International Association of Risk and Compliance Professionals (IARCP)

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International Association of Risk and Compliance Professionals (IARCP)1200 G Street NW Suite 800 Washington, DC 20005-6705 USA Tel: 202-449-9750 www.risk-compliance-association.comTop 10 risk and compliance management related news stories and world events that (for better or for worse) shaped the week's agenda, and what is next

Dear Member,

Which is the difference between triggers and vulnerabilities?

Dear Mr Bernanke, can you clarify please?

He did, at the 49th Annual Conference on Bank Structure and Competition sponsored by the Federal Reserve Bank of Chicago, Chicago, Illinois

He said:

To respond to this point, I will distinguish, as I have elsewhere, between triggers and vulnerabilities.

The triggers of any crisis are the particular events that touch off the crisis--the proximate causes, if you will.

For the 2007-09 crisis, a prominent trigger was the losses suffered by holders of subprime mortgages.

In contrast, the vulnerabilities associated with a crisis are preexisting features of the financial system that amplify and propagate the initial shocks.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 2

Examples of vulnerabilities include high levels of leverage, maturity transformation, interconnectedness, and complexity, all of which have the potential to magnify shocks to the financial system.

Absent vulnerabilities, triggers might produce sizable losses to certain firms, investors, or asset classes but would generally not lead to full-blown financial crises; the collapse of the relatively small market for subprime mortgages, for example, would not have been nearly as consequential without preexisting fragilities in securitization practices and short-term funding markets which greatly increased its impact.

Did you address vulnerabilities this week?

Mr Bernanke continued:

Moreover, attempts to address specific vulnerabilities can be supplemented by broader measures--such as requiring banks to hold more capital and liquidity--that make the system more resilient to a range of shocks.Read more at Number 1 below.Welcome to the Top 10 list.

Best Regards,George Lekatis President of the IARCPGeneral Manager, Compliance LLC 1200 G Street NW Suite 800,Washington DC 20005, USA Tel: (202) 449-9750Email: lekatis@risk-compliance-association.com Web: www.risk-compliance-association.comHQ: 1220 N. Market Street Suite 804, Wilmington DE 19801, USATel: (302) 342-8828International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 3Chairman Ben S. BernankeAt the 49th Annual Conference on Bank Structure and Competition sponsored by the Federal Reserve Bank of Chicago, Chicago, Illinois

Monitoring the Financial System

We are now more than four years beyond the most intense phase of the financial crisis, but its legacy remains.

Our economy has not yet fully regained the jobs lost in the recession that accompanied the financial near collapse.

And our financial system--despite significant healing over the past four years--continues to struggle with the economic, legal, and reputational consequences of the events of 2007 to 2009.Erkki LiikanenBanking structure and monetary policy what have we learned in the last 20 years?

Presentation by Mr Erkki Liikanen, Governor of the Bank of Finland and Chairman of the Highlevel Expert Group on the structure of the EU banking sector, at the conference Twentyyears of transition experiences and challenges, arranged by the National Bank of Slovakia, Bratislava.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 4The impact of the crisis on financial integration in Central and Eastern Europe

Speech by Mr Ignazio Visco, Governor of the Bank of Italy, at the conference Twenty yearsof transition experiences and challenges, hosted bythe National Bank of Slovakia, Bratislava

The transition countries of Central and Eastern Europe were no exception: their quite rapid financial integration over the pasttwenty-years brought about lasting economic benefits, but also left them relatively exposed to the global