it saw fit, because its taxpayers would be stuck with the bill should another British bank need rescuing. At the same time, there has been a growing recognition that stronger, Europewide institutions are needed to help build confidence in banks that have been weakened by the fallout from the financial and sovereign debt crises.

Some E.U. countries, including France and Austria, had opposed letting countries set higher capital requirements, fearing it would make their banks look less safe by comparison, and could also crimp growth by forcing banks to curtail lending.

As part of the compromise, member states can impose stricter requirements on domestic banks for up to two years at a time. E.U. regulators would not be able to overrule a nation’s decision to take such a step unless they were backed by a vote of the finance ministers as well.

“The compromise strikes a balance between the need for common rules to safeguard the internal market, while allowing member states to have sufficient flexibility to apply stricter rules to safeguard national stability,” said the Danish economy minister, Margrethe Vestager, chairwoman of the meeting on Tuesday.

Source: New York Times

Joint Consultation Paper on the proposed response to the European Commission’s Call for Advice on the Fundamental Review of Financial Conglomerates Directive.

The Joint Committee of the European Supervisory Authorities (EBA, EIOPA and ESMA) is launching today a three-month public consultation on the proposed response to the call for technical advice from the European Commission on the fundamental review of the Financial Conglomerates Directive (“the FICOD“).

This consultation covers three broad areas where advice is sought by the European Commission: the scope of application, the group wide internal governance requirements and sanctions and supervisory empowerments under the FICOD.

In its proposed response, the Joint Committee issues a series of recommendations for the review of the FICOD, including the widening of the scope of supervision, addressing requirements and responsibilities to a designated entity within the financial conglomerate and the framework of supervisory powers provided by the FICOD.

Moreover, the Joint Committee will be providing later this year, a supervisory contribution to the wider fundamental review of the FICOD, which is being carried out by the European Commission.

Consultation process

The consultation paper is available on the websites of the three ESAs: EBA, EIOPA and ESMA.

Please send your comments by 13 August 2012 COB to the EBA, EIOPA and ESMA, using the template provided, by e-mail to joint-committee@eba.europa.eu , jointcommittee@eiopa.europa.eu andjoint.committee@esma.europa.eu by indicating the reference ‘JC/CP/2012/01’on the subject field.
All contributions received will be published following the close of the consultation, unless otherwise requested.

Notes

(1) The Joint Committee of the European Supervisory Authorities received a Call for technical advice from the European Commission (EC) to assist the European Commission in its fundamental review of the Directive 2002/87/EC on the supplementary supervision of credit institutions, insurance undertakings and investment firms in a financial conglomerate (“the FICOD”). The fundamental review follows the technical review, resulting in the Directive 2011/89/EU published in the Official Journal on 8 December 2011.
The European Commission has asked the Joint Committee to conduct ‘an assessment of supervisory practices and experiences, in the context of international developments and recently available legislation, in the areas of (A) scope of application, especially the inclusion of non-regulated entities (B) internal governance requirements and sanctions, in particular with respect to the obligations of the parent entity, and (C) supervisory empowerment, in particular the necessary legislative provisions in case the parent entity is a (non-regulated) holding company’.

(2) The Joint Committee is a forum for cooperation that was established on 1 January 2011, with the goal of strengthening cooperation between the European Banking Authority (EBA), the European Insurance and Occupational Pensions Authority (EIOPA) and European Securities and Markets Authority (ESMA), collectively known as the three European Supervisory Authorities (ESAs). Through the Joint Committee, the three ESAs cooperate regularly and closely and ensure consistency in their practices. In particular, the Joint Committee works in the areas of supervision of financial conglomerates, accounting and auditing, micro-prudential analyses of cross-sectoral developments, risks and vulnerabilities for financial stability, retail investment products and measures combating money laundering. In addition to being a forum for cooperation, the Joint Committee also plays an important role in the exchange of information with the European Systemic Risk Board (ESRB) and in developing the relationship between the ESRB and the ESAs.

Source: European Banking Authority

Speech by Peter Praet, Member of the Executive Board of the ECB: Managing financial crises: the role of the ECB.
40th Economics Conference of the Oesterreichische Nationalbank, Vienna, May 2012

Ladies and Gentlemen,

It is a real pleasure for me to share my thoughts on the role of the European Central Bank (ECB) in managing financial crises at the 40th Economics Conference of the Oesterreichische Nationalbank.

1. Introduction

We meet here to discuss this subject at a time when it has already preoccupied us for almost half a decade. And yet it could not be more topical today. What started as a liquidity crisis in the money market in 2007 quickly morphed into a full-blown financial crisis following Lehman’s collapse in autumn 2008, and finally into a sovereign debt crisis starting in May 2010. We have been facing a situation in which all these elements rapidly and profoundly reinforce each other, thus combining to create a challenge far bigger than the sum of its individual parts.

Since the onset of the crisis, financial market turbulence and the associated deterioration in credit conditions and overall economic confidence have dragged down the real economy. The resulting downward impact on economic activity has led to an erosion of tax bases and taken a massive toll on public finances. The concomitant threats to debt sustainability, in turn, have required several governments to adopt ambitious fiscal consolidation measures during the downturn to regain control of their fiscal positions. Furthermore, the financial and economic crisis forced many governments to intervene in domestic banking sectors, again placing severe strains on fiscal positions in several cases. Vice versa, fiscal sustainability concerns have rapidly spilled over to the financial sector, thus giving rise to a vicious cycle that is difficult to break.

Disentangling this web of mutually reinforcing risk factors is the number one challenge that we, as economic policy-makers, are facing. As I will show, the ECB has played an important role in confronting this challenge. By cutting its main policy rates and introducing additional measures to directly address liquidity and funding constraints in the banking sector, it has bought time to facilitate the structural adjustment of the financial industry. It belongs to governments to continue their efforts to ensure fiscal discipline, restore competitiveness and to remove remaining shortcomings in economic governance at the European level.

Identifying and addressing these shortcomings is key for the future.

2. Lessons from the past – risks for the future

A central observation regarding the period before the crisis is that most countries did not do enough to ensure resilience in the face of adverse economic shocks. For example, while headline fiscal balances in many countries improved over the period between the introduction of the euro and the start of the crisis, this improvement was driven to a considerable extent by very favourable cyclical conditions. These in turn disguised the vulnerabilities originating from expansionary expenditure policies. Moreover, despite benign economic conditions, half of the euro area member countries were already recording deficits before the crisis. This failure to sufficiently consolidate public finances in good times left little or no room to absorb the fiscal burden arising from the recession and bank rescue measures. In addition, rather than using the cyclical upswing to implement far-reaching structural reforms, a number of countries witnesses a sharp deterioration of their competitiveness, as evidenced, inter alia, by sharp increases in unit labour costs. The reliance on demand-side expansion, often fuelled by public sector deficit spending, exacerbated the downturn in these countries when credit conditions took a turn for the worse.

While responsibility for addressing these developments was – and continues to be – for the most part on the side of national governments, the situation has wide-ranging implications for financial and economic conditions in the euro area as a whole. And it thus creates substantial challenges for monetary policy in EMU.

The ECB’s monetary policy is firmly and unambiguously anchored in our primary objective of maintaining price stability in the euro area which is defined by keeping euro area HICP inflation below, but close to, 2% over the medium term. The credibility of this commitment is corroborated by medium-term inflation expectations for the euro area economy, which remain in line with our objective.

This mandate has also guided the ECB’s policy response throughout the crisis. When confronted with acute downside risks to price stability, the ECB reduced its main policy rates and adopted a range of additional policy measures, often referred to as “non-standard” measures. These have served as a complement to the changes in interest rates when the channels by which, in normal times, the central bank transmits policy signals to the broader economy were seriously impaired. As I will discuss in more detail below, these policies were devised in such a way that the ECB’s capacity to ensure price stability over the medium term was preserved, thereby contributing to the overall stability of the financial system in the euro area.

However, the central bank’s contribution to fighting the impact of the crisis entails a delicate balancing act. On the one hand, the risks to price stability emanating from a possible financial meltdown call for decisive action from the central bank. On the other hand, the resulting mitigation of a crisis which, to a considerable extent, reflected shortcomings in other policy areas and excesses in the financial sector, can alter incentives for the different actors to correct the imbalances that undermined financial stability in the first place. If the central bank does not react forcefully, it risks losing its ability to deliver on its mandate of price stability. At the same time, monetary policy cannot address the root causes of the crisis; this can only be done by policy-makers at national level and actors in the different sectors of the economy that have built up excessive leverage. This in turn requires a broad range of measures usually comprising growth-enhancing structural reforms, fiscal consolidation, restructuring of the domestic banking sector and balance sheet repair. But such measures are likely to prove challenging and politically costly to implement.

If domestic policy-makers and other economic actors delay necessary reforms and adjustments on the expectation that the central bank may have to provide renewed support should market conditions deteriorate, monetary policy may end up being subject to a short-term bias. Such a strategy could give rise to a regime of “financial dominance”, which Hervé Hannoun, the Deputy General Manager of the Bank for International Settlements, recently described as a situation in which “monetary policy becomes increasingly dominated by short-term concerns about adverse financial market developments”.

To avoid such a situation, extraordinary monetary policy interventions have to be temporary in nature and tied to a commitment of swift reversal as soon as conditions improve. But would this commitment be sufficient to align the incentives of the different actors involved? This question relates to the concept of “time inconsistency”, which describes conditions in which a policy-maker states its intention to follow a specific course of action in the future but cannot credibly commit itself to this course. As a consequence, other economic agents expect the policy-maker to deviate from its stated intention and adjust their actions accordingly.

The solution proposed in the economic literature to this type of problems is based largely on two elements: institutional frameworks setting out clearly defined objectives for key policy areas and the adoption of “rule-type behaviour” that consistently and predictably determines the response of policy-makers to specific circumstances. These elements increase the credibility of policy commitments, thereby allowing a policy-maker to steer expectations of other actors in line with its long-term intentions and overcoming the short-term bias resulting from the time inconsistency problem.

Both of these crucial elements are in place in the euro area as regards the single monetary policy. The Treaty on the Functioning of the European Union establishes a strong institutional framework for monetary policy in the euro area based on central bank independence and a primary objective of price stability, as enshrined in Articles 130 and 127, respectively. Together with the prohibition of monetary financing of public debt, laid down in Article 123, this framework provides an important safeguard against monetary policy being dominated by fiscal policy considerations. And the ECB’s monetary policy strategy, which builds on a comprehensive analysis of risks to price stability via its two pillars and is communicated to the general public in a regular and transparent manner, entails “rule-type behaviour” on the part of the ECB. These elements provide a framework which is geared towards the medium term and which counteracts short-term bias towards fine-tuning macroeconomic and financial developments.

The current crisis has instead exposed severe shortcomings in the institutional architecture of EMU as regards the areas of fiscal, structural and financial stability. These shortcomings have made it possible for national authorities to often pursue economic policies that finally led to strong negative externalities on the euro area as a whole. Besides inducing a build-up of risks, this also indirectly affected the smooth functioning of EMU by exacerbating heterogeneity between countries. In particular, misaligned budgetary policies, unsustainable wage developments and structural rigidities in product and labour markets, as observed in several countries, constitute a source of persistent inflation differentials within the currency union. These in turn represent also a challenge for monetary policy.

As regards the origin of such institutional shortcomings, there are four factors that play a particularly prominent role: first, weakly enforced fiscal rules incapable of promoting prudent fiscal policies in times of favourable economic conditions; second, the absence of a mechanism to prevent and correct macroeconomic imbalances within the EU; third, insufficient coordination of macro and micro-prudential supervision of financial sectors at the EU level; and finally, the absence of a crisis management framework to avoid contagion between countries and sectors.

In response to these problems, policy-makers have set in motion ambitious reforms to strengthen economic governance at the EU level, and many national governments have committed to ambitious fiscal and structural reforms. All these measures should contribute to addressing the underlying causes of the crisis, thereby also supporting the smooth functioning of EMU in the future. But let me first explain, in more detail, the ECB’s policy since the start of the current crisis.

3. The ECB’s response to the financial and sovereign debt crisis – measures and guiding principles

Since the intensification of the financial crisis in September 2008, and against the background of rapidly receding inflationary pressures, the ECB has implemented monetary policy measures that are unprecedented in nature and scope. This has included a swift reduction in our key interest rates to historical lows, with the rate on the main refinancing operations now standing at 1% as compared with 4.25% in summer 2008. These steps are often referred to as “standard” policy measures, since changes in short-term interest rates are the main tool adopted by the ECB to achieve its price stability objective.

However, besides triggering a sharp fall in global economic activity, the crisis severely affected the monetary transmission channels. In particular, central banks around the world were confronted with repeated waves of market turbulence, in which liquidity in overnight and longer-term money markets was sharply falling, in view of heightened uncertainty about counterparty risk between banks. As consequence, the functioning of the interbank market was seriously hampered and the ability of banks to provide credit to the real economy was at risk. These developments severely jeopardised the ECB’s ability to affect economic magnitudes and ultimately to contain downside risks to price stability.

In response, the ECB embarked on a series of “non-standard” measures with the aim of relieving liquidity and funding constraints in the banking sector and mitigating impairments to the monetary policy transmission channels. In particular, they have taken the form of: provision to euro area banks of unlimited liquidity at a fixed rate against adequate collateral; a substantial lengthening of the maximum maturity of refinancing operations; the extension of the list of assets accepted as collateral; and the provision of liquidity in foreign currencies. These measures have served to improve financing conditions and credit flows above and beyond what could be achieved through reductions in the key ECB interest rates.

While these measures clearly differ in their specific design and scope, they all follow the same guiding principle: a clear focus on the ultimate objective of price stability, supported by the intermediate target of ensuring depth and liquidity in dysfunctional market segments to restore the proper functioning of the monetary policy transmission mechanism. To that effect, they serve as complements to our standard monetary policy tools and can be unwound should upward pressures on price stability materialise.

Let me provide an example of this guiding principle, by looking at the most recent non-standard monetary policy measures taken by the ECB, i.e. the long-term refinancing operations (LTROs) decided in December 2011.

The second half of 2011 was characterised by a renewed intensification of turbulence in sovereign debt markets, which quickly spilled over to the banking system. As a consequence, the access of euro area banks to market-based funding came under strain, as reflected, for instance, in a substantial surge of euro area money market spreads since July 2011. In the ECB bank lending survey more than half of all participating euro area banks reported a deterioration in wholesale funding conditions.

Without effective remedies, these developments could have severely undermined bank lending to firms and households and triggered broad-based selling of assets. The LTROs were aimed at alleviating these adverse funding conditions. Banks were able to satisfy their additional liquidity needs, in the context of a net liquidity injection of around €520 billion – taking into account the shifting of liquidity out of other operations. Moreover, the LTROs provided banks with a more certain medium-term funding situation owing to the longer maturity of the new operations.

The full supportive impact of the three-year LTROs will need time to unfold. Any assessment of their impact on the economy can be only preliminary in nature at this stage.

However, the data available to date give some encouraging signals. Money and credit figures up to March confirm a broad stabilisation of financial conditions and thereby the avoidance of an abrupt and disorderly adjustment in the balance sheets of credit institutions. Funding conditions for banks have generally improved, and there has been increased issuance activity and a re-opening of some segments of funding markets. At the same time, the demand for credit remains weak in the light of still subdued economic activity and the ongoing process of balance sheet adjustment in non-financial sectors.

Beyond these short-term effects on market conditions, a key aspect in the design of the three-year LTRO is its consistency with the ECB’s capacity to ensure price stability in the medium term. Most importantly, the interest rate on the three-year operations is indexed to the ECB’s main policy rate, i.e. the rate on the main refinancing operations. Thus, if ECB were to increase this rate, the costs for the remaining period of the three-year LTROs would also rise. Hence, the three-year liquidity allocation does not stand in the way of an increase in short-term interest rates; rather, it would allow such an increase to be immediately translated into the outstanding liquidity operations.

As in the past, the Governing Council will be vigilant in order to contain upside risks to price stability. In this context, let me point out that what is relevant for measuring monetary liquidity is not the balance sheet of the Eurosystem, but the balance sheet of the euro area banking sector. Only the latter shows the interaction with the real economy. This interaction is captured by monetary and credit data which, despite the recent stabilisation I mentioned earlier, are still very subdued.

If these conditions were to change in a way that entailed upside risks to price stability, the Governing Council would use all the instruments at its disposal to continue delivering on its primary mandate.

The ECB’s monetary analysis pillar serves to assess signals coming from developments in money and credit conditions. I would also like to mention that our monetary analysis is not narrowly confined to the analysis of headline money and credit dynamics, but also tries to understand their determinants.

Let me summarise. The ECB has taken an active role in mitigating the financial and economic crisis in the euro area, which has been fully consistent with its mandate. Reductions in the main policy rates have served to counteract acute downside risks to price stability. Non-standard measures have addressed impairments to monetary transmission channels, thereby complementing changes in policy rates when highly dysfunctional and perturbed market conditions impeded their effectiveness. To preserve our primary objective to ensure price stability, these non-standard measures are temporary and will be withdrawn if upward pressures to price stability materialise.

4. The way forward and conclusions

However, the ECB’s exceptional measures should not distract from the fundamental causes of the crisis and the adjustments needed in the fiscal, structural and financial domains. The institutional architecture in the EU has to ensure that Member States live up to their responsibility for restoring fiscal sustainability and competitiveness and for implementing effective financial supervision. It is crucial to clearly separate the central bank’s responsibilities from other policy domains, such as fiscal sustainability and financial stability.

Therefore, efforts to reinforce the economic governance framework at the European level are indispensable. In this regard, European policy-makers have made important progress recently. As a result of the strengthening of the fiscal rules of the Stability and Growth Pact and the introduction of the fiscal compact, member states now face stronger incentives to adopt sound budgetary policies, which are crucial for a smooth functioning of EMU. These derive, inter alia, from the requirement for national authorities to legally adopt a fiscal rule, preferably at constitutional level, stipulating that the general government deficit remain below 0.5% of GDP in structural terms. The new Macroeconomic Imbalances Procedure constitutes a useful mechanism requiring governments to adopt competitiveness-enhancing policies and tackle potential sources of financial instability in their domestic economies. The establishment of the European Supervisory Authorities and the European Systemic Risk Board has led to closer cooperation in micro and macroeconomic supervision within the EU that is commensurate to its deep economic and financial integration. Finally, the creation of firewalls in the form of the European Financial Stability Facility and European Stability Mechanism will contribute to isolating the euro area as a whole from financial turmoil affecting individual or a small group of countries. By providing financial assistance linked to strong and comprehensive conditionality, these mechanisms should also grant recipient countries additional time to overcome structural deficiencies in specific sectors of their economies.

While the EU governance framework thus contains some key elements necessary to overcome the current crisis and mitigate future crises, it is now paramount that all these elements are implemented in a swift and steadfast manner.

Moreover, to meet the challenges with which our economies will be confronted over the coming decades, most notably in the form of population ageing and increasing competition from emerging market economies, structural reform efforts aimed at boosting long-term economic growth should be high on the European agenda. Only if productivity and competitiveness keep pace with these challenges will Europe be able to preserve a standard of living similar to that we enjoy now. To mark this commitment to fostering long-term economic growth, key principles for sound and sustainable growth could be enshrined in the common economic governance framework.

All these reform efforts will put the framework for fiscal and macroeconomic policies (the “E” in Economic and Monetary Union) on a stronger footing and will facilitate the conduct of monetary policy – which has been supported by the strong institutional framework provided by the Maastricht Treaty since the very beginning of EMU. A strong institutional framework as regards both Economic and Monetary Union, coupled with an extension of “rule-type behaviour” to other key policy areas, can also make it possible to address the moral hazard problem inherent in any supportive policy measure that needs to be taken during the crisis.

Source:European Central Bank

Resolution: a progress report – speech by Paul Tucker, Bank of England

Speaking at the Institute for Law and Finance Conference in Frankfurt on 3 May 2012, Paul Tucker – the Bank’s Deputy Governor for Financial Stability and Chairman of the Financial Stability Board’s Resolution Steering Group – provided a progress report on global planning for resolution regimes aimed at addressing the problem of Too Big To Fail. He stressed that a robust, credible resolution regime “… can lead to a much better financial system, with stronger market discipline and so less stability-threatening imprudence”; and he outlined some different resolution strategies and developing thinking on how to operationalise these strategies.

Paul Tucker observed that, since the financial crisis, the “…genie is out of the bottle” and governments no longer have a free option to choose whether or not to pursue a resolution policy agenda to address Too Big To Fail; if risks in banking are not incorporated into the yields of bonds issued by those banks, they will end up reflected in higher sovereign borrowing costs. “Resolution regimes are a way for the authorities to avoid the direct hit to the public finances while at the same time containing disorder in the financial system”. But Paul Tucker said that “… there is no silver bullet. We need resolution tools that work in different contexts for different types of bank/dealer.”

Paul Tucker remarked that all resolution tools should share a common trigger; and that that trigger should be set at the point at which the bank “…no longer meets the criteria for being authorised and, crucially, when there is no reasonable prospect of its doing so again.”

Paul Tucker noted that employing resolution tools to transfer the critical functions of a bank to a buyer may be achievable only for relatively simple commercial banks. Bail-in offers an alternative resolution tool designed to meet the challenges of resolving Systemically Important Financial Institutions (SIFIs). By writing off the equity and converting part of the bank’s debt into equity, the bank and its group can be recapitalised without the complexity of separating its business lines and without destroying all of its franchise value.

Paul Tucker then described two types of resolution strategy that employ bail-in. The first is ‘top-down’ resolutions of complex groups, employing bail-in at the level of the holding company. By bailing-in only at the level of the holding company, the resolution allocates losses in a way that reflects the structural subordination of debt issued at the top of the group. The resolution also avoids affecting the balance sheets of the operating subsidiaries and so reduces the cross-border problems caused by conflicting insolvency laws.

Paul Tucker went on to mention the debate about which kinds of creditor claims should be bailed in. He observed that the approach to allocating losses “…should probably be the same whatever the resolution tool used and, indeed, the same as in a standard insolvent liquidation.” That suggests that, in the long run, one way to ‘exempt’ some types of claim would be to place them higher in the creditor hierarchy by changing insolvency law.

Applying the top-down approach relies on the holding company and its group having sufficient debt to bail-in. For large and complex banking groups that are funded by deposits rather than bonds, Paul Tucker outlined a second type of resolution strategy. Under this strategy, the Deposit Insurance Scheme is effectively bailed-in by contributing upfront an amount towards the recapitalisation that is not more than the Deposit Insurer would have stood to lose in a standard liquidation. Insured deposits remain intact. “That approach could, if necessary, be applied in different regions to different distressed subsidiaries of the group.” There is much work still to be done on planning, but he notes that “…it is worth doing.”

Paul Tucker then looked ahead to the Financial Stability Board’s work programme for 2012 and into 2013. Preliminary peer reviews will be followed by more exacting examinations of jurisdictions’ resolution regimes by the IMF and World Bank. “Meanwhile, authorities are enjoined to produce assessments of resolvability of Global SIFIs and the obstacles in their way; firm-specific agreements for co-operation amongst home and host resolution agencies and supervisors; and resolution plans by the end of this year.”

Finally, Paul Tucker considered the implications this has for supervisors. He argued that holders of bank debt will be incentivised to monitor the risks taken by banks. “This is market discipline: an extra line of defence.” But supervisors will not be idle, and must carry out detailed planning for how they would execute a bail-in via dedicated Crisis Management Groups and Living Wills. Paul Tucker said the Bank of England is fully behind the FSB’s proposed Peer Review process. Paul Tucker concluded by saying that the EU directive on resolution regimes will be “…crucial in giving us all the tools we need”; with Dodd-Frank already in place, “…it will help set the tone for the world.”

Download the full Speech

Speech given by Mervyn King, Governor of the Bank of England.
The 2012 BBC Today Programme Lecture, London, May 2012

The following is an extract from the speech:

… So tonight I want to try to answer three questions. First, what went wrong? Second, what are the lessons? Third, what needs to change?

Let me start by pointing out what did not go wrong. In the five years before the onset of the crisis, across the industrialised world growth was steady and both unemployment and inflation were low and stable. Whether in this country, the United States or Europe, there was no unsustainable boom like that seen in the 1980s; this was a bust without a boom.

So what was the problem? In a nutshell, our banking and financial system overextended itself. That left it fragile and vulnerable to a sudden loss of confidence.

The most obvious symptom was that banks were lending too much. Strikingly, most of that increase in lending wasn’t to families or businesses, but to other parts of the financial system. To finance this, banks were borrowing large amounts themselves. And this was their Achilles’ heel. By the end of 2006, some banks had borrowed as much as £50 for every pound provided by their own shareholders. So even a small piece of bad news about the value of its assets would wipe out much of a bank’s capital, and leave depositors scurrying for the door. What made the situation worse was that the fortunes of banks had become closely tied together through transactions in complex and obscure financial instruments. So it was difficult to know which banks were safe and which weren’t. The result was an increasingly fragile banking system.

So how did banks find themselves in such a precarious position? Banks are a vital part of our economy. They run the payment system, allowing us to pay our bills and receive our wages. They finance businesses investing in new ventures and families buying a new home. Without a banking system our economy would grind to a halt. Because of that, markets correctly believed that no government could let a bank fail since that would cause immense disruption to the economy. This meant that large banks in particular benefited from an implicit taxpayer guarantee, enabling them to borrow cheaply to finance their lending. In good times, banks took the benefits for their employees and shareholders, while in bad times the taxpayer bore the costs. For the banks, it was a case of heads I win, tails you – the taxpayer – lose.

This cheap funding fuelled lending. Banks got bigger. In the UK, their balance sheets rose from around one-half to more than five times our national income in a generation. As the banks got bigger, so did the implicit subsidy – by the time of the crisis it reached many billions of pounds a year. The bigger banks became, the more they were seen as too important to fail, and the surer markets became that the taxpayer would bail them out. But there are only so many good loans and investments to be made. In order to expand, banks made increasingly risky investments. To make matters worse, they started making huge bets with each other on whether loans that had already been made would be repaid. The seeds of the eventual downfall of the financial system had been sown. As loans and investments went bad, those seeds started to sprout.

In August 2007 came the moment when financial markets began to realise that the emperor had no clothes. The announcement by the French bank BNP Paribas that it would suspend repayments from two of its investment funds triggered a loss of confidence and a freezing of some capital markets. A month later, the crisis claimed its first victim when Northern Rock failed. In the months that followed, there was a steady procession of banking failures culminating in the collapse of the American bank Lehman Brothers in September 2008. Financial waters, already extremely chilly, then froze solid. Banks found it almost impossible to finance themselves because no-one knew which banks were safe and which weren’t.

From the start of the crisis, central banks provided emergency loans but these amounted to little more than holding a sheet in front of the emperor to conceal the nakedness of the banks. They didn’t solve the underlying problem – banks needed not loans but injections of shareholders’ capital in order to be able to absorb losses from the risky investments they had made. From the beginning of 2008, we at the Bank of England began to argue that UK banks needed extra capital – a lot of extra capital, possibly £100 billion or more. It wasn’t a popular message. But nine months later, market pressure forced banks to raise new capital or accept it from the state. UK tax payers ended up owning large portions of two of our four biggest banks, Royal Bank of Scotland and Lloyds TSB, but almost all banks would have failed had not taxpayer support been extended. That bold action in October 2008 could have happened sooner. But the most important thing is that it was done. And the policy of recapitalising the banks was soon copied by other countries.

Bailing out the banks came too late though to prevent the financial crisis from spilling over into the world economy. The realisation of the true state of the banking system led to a collapse of confidence around the world and a deep global recession. Over 25 million jobs disappeared worldwide. And unemployment in Britain rose by over a million. To many of you this will seem deeply unfair, and it is. I can understand why so many people are angry.

It’s vital that we learn from the crisis. A good place to start is to ask, as the Queen famously did, “Why did no-one see this coming?” The answer is extremely simple: no-one believed it could happen. Recessions were supposed to follow booms and high inflation, not periods of steady and sustainable growth with low inflation. There seemed to be no reason to expect the worst recession since the 1930s. After the ravages of inflation in the 1970s – younger listeners might need to be reminded that inflation hit 27% in 1975 – it was I think understandable that we focussed on the need to bring inflation down. But conquering inflation was not enough to ensure stability. Although inflation was under control, fragilities were building in the banking system. On all sides there was a failure of imagination to appreciate the scale of the fragilities and their potential consequences. No-one could quite bring themselves to believe that in our modern financial system the biggest banks in the world could fall over. But they did.

That isn’t to say we were blind to what was going on. For several years, central banks, including the Bank of England, had warned that financial markets were underestimating risks. So why, you might ask, did the Bank of England not do more to prevent the disaster? We should have. But the power to regulate banks had been taken away from us in 1997. Our power was limited to that of publishing reports and preaching sermons. And we did preach sermons about the risks. But we didn’t imagine the scale of the disaster that would occur when the risks crystallised. With the benefit of hindsight, we should have shouted from the rooftops that a system had been built in which banks were too important to fail, that banks had grown too quickly and borrowed too much, and that so-called ‘light-touch’ regulation hadn’t prevented any of this. And in the crisis, we tried, but should have tried harder, to persuade everyone of the need to recapitalise the banks sooner and by more. We should have preached that the lessons of history were being forgotten – because banking crises have happened before.

In the 1930s, the Great Depression saw a collapse of the banking system in the United States. So severe was it that President Franklin Roosevelt, only a week after his inauguration in March 1933, announced a bank holiday shutting the banks to provide a breathing space so that confidence could be restored. Here he is, in his first fireside chat, explaining banking to the American people:

AUDIO INSERT:

“My friends I want to talk for a few minutes with the people of the United States about banking… We have had a bad banking situation. Some of our bankers have shown themselves either incompetent or dishonest in their handling of the people’s funds. They had used some money entrusted to them in speculation and unwise loans. This was of course not true in the vast majority of our banks but it was true in enough of them to shock the people of the United States for a time into a sense of insecurity and to put them in a frame of mind where they did not differentiate but seemed to assume that an act of a comparative few had tainted them all. And so it became the government’s job to straighten out this situation and to do it as quickly as possible and that job is being performed.”

We too have had a “bad banking situation”. Roosevelt showed bold and decisive political leadership in explaining to his listeners the reasons why they should not fear banks but trust their Government to ensure that the economy could be saved from the bank failures that had led to the Great Depression.

For the sake of future generations, we too must be bold and decisive and, while the memory is fresh, learn the lessons from this crisis. Reform is essential.

Three reforms top my list. The first concerns regulation of banks. Next year, the responsibility for regulating banks will return to the Bank of England.

Next time we find ourselves with steady growth and low inflation, but with risks building in the financial sector, we shall be able to do something about it. The Bank’s new Financial Policy Committee will have the power to step in and prevent a hangover by taking away the punchbowl just as the party in the financial system is getting going.

We believe that successful regulation means understanding and guarding against the big risks, not compliance with ever more detailed rules. That means focussing on the wood not the trees, looking not just at individual banks but also at how their fortunes are tied together with other banks and with the rest of the economy. For example, the biggest risk to banks at present stems from the troubles in the euro area. These are far from over. That’s why we’ve been pushing banks to pay out less to their shareholders and employees and instead retain profits as a cushion against possible losses.

In future, to protect the rest of the economy from failures in the banking system, we need to ensure that more of banks’ shareholders’ own money is on the line, and banks rely correspondingly less on debt. If banks and their shareholders have more to lose, they will be more careful in choosing to whom they lend. And, when banks make losses, there is more of a cushion before the bank fails, and less chance that the taxpayer will have to foot the bill.

Nevertheless, bank failures will happen from time to time – indeed failure is part and parcel of a prosperous market economy. So the second reform on my list aims to make sure badly run banks can fail safely – that is, without causing damage to ordinary depositors and the rest of the economy, and without billing the taxpayer. That requires a special legal framework to allow a failing bank to continue to provide its essential services while its finances are being sorted out. Such a framework is called a resolution mechanism. It’s precisely what was lacking when Northern Rock failed in 2007, leaving nationalisation as the only alternative. That painful lesson has been learnt, and the 2009 Banking Act introduced a resolution mechanism in Britain for the first time. But that won’t work for big global banks with operations around the world. So there is much more to do.

The third reform is to restructure the banking system. In so doing we must recognise the crucial distinction between essential banking services to people like you and me, on the one hand, and complex and potentially risky trading activities, on the other. We don’t build nuclear power stations in densely populated areas; nor should we allow essential banking services and risky investment banking activities to be carried out in the same “too important to fail” bank. Last autumn, the Independent Commission on Banking, chaired by Sir John Vickers and comprising some of our most brilliant bankers and economists, published recommendations on how to do this. It’s vital that Parliament legislates to enact these proposals sooner rather than later.

Regulation, resolution and restructuring of the banks are the three Rs of a new approach to make banking, and so our economy, safer.

The three Rs will be central to the work of the Bank of England. And all of that will come on top of our responsibility for monetary policy to reduce inflation while supporting a gradual recovery of our battered economy. It’s the biggest challenge the Bank has faced for decades.

We are up to the task. Already we see vested interests rise up to defend their bonuses and profits. But, as an independent central bank with over three centuries of history, we can resist those short-term pressures and take the longer view needed to prevent another crisis. …

Download the full Speech

View the Speech on You Tube

Also hear a wide ranging interview with the BBC’s Evan Davis following Mervyn King’s Today Lecture

Source: Bank of England

European Union set for clash on banking rules

Deep divisions over European banking rules will be exposed on Wednesday as finance ministers clash on how best to tighten regulation and protect taxpayers without stifling lending or damaging competition.

Translating the “Basel III” international rules on bank capital into law has emerged as the most highly charged financial regulation issue in Brussels – throwing up sharp disputes and creating unusual political bedfellows.

At stake is who decides what risks the EU’s 8,300 banks can take, and what tools regulators will have to deflate dangerous credit bubbles of the sort that plunged the world economy into crisis in 2008.

The talks will also test the EU’s fidelity to the Basel accord, a complex package that will, over the next six years, seek to head off more taxpayer bailouts by forcing banks to build up buffers of equity, cash and liquid assets.

Some big disagreements have yet to be overcome.

“Now it’s up to politicians,” said Margrethe Vestager, the Danish economy minister who will chair the meeting in Brussels. “You can’t move it until ministers are together.”

A final deal, which will need the European parliament’s approval, will be an important benchmark. Along with resetting the power balance between national and EU regulators, the final law will indicate to the US and Asia how elastic the Basel accord will be in practice.

The odds seem stacked against a breakthrough, at least at this first finance ministers’ meeting. Key players – such as the UK’s George Osborne – are not attending, suggesting that a deal is unlikely before the next gathering in two weeks.

“This will be to let off steam,” said one senior diplomat.

At one extreme stands a French-led bloc pushing for softer requirements on bank capital and leverage plus a Brussels veto over national authorities that want to pile on extra capital requirements. It has won Paris the full-throated support of most British and continental banks.

At the other is Britain, home to Europe’s main financial centre, which is calling for strict enforcement of the Basel minimum requirements and the right for national regulators to impose even tougher rules without prior EU approval. Its backers include the European Central Bank and, on most issues, the Basel committee itself.

Debate revolves around a European Commission text, proposed last summer . While EU officials say it complies with Basel, there are controversial tweaks and additions. Most contentious is the “maximum harmonisation” approach, giving national authorities flexibility within a minimum and maximum level of bank capital.

To protect the single market, Brussels wants the final say on imposing extra demands, so it will be able to contain the spillover if one nation tightens its rules and prompts its banks to yank funding from other parts of the EU.

The latest compromise proposal, brokered by the Danish, would give national regulators the option to tack on an extra 3 per cent capital buffer.

“But the issue is control [over decision-making],” said one diplomat. “We could go on playing numbers bingo until we die.”

Talks will explore a compromise that falls short of a Brussels veto – possibly by co-ordinating through various EU bodies.

At the same time, Britain is complaining about minimum standards for capital, saying some concessions make “a Swiss cheese” of the accord. Few countries back the strict UK stand; France and Germany, by contrast, are winning support to relax leverage requirements.

Some analysts say these “deviations” set a bad example.

“Global standard-setters have lost the EU as a consistent champion,” says Nicolas Véron, senior fellow at the Brussels-based Bruegel think-tank. “The EU now looks much more like the US – in favour of global standards when it likes them and not in favor when it dislikes them.”

Ms Vestager disagrees. “Our implementation of Basel III covers 27 different banking systems,” she said. “The US will apply it to fewer systemically important banks. We need the handling room.”

The big question is whether the UK will stand its ground and be outvoted for the first time on an important financial services proposal.

“Will they have the gall to run over the UK? The threat is there,” said one senior diplomat. “And the Brits may just want to pick a fight.”

What they want …

Franco-German demand

Issue: The leverage ratio is designed to prevent banks from understating the riskiness of their holdings. Basel III calls for banks to start disclosing in 2015 the ratio of their top-quality capital to their total assets. A minimum 3 per cent ratio is then supposed to take effect in 2018.

Politics: France and Germany, whose banks are likely to be hit particularly hard, are fighting to delay disclosure to 2018 and put off compliance. EU Member states are evenly split. Brussels backs the original 2015 deadline; the British plan to make their banks disclose next year.

German demand

Issue: The European Commission proposal makes it easier for German banks to continue counting their “silent partnerships” – a kind of non-voting capital – toward their capital requirements. Basel III says such forms of capital can only be counted if they are clearly “loss-absorbing” and can be written down if the bank runs into trouble.

Politics: The UK, Italy and the ECB complain that the explicit requirement on loss-absorbing equity has been omitted from the EU text. Even so, Paris and Berlin and a clear majority of countries back the Commission’s interpretation.

French demand

Issue: Banks that own insurance companies, under Basel III, cannot double-count capital towards requirements of both the insurer and the bank parent. France and the Commission disagree, but they were outgunned on the Basel committee. A softer rule would potentially give a multi-billion euro boost to the capital buffers of Société Générale, Crédit Agricole or Lloyds.

Politics: A clear majority of countries back the Commission’s proposal giving more flexibility for banks with insurance arms. The UK is opposed, along with the Basel committee and the ECB. But London lacks a blocking minority. If the Commission’s rule is passed, UK regulators will not allow Lloyds to benefit.

UK-Swedish demand

Issue: The EU proposal stops national regulators from demanding much higher capital requirements without prior approval from Brussels. This is to protect the single market and stop banks meeting tighter rules at home by cutting lending in other EU countries. Basel only sets a minimum requirement.

Politics: The UK and Sweden want to set higher capital levels for banks and are resisting Brussels being given a veto. They are supported by a blocking minority of countries. France is leading calls for EU more safeguards and also has a blocking minority. A compromise could involve coordination rather than pre-approval, or an increased maximum level.

Source: Financial Times

Are the perils posed by too-big-to-fail banks a thing of the past?

That’s what we keep hearing from Washington. Politicians who wrote the Dodd-Frank law insist that it eliminates the dangers posed by large, politically connected financial institutions. At a news conference last week, Ben S. Bernanke, the chairman of the Federal Reserve, said that higher capital and greater liquidity requirements for big banks, combined with more watchful regulators, were making our financial giants stronger and less likely to require taxpayer backstops.

Outside the Beltway, however, it is hardly clear that we’ve resolved this signal threat. Big banks are bigger than ever, and they exert enormous power over regulators and lawmakers. Increasingly, smaller institutions can’t compete.

So it was refreshing last week to hear Kevin M. Warsh , a former Fed governor, speak candidly and critically about the government backing that continues to support our largest banks. Equally refreshing were his prescriptions for eliminating the too-big-to-fail problem.

“We cannot have a durable, competitive, dynamic banking system that facilitates economic growth if policy protects the franchises of oligopolies atop the financial sector,” Mr. Warsh told an audience at the Stanford Law School on Wednesday night. “Those ‘interconnected’ firms that find themselves dependent on implicit government support do not serve our economy’s interest.”

Mr. Warsh, who is a distinguished visiting fellow at the Hoover Institution at Stanford and a lecturer at Stanford’s Graduate School of Business, left government in 2011. His last position was at the Fed, where he was a governor for five years. Given his front-row Fed seat during the financial crisis, his views on preventing a repeat of it carry some weight.

Put simply, Mr. Warsh does not believe that higher capital standards for banks and greater regulatory scrutiny will be enough to prevent future taxpayer-financed bailouts. “At core, I’m worried that the Dodd-Frank Act doubles down on regulators, gives upon markets and outsources capital requirements to an international standards group in Basel, Switzerland,” he said in an interview last week.

Importantly, none of these responses have moved us closer to “ridding the United States financial system of large, quasi-public utilities atop the sector,” he said.

Mr. Warsh does not prescribe breaking up giant institutions. Rather, he says their disclosures must be subject to new and ramped-up transparency requirements so investors can differentiate strength from weakness.

“The Federal Reserve’s most recent stress tests — particularly the enhanced disclosure — are a step in the right direction,” he told his Stanford audience. “Still, disclosure practices by the largest financial firms remain lacking, and the periodic reporting overseen by the Securities and Exchange Commission tends to obfuscate as much as inform.”

Regulators must require clearer and more expansive disclosures so that the financial statements and associated risks of large and complex companies can be assessed, Mr. Warsh said. If investors had more detailed information from these institutions, they would very likely sell their shares and debt if they took too many risks. This would hold the managers of these institutions accountable for reckless behavior by making them pay more to fund their businesses.

But this powerful market force is ineffectual in a world where investors believe that the government will save faltering institutions. “Unfortunately, the Dodd-Frank Act has only reinforced the view that big and troubled banks will receive special government assistance,” Mr. Warsh said in his speech. “By sanctioning some list of too-big-to-fail firms — and treating them different than the rest — policy makers are signaling to markets that the government is vested in their survival.”

Mr. Warsh also questions our nation’s participation in the Basel negotiations regarding bank capital requirements. He pointed out that many of the countries working alongside the United States on these rules back their banks more explicitly than we do. Therefore, their approach to capital standards is bound to vary greatly from ours.

“My concern is that the negotiation, while well intended, is between banking systems that at their core are fundamentally different and aspire to fundamentally different things,” he said. “The largest banks in Japan, Germany, for example, have long been akin to national champions. Perhaps they reason that their banks need less capital than ours because their sovereigns more assuredly stand behind them.”

Our financial regulators, Mr. Warsh suggested, should work with countries that don’t explicitly back their largest institutions. “We should work with them to instill real market discipline and real capital levels and do a more rigorous job on regulation,” he said. Britain and Switzerland are two possible candidates for this joint effort, in large part because their banks are too big to be bailed out by their governments.

Circling back to the pernicious effects of large and politically interconnected banks, Mr. Warsh makes a direct link between the favors handed to these institutions and our disturbingly high unemployment rate. Small and medium-size banks, after all, are at a competitive disadvantage to the big guys, so they are less able to lend to companies of modest size, which do so much of the hiring in this country.

“The policy has favored large global banks and disfavored small and medium-sized banks,” he said. “So I’m not surprised that real economic and job growth that should come from these enterprises is still lacking. Our failure to have a dynamic competitive banking system is a partial explanation for the weakness we are seeing.”

Granted, Mr. Warsh is far outnumbered by those arguing for the status quo and the continued hegemony of big banks. Many of those people, not surprisingly, work in Washington. But their refusal to concede that taxpayers remain imperiled by banks too big to succeed only ensures that we will face another financial crisis. And that it will come sooner, not later.

Source: New York Times

International Monetary Fund. Full 2012 Global Financial Stability Report: The Quest for Lasting Stability

April 2012.

The April 2012 Global Financial Stability Report assesses changes in risks to financial stability over the past six months, focusing on sovereign vulnerabilities, risks stemming from private sector deleveraging, and assessing the continued resilience of emerging markets. The report probes the implications of recent reforms in the financial system for market perception of safe assets, and investigates the growing public and private costs of increased longevity risk from aging populations.

Download the full Global Financial Stability Report

Source: International Monetary Fund

Press Briefing on the Global Financial Stability Report

José Viñals, Financial Counsellor and Director, Monetary and Capital Markets Department
Robert Sheehy, Deputy Director, Monetary and Capital Markets Department
Jan Brockmeijer, Deputy Director, Monetary and Capital Markets Department
Peter Dattels, Assistant Director, Monetary and Capital Markets Department
William Murray, Division Chief, External Relations Department, IMF

Mr. Murray – Good day. I am William Murray, Chief of Media Relations of the IMF, and this is the Spring 2012 Global Financial Stability Report press conference. Let me do some quick housekeeping before I introduce our briefers today.

First of all, we welcome everybody at our webcast, at the Press Center, and elsewhere that are participating remotely via the internet. For those in the room, we have simultaneous interpretation: English, Channel 1; French, Channel 2; Spanish Channel 3; and Arabic on Channel 6.

Let me now start by introducing our speakers: José Viñals, Financial Counsellor and Director of the Monetary and Capital Markets Department; to my far right, Jan Brockmeijer, Deputy Director; Robert Sheehy, Deputy Director; and to my immediate right, Peter Dattels, Assistant Director of the Monetary and Capital Markets Department. José will have some opening remarks, which I believe we have distributed to the press already, and then we will take your questions. José?

Mr. Viñals – Thank you very much, Bill, and good morning to you all. This Global Financial Stability Report has two key messages: first, policy actions have brought gains to global financial stability since our September report; and second, nevertheless current policy efforts are not enough to achieve lasting stability, and this refers both to Europe and to other advanced economies, like the United States and Japan.

Much has been done. In recent months, important and unprecedented policy steps have been taken to quell the crisis in the Euro Area. At the national level, stronger policies are being put in place in Italy and Spain; a new agreement has been reached on Greece; and Ireland and Portugal are making good progress in implementing their respective programs. Importantly, the European Central Bank’s decisive actions have supported bank liquidity and eased funding strains while banks are enforcing their capital positions under the guidance of the European Banking authority. Finally, steps have been taken to enhance economic governance, promote fiscal discipline, and buttress the firewall at the Euro Area level.

These actions and policies have brought much-needed relief to financial markets since the peak of the crisis late last year, but it is too soon to say that we have exited from the crisis because lasting financial stability is not yet ensured.

Indeed, we have been reminded in recent weeks that sentiment can quickly shift and rekindle sovereign financing stress, leaving many sovereigns and banking systems caught in a vicious circle. Furthermore, pressures on European banks remain from high rollover requirements, weak growth along with the need to strengthen balance sheets, including by shrinking.

Some deleveraging is healthy when banks increase capital, cut non-core activities, and reduce reliance on wholesale funding that results in more robust balance sheets. But like Goldilocks, the amount, the pace, and the location of deleveraging must be just right at the aggregate level, not too large, too fast, or too concentrated in one region or country.

So far, current policies have prevented a generalized credit crunch, but we still anticipate a considerable squeeze on credit which will impede growth. We estimate that large European Union-based banks could shrink their combined balance sheets by as much as $2.6 trillion, or about 7 percent of total assets, by the end of 2013, with about a quarter of that shrinkage leading to a cutback in lending.

Overall, we estimate that deleveraging by European Union (EU) banks could reduce the supply of credit in the Euro Area by about 1.7 percent over two years. However, if current policy commitments are not implemented and financial stresses intensify, the downside risks of large-scale and synchronized deleveraging could do serious damage to asset prices, credit supply, and economic activity in Europe and beyond.

In this scenario, we estimate that large EU banks could shed a total of $3.8 trillion, or about 10 percent of total assets, by the end of 2013. Such a retrenchment by EU banks could reduce euro-area credit supply by 4.4 percent and GDP could fall by 1.4 percent from the baseline after two years.

Outside the Euro Area, the region potentially most affected by the deleveraging process is Emerging Europe. Other emerging markets are unlikely to remain immune. While emerging markets generally have substantial policy buffers, such an external shock could combine with homegrown vulnerabilities, like those related to persistently rapid growth of credit, and further undermine global stability. Unaddressed fiscal challenges in the United States and in Japan represent also latent risks to global stability. Both countries have yet to forge much-needed political consensus for medium term deficit reductions, and the United States is also grappling with high household debt burdens and an overhang of home foreclosures.

Let me now turn to the policy recommendations. The question here is how can we achieve lasting financial stability? In the Euro Area, policy steps are needed along several dimensions. To prevent the materialization of the downside risks that I have just mentioned, continued adjustment efforts are needed at the national level, especially by countries currently under strain.

Those reform efforts are being bolstered by a financing backstop that has recently been strengthened. This Euro Area firewall should also be able to take direct stakes in banks in order to break the adverse feedback loop between sovereigns and banks.

To ensure an orderly process of bank deleveraging, close macro-prudential oversight by European banking authorities of bank business plans is called for, and greater efforts are needed to restructure viable banks and resolve weak banks.

To strive for better and more balanced growth, accommodative monetary policies need to be combined with a sufficiently gradual withdrawal of fiscal support in countries not subject to market pressures, as well as structural policies to lift potential growth rates.

Last on Europe, but certainly far from least, it is necessary to provide a vision of more and better Europe to help regain confidence in the Euro Area future.

A roadmap for a more integrated economic and monetary union should be laid out and committed to. This encompasses two key objectives: a truly Pan-European framework for bank supervision and regulation, as well as deposit insurance, and greater ex ante fiscal risk sharing; for example, through some central financing mechanism. I am well aware that this will not be politically easy, nor immediately achievable, but a consensus needs to be forged now to help restore confidence.

Going beyond Europe, it is essential to start addressing now the medium-term fiscal challenges in the United States and Japan, and this should be accompanied in the United States by stronger efforts to address household debt and accelerate housing market reforms.

In emerging markets, which are in a relatively good situation, policymakers should not take stability for granted. Given the risks in advanced economies, policy room may need to be used to cushion external shocks and volatile capital flows. Home-grown vulnerabilities, like those I mentioned, linked to persistently rapid growth of credit need to be addressed to increase resilience. To conclude, none of these policies are easy and some are, indeed, politically difficult. I believe that they are within reach, so let us not miss this opportunity. Policymakers and politicians must act now and in close collaboration to end this crisis once and for all. This time must be different.

Thank you very much. My colleagues and I will be happy to answer any questions that you may have.

Mr. Murray- Thank you, José. A quick reminder to those that have dialed in by the Press Center. Please start submitting your questions so that we can get to them eventually.

Question – Even in your more benign scenario you imply a very considerable shrinkage in bank lending in Europe over the next two years. In your opinion, should the ECB be countering this with further unconventional measures such as the sort of quantitative easing that both the Fed and the Bank of England have engaged in?

Mr. Viñals – I think that the ECB decisions have been certainly decisive in this crisis, and not just the decisions that have been taken now but the decisions that were taken since the beginning of the crisis, and particularly since the beginning of the sovereign debt crisis when they started with the Securities Market Purchases Program, and then added limited amounts of liquidity, and now they went to the three-year liquidity operation. One thing which I think history has taught us is that, while central bank action may be essential and, indeed, has been essential to avert a collapse, it is certainly not sufficient. I think that the focus should be put not on what else can the ECB do. The ECB has bought very precious time that now the political authorities need to use in order to do the other things which are needed: to implement very strongly the national policies that are needed in order to regain stability and enhance sustained growth—and potential growth, let us remember, is limited in Europe and should be enhanced with appropriate structural reform— and make sure that the time that has been bought is used to put in place this stronger firewall, and that is already happening.

Also, I think that the European authorities need to provide to investors a clear vision of where the monetary union is going, because the answer to this is a more and better Europe, not less Europe. So, let me emphasize that fundamental as the actions of the ECB have been, one cannot count on the ECB being there always to save the day. I think that the action needs to come from the other parts of economic policy.

Question – A technical qualification and a question. How do you arrive at the proportion of one quarter of the shrinkage in the supply of credit from the reduction in assets, in total assets. Also, the deleveraging is bound to hit harder countries in the periphery of Europe. I wonder if you have an estimate of the deleveraging, the shrinkage in assets, and the reduction in credit for the case of Italy, and what is your assessment of the soundness of the Italian banking system.

Mr. Viñals – Let me just say a couple of things and then let my colleague, Pete Dattels, provide the answer to the first technical question that you posed.

I think that the soundness of the Italian banking system is elevated. I think it is very encouraging the actions being recently taken by the Italian authorities in order to further enhance the solidity of Italian banks, which have made an important effort in raising capital and in going to a sufficiently strong position.

Regarding the reduction in the supply of credit, in the report we have specific estimates of the impact for Italy as compared to the Euro Area. I was saying before that, in the current policy scenario, the supply of credit in the Euro Area could shrink by up to 1.7 percent over two years. In the case of Italy, this is about 1 percentage point higher. So, the countries which are now subject to more strains regarding sovereign funding and bank funding are naturally the ones which are experiencing a larger impact from the deleveraging process.

Mr. Dattels – Just to describe a little bit the analysis that has been done on a very detailed basis, bank by bank. What we have observed in the deleveraging process is that European-EU banks have resorted to looking, first, at where they can cut back assets as opposed to credit initially. So, we see some trimming of non-core assets, reductions in assets held abroad which have been funded by, let us say, US dollars. So, that type of deleveraging process we see as representing the bulk of that, the downsizing of banks into a more robust footing.

When we go through this process, you will see in the scenarios that we have that, as these scenarios get more progressively severe, the ability for banks to basically do the easy deleveraging starts to finish and then it starts to bite a little bit harder on the loan and the lending. That is why we are emphasizing the need to put the policies in place to manage the deleveraging process.

The other element that we have is that there is a certain degree of home bias to this. In other words, the banks that are under deleveraging pressures protect their home markets and it is the last part of the deleveraging process that hits.

In terms of the impact within the Eurozone, the work that we have done looks at the entire banking system and that is highlighted in Figure 2.31. You do see a substantial amount of difference within the Eurozone where you have very little pressure, let us say, on Germany and France, and increasing pressure on the periphery as those banks are under significant deleveraging pressure and as banks at the core pull back cross-border lending within the Eurozone. So, you can see in Spain that the impact over the two years is about 4 percent on total credit.

Question – Two questions. In your report you mention that a large firewall is needed in Europe. What is “large” in numbers? Second, this deleveraging process in Europe is accompanied by new capital requirements that the banks should address by the end of June. Is this going to accelerate the negative impact for economic activity?

Mr. Viñals – I will answer your second question and then I will go to the first one.

The capital requirements which are coming from the exercise led by the European Banking Authority is fully taken into account in our calculations, so these are already factored in. That is a relatively small part of the total deleveraging forces.

I think that what is much more important is, on the one hand, the plans that banks have to adapt their business lines with the new, let us say, economic realities coming from deregulation. This is going to be put in place coming from the need to adapt to an environment where certain banking activities which were profitable during the crisis are no longer so profitable. This deleveraging is also influenced very much by how easy it is going to be down the road for banks to go back to market financing.

All these factors are much more important than the one linked to capital increases, but these capital increases which are on the way in Europe under the auspices of the European Banking Authority have been fully taken into account so they should not be added as another sort of further pressure to deleveraging on top of what we already have, but, I repeat, these are relatively small in their impact.

Your other question is we are calling for a large firewall. What we are acknowledging is that a large firewall has been put in place. I think that the firewall is important and we think that the efforts made by the European authorities in putting in place a stronger firewall are certainly fundamental.

But the firewall is only one component, is only one piece of a puzzle composed of other things which are fundamental. At the national level, it is essential that the countries that need to do their homework do it without delay and in the right manner. At the European level, it is essential that there is this vision of a more and better Europe which is transmitted to markets, which is transmitted to the public in general, because that is fundamental for confidence to return.

So, we think that one needs to see this in context, and what we are advocating in the report is that the European authorities, which had done very important efforts in recent months both at the national level, at the European and at the Euro Area level, continue these efforts in order to complete the architecture of what we think is the solution to restore lasting financial stability. Without that, we will not be able to exit from the crisis and we have the real danger of going back into vicious circles which can be very damaging to economic activity.

Question – I have two questions. First, in the report you mentioned in facing nonperforming loans the Chinese government has the resources to recapitalize its domestic banks. Could you elaborate more about how this is likely to hurt the central government’s fiscal condition?

The second question is your summation about capital flows to emerging market countries, and there are several countries who contracted capital controls. As I understand, the IMF considers capital controls as the last resort. How do you respond to the criticism that the IMF has focused too much on the sequence or the order of the policies instead of on the effectiveness of these policies?

Mr. Viñals – On the first question on China, undoubtedly, if there were to be increases in the nonperforming loans of Chinese banks, this is something which will have to be taken care of. Now, we think that where the risks may be higher are in the area of real estate property developers’ loans rather than on the mortgage loans. Of course, the good thing about China is that they have fiscal space to accommodate any shock to the banks. So, instead of ultimately a financial stability issue, what you would have is an incipient financial stability issue dealt with by public finances. That would involve certain risk-sharing in China from the central government to the banks and also perhaps to the local governments, which, through their special vehicles to promote construction, and so on, have taken up those loans. So, certainly it is going to imply some costs on the fiscal side, on the part of the central budget in China.

On your other question regarding the position of the IMF in terms of capital flows, well, we think that capital flows, in principle, are good, but that sometimes they may pose challenges to countries where they change very abruptly. We have looked at this very carefully and we have recommended that there should be a balanced approach to dealing with the macro-financial challenges posed by capital flows.

We have looked at the effectiveness of the different measures, of macroeconomic measures, monetary and fiscal policies, of prudential measures in order to keep the financial system stable, and also to other measures which may influence the size of the flows. We think that capital flow management measures are part of the toolkit but that they have to be used only when appropriate.

So, what would not be right is to use these capital flow measures or to restrict capital flows in order to prevent some problems, where the best way of preventing these problems may be by macroeconomic policy adjustment at home. These capital flow management measures are a complement and not a substitute of much-needed macroeconomic policy adjustment and financial sector adjustment at home. This is the message from the IMF. They are part of the toolkit, but you should not abuse them because, if we were to do so, we would undermine financial globalization. An appropriate use in the context of complete policy strategies is something that the Fund has recognized.

Question – I have two questions. What is your opinion about European banks that are operating in countries of Latin America? How will these banks work in this scenario? What are the risks in countries that are having high levels of credit increases like Paraguay, Nicaragua, for example?

Mr. Viñals – On the risks for countries which have rapid credit growth, as long as this is persistent over time, then you have an issue. Many emerging markets and developing countries need to go through a process of financial deepening, which means that they need to increase the size of their financial sector and, over time, they need to increase the role of credit to GDP because they start from very low ratios. But they have to do this in a gradual manner. When you have periods where credit is growing very fast, very quickly, we know that this is a leading indicator of nonperforming loans tomorrow. That is something which is exemplified by the experience of many countries in the world.

So, we think authorities should exercise vigilance on this, they should make sure that banks are appropriately accounting the quality of these loans, that they are provisioning sufficiently, that they have capital buffers and capital positions which are consistent with the risks that they are undertaking, and also that if you think that the growth of credit is very rapid and that you need to bring this down, you have to use the policy levers at your disposal, including monetary policy, fiscal policy. In some of these countries a lot of this credit may be linked also to public finances and to deficits, and so on, and you also have to use the prudential measures on the financial side that I have just outlined.

Regarding European banks in Latin America, we have looked in our simulations at the impact that the deleveraging process would have in Latin American economies through both those European banks present in Latin America through branches and subsidiaries, and also we have looked at cross-border credit which is supplied to Latin American firms, households, and governments without going strictly through banks or subsidiaries. So, this is truly cross-border. There is some impact in Latin America, but this impact is relatively small compared with other regions, in particular Emerging Europe, which is the one that would be mostly affected.

Now, one thing that is important in Latin America is that, so far, deleveraging has been manageable and has been well managed. For example, when a European bank has sold its stake in a bank in Colombia, then there has been a Latin American bank from another country which has taken this stake. So, there has been some substitution in terms of domestic banks taking the role of foreign banks, and this has helped to keep the situation manageable.

What we point out in the report is not that the situation in terms of deleveraging in the rest of the world has not been manageable. It has been manageable and has been well managed in Latin America, in Asia, and in Eastern Europe. What we point out are the concerns that, if market stress were to increase, could exacerbate these deleveraging pressures and those would be harder to manage than so far has been the case.

Question – My question is if you are in discussions with the European Union about putting direct capital into Spanish banks.

Mr. Viñals – I am not aware of any such discussions.

Question – You talked about what European banks were doing.

Mr. Vinals – Sorry? European banks?

Question – Yes. You talk about European banks cutting back on some part of their assets of about (inaudible). I feel that for most of them, actually, in foreign presses, you have got a chunk lying in (inaudible) Africa and stock markets like Egypt, Nigeria, and South Africa. Now, what is likely impact of some of those assets on the [?] markets and their indices as well?

Mr. Viñals – Sorry, I had some difficulty—

Mr. Murray – Just to clarify, what you are asking is the deleveraging translating into flight of capital to those emerging markets; is that what you are saying?

Question – From those markets.

Mr. Murray – From those markets, South Africa, Nigeria, etc.

Mr. Viñals – Well, so far, we have not seen this happening except in the following sense. Capital flows, they do not like too much risk. So, one thing that we have seen is that when confidence is shaky and risk appetite is low, there tends to be a retrenchment and capital flows out of emerging markets. This is something that happens in general inside and outside of Africa. This is something that happened for the broad category of emerging markets and some frontier countries during October and November where tensions escalated in the Euro Area.

Then, after the actions by the European Central Bank, the policy decisions by the European Leaders, the agreement on Greece happened, all of these tensions deescalated, risk aversion dropped, and then capital flew back to these countries in rather intense amounts. So, what I think is fundamental is capital flow volatility. This is something which is going to affect much more emerging markets and frontier countries than low-income countries. I think that low-income countries have other issues.

They could also be hit through the deleveraging process insofar as strong deleveraging which goes beyond what is reasonable and healthy may put a drain on global economic activity, and this may lead to a drop in exports for these low-income countries. That would be a channel. But I do not think that the capital flows channel is the most relevant for low-income countries, particularly in Africa. I think that the trade channels may be more important.

Mr. Dattels – I might just add that the difference between the Lehman crisis, which affected all banks in the system and where we had a lot of concern about trade finance, which is obviously very important for developing and emerging markets, is that this time around, because it has been concentrated in European banks, and European banks are big providers of trade finance, what we have seen is other stronger banks stepping in to provide trade finance. So, there has been very little impact on that vital financial link.

Where it is slightly different from the Lehman crisis is that, because some of the deleveraging factors are structural, for example, some of the areas of specialty finance require long-term funding from banks, that type of funding is slightly more scarce because of the need for banks to stabilize and lengthen the maturity of their liability structure, but as José was saying, so far, so good, under the current conditions.

Question – Can you give us your estimates of what the spillover effects on the rest of the world would be in the event of another major European crisis both through the financing channels and through the trade channels?

Mr. Viñals – Well, I do not even want to put a number in a trillion-dollar questions. It is a difficult question to answer because one must first have some metric for what do you mean by an escalation of the crisis, up to where it goes. One thing that we have done in the report is to take some scenarios, and I will give you what we have done, which is the following.

If we were to move from the current policy scenario to one where confidence is further shaken and where access of sovereigns and banks to funding is further limited from the levels we have today and spreads increase, and we have some assumptions regarding by how much spreads increased, this is our downside scenario. In this downside scenario, what we have is an acceleration of deleveraging, which will imply that, after two years, economic activity in the Euro Area, for example, would be about 1.4 percent below than what the baseline is. So, it would certainly take a toll in the Euro Area.

We have also looked at what would happen if we had an exit of capital flows from emerging markets like the one that took place during the Lehman period. What we have said is, all the portfolio flows that came into emerging markets or the main emerging markets receiving these inflows between 2009 and 2011, what would happen if they were to exit suddenly in a quarter as it happened during Lehman. The impact that we measure in the report is that you would have reductions in GDP growth in different emerging markets, the ones that have been the most important recipients of these inflows, between 1.5 and 2.5–3 percent of GDP. So, we are saying that, yes, an escalation of tensions in Europe would take a toll on the growth of these emerging markets, as well as taking a toll on the growth of the Euro Area itself.

Question – I noticed that you echoed the message in the World Economic Outlook regarding the possible recapitalization of euro zone banks through the firewall. If I remember correctly, when Christine Lagarde suggested this at Jackson Hole, euro zone policymakers scorned the idea. What makes you think that euro zone policymakers’ attitudes toward recapitalization have changed since then? Could you shed any light on what is the IMF’s thinking on how much needs to be set aside for bank recapitalization and what the trigger would be for making these payments through the euro zone firewall?

Mr. Viñals – Let me clarify the following. The ESM, the European Stability Mechanism, already has legally the capacity to provide money that would be used for recapitalizing banks, and the same thing goes with the European Financial Stability Facility. In fact, part of the money has been used in program countries, like in the case of Greece, for example, where this money is set aside for recapitalization of Greek banks.

The important thing is whether part of the money of the ESM can be used not only to, among other things, help recapitalize banks in the context of lending to the national sovereigns so that the national sovereigns put the money in their banks, so an indirect way of doing that, or whether the ESM should have the ability to directly take a stake in banks.

Why is it that we think that this would be important? Because that will help to break the adverse loop between sovereign risks at the national level and banking risks at the national level. So, by having these directly-taken stakes by the EFSF, ESM—that is, the ESM in the future—you would break this link. That is what we are advocating.

But, remember, the EFSF and the ESM already have the capacity to channel money into banks through the national sovereign, and not only within a program, but it is also envisaged that this could happen outside of a specific IMF-EU program, but as long as it is through the national sovereign.

Now, in terms of the question of how much capital do European banks need, we think that this is an issue that has already been addressed by the European Banking Authority through their recapitalization exercise. We think that European banks complying with the targets set by EBA is the right thing to do, and I think that is the answer. So, we do not have anything beyond that. I think that this is what banks should do and that is what banks are doing according to the plans that they have submitted to EBA. We are putting action now on things which have received less attention. We think that there are three key “Rs” in order to solve the banking problems in Europe. One is recapitalize. The other is restructure. There are times when what you have to think is whether the financial institution, the bank as it is, is not the best possible way it could be and, if not, you have to restructure. Restructuring is fundamental, and this is happening in some European countries, but it is not happening in other European countries.

Then you have to have the third “R,” which is resolve. You have to close down and liquidate banks which are not viable. So, recapitalize, restructure, and resolve. This is what we think needs to be done in order to fully stabilize the banking system in Europe.

Mr. Murray – We have a number of questions online. Some of them are really germane to other press briefings we will have over the course of the week in terms of Regional Economic Outlooks. We will get back to those journalists off-line. Let me take a couple more questions here in the room and then I am going to wrap this up.

Question – Just so I can try and explain this to my readers, Spanish ten-year bonds at the moment are close to 6 percent. In any kind of medium term, that is not sustainable. From what I understand, you consider the firewall, the EFSF/ESM, should be principally used to recapitalize banks, but you also in your response to my colleague here pretty much discounted the option of the ECB engaging in massive bond purchases, sovereign bond purchases.

A lot of economists would say it is not going to be possible to bring down interest rates, Spanish interest rates if you do not have one of those options, if you do not use the firewall as a lender of last resort or the ECB. So, how do you expect Spanish bonds to come down to sustainable rates?

Mr. Viñals – Let me clarify something, because I did not say—and I want to emphasize I did not say—that the ECB should not use the tools at its disposal, like the Securities Market Purchase Program that is open and can be used, if needed, or that the ECB should not have further operations. What I am saying is that this is not the solution; this may be part of the solution, but this is not the solution. What you need is to stabilize the situation once and for all, and once and for all meaning doing things that need to be done.

Now, I think that one component which is very important behind the recent stories is that markets need to be persuaded by the national authorities that the national authorities are doing the right thing, and I think that Spain is doing a lot of very important things recently. There is financial sector reform of recapitalizing, reprovisioning, restructuring, which I think has gone in the right direction and which needs to be completed as soon as possible. There has been very ambitious labor reform which has been approved and which needs to be implemented as soon as possible. There are legislative initiatives in order to bring public finances of the autonomous communities under control.

So, I think that this is all very important and I think that this will ultimately pay off. That rates may go one day up, even if it is high, I think that should not let us take our eyes off the prize. We need to continue strongly implementing the national measures at the right level.

Another clarification. I did not say that the ESM has to be only or primarily used for recapitalizing banks. There are a number of things the ESM can do, and sometimes it may be helping banks in some countries, and other times it may be helping even to purchase sovereign bonds in other countries. This is also within the legal remit of the ESM. Other times it would be contributing to programs, like has been the case with Greece, and so on.

So, I think that there are a number of things that can be done. The continued support from the ECB through an accommodative monetary policy and intervening in markets by adequate provision of liquidity and buying sovereign bonds when necessary, all of these are options, but that is not the only game in town.

If we think that that is the only game in town, we are wrong, because you also need very important decisions at the European level in terms of the political agreements which are needed in order to continue working, continue the excellent work that has been done recently, and put in place a vision of the European Monetary Union which really helps markets become confident again and say, okay, now we are willing to come back because this is a project which we can believe in and in which we see the full support of the key stakeholders in terms of member countries. That is what is needed. A lot has been done; let us complete the job; let us not leave it unfinished. That is the point I want to make.

Question – Reading the various reports, your report, Mr. Cottarelli’s report, it is obvious that states give billions to banks, and without these billions, some of the banks may collapse. Tell me if it is correct. My second question is, what is your outlook for the Greek banks?

Mr. Viñals – Well, I think that from the beginning of the crisis, in the United States, in Europe, the public sector has had to step in in order to safeguard the stability of the banking system, because the banking system provides through credit flows the equivalent of blood in the human body. If blood dries up, you die. So, it is fundamental to keep the financial system and the banking system from imploding and credit from imploding. That is why money was put into the banks subject to conditions so that financial stability could be maintained or preserved as much as possible.

The same thing is happening in Greece. In Greece, the program contemplated by the IMF and our European partners is basically a program where there is a program for fiscal adjustment, for structural reforms to support growth over the medium term, and also for keeping a viable core in the financial system and in the banking system which is capable of providing credit to the economy. Within this program, there is a provision made for public funds which may be used to help support the banking system.

I think that this is natural. The important thing is that these actions pay off and that Greece can recover growth so that it can repay these loans and go back to being a normal economy. That is basically the purpose of the program that we have put forward in Greece. In the case of Ireland, again, the banking system was under tremendous trouble. The government had to step in; resources were not enough; and we had to go to a program. Now they are making good progress and they are on a course to recover. So, that is the story.

Question – I want to ask about the European banks in the Middle East, especially in the Arab Spring countries, that if they do these things, I think the economies in these countries cannot compete, or cannot increase, or something like this.

Mr. Viñals – Well, this is why we are insisting very much in order to avoid any negative impact beyond inside and outside of Europe. This is why we are insisting very much on putting in place the full array of policies, of which part of it has been done, but completing the job by putting in place the full array of policies which will help to restore confidence.

The region you are talking about is not the most affected by the European banking deleveraging. It is really Emerging Europe. The country you represent is not so affected. But, again, I think it is in the interest of the global community to avoid an escalation of tensions in Europe, which may lead not only to negative spillovers through the deleveraging process, but also through trade channels, through a reduction of global confidence, and this is something which, through other ways, would be negative for everybody.

So, it is in the interest of Europe and it is in the interest of the world, and this is why, in addition to the stronger European firewall that has been put in place, the Fund is making efforts to increase its resources sufficiently so as to have a global firewall that can help any member country that may get into trouble.

Mr. Murray – Thank you, José. Just a quick service note reminder here. At 8:45 a.m., Washington time, tomorrow, Christine Lagarde, the Managing Director of the IMF, will hold a press conference here in this room. It will also be webcast. Thank you, José, Robert, Jan, and Peter for joining us today. Thank you all. If you have any follow-up questions, e-mail to media@imf.org and we will follow up for you. Thank you very much.

The Basel Committee on Banking Supervision has published a peer review of the implementation by national supervisory authorities of the Basel Committee’s principles for sound stress testing practices and supervision.

Stress testing is an important tool used by banks to identify the potential for unexpected adverse outcomes across a range of risks and scenarios. In 2009, the Committee reviewed the performance of stress testing practices during the financial crisis and published recommendations for banks and supervisors entitled Principles for sound stress testing practices and supervision. The guidance set out a comprehensive set of principles for the sound governance, design and implementation of stress testing programmes at banks, as well as high-level expectations for the role and responsibilities of supervisors.

As part of its mandate to assess the implementation of standards across countries and to foster the promotion of good supervisory practice, the Committee’s Standards Implementation Group (SIG) conducted a peer review during 2011 of supervisory authorities’ implementation of the principles. The review found that stress testing has become a key component of the supervisory assessment process as well as a tool for contingency planning and communication. Countries are, however, at varying stages of maturity in the implementation of the principles; as a result, more work remains to be done to fully implement the principles in many countries.

Overall, the review found the 2009 stress testing principles to be generally effective. The Committee, however, will continue to monitor implementation of the principles and determine whether, in the future, additional guidance might be necessary.

Source: The Basel Committee on Banking Supervision

At its Plenary meeting on 10 January, the Financial Stability Board (FSB) Plenary underscored the importance of work to improve the role that external audits play in providing information to prudential supervisors and regulators of financial institutions, and to reinforce the effectiveness of the regulation of external audits, particularly those of financial institutions

The recent global financial crisis has demonstrated the importance of addressing these issues. Work to improve audit practices and standards is ongoing, with some regulators and auditing standard setters having issued finalised guidance on certain audit issues, and proposals in some other jurisdictions are subject to public consultation. In view of the global nature of markets, financial institutions and audit firms, greater international consistency in external audit practices and requirements will be important while continuing to promote their high quality.

In particular, the FSB encourages further work in the following areas:

1. Improving the information that external audits provide to prudential supervisors and regulators of financial institutions, including systemically important financial institutions (SIFIs). As part of this effort, the FSB will provide input to the Basel Committee’s ongoing revision of its external audit policy papers and as it develops new robust external audit guidance, to be proposed by end-2012, and to the International Association of Insurance Supervisors as it updates and enhances its policies with respect to external audits of insurance companies.

2. Reinforcing the effectiveness of audit regulation, particularly for external audits of financial institutions, to improve audit quality. The FSB is requesting the International Forum of Independent Audit Regulators (IFIAR) to report on (I) challenges and problems that its members have identified in their inspection programmes relating to external audits of financial institutions, including audits of SIFIs; (ii) responses by IFIAR members to those issues, including follow-up with external audit firms; and (iii) member recommendations concerning steps that could be taken by audit regulators and auditors to further strengthen external audits of financial institutions.

The FSB also recognises the importance of other work underway to improve audit practices and standards and:

• encourages the continued efforts of the International Audit and Assurance Standards Board (IAASB), internationally, and other audit standard setters in their national contexts to improve the standards on information that external audits provide to investors and other financial report users. The approaches set forth in various consultative documents differ across jurisdictions, and it will be important to seek high quality standards that enhance audit practices, and to the extent possible, improved international consistency. IOSCO has agreed to monitor developments in this area and provide updates to the FSB on progress.
• asks IOSCO to report to the FSB on authorities’ experiences with the considerations in IOSCO’s 2008 report on audit contingency planning.
• asks FSB members and other key bodies such as the IAASB, to provide input to the World Bank’s review of how to enhance its Accounting and Auditing Reports on Standards and Codes (ROSCs).

Promoting high quality international accounting and auditing standards and practices is an important aspect of the FSB’s activities. The FSB will continue to support dialogue between audit standards setters and regulators, investors, market regulators, prudential authorities, financial institutions and audit firms on improving the quality of external audit and its contribution to financial stability.

Notes

The FSB has been established to coordinate at the international level the work of national financial authorities and international standard setting bodies and to develop and promote the implementation of effective regulatory, supervisory and other financial sector policies in the interest of financial stability. It brings together national authorities responsible for financial stability in 24 countries and jurisdictions, international financial institutions, sector-specific international groupings of regulators and supervisors, and committees of central bank experts.

The FSB is chaired by Mark Carney, Governor of the Bank of Canada. Its Secretariat is located in Basel, Switzerland, and hosted by the Bank for International Settlements.

Source: Financial Stability Board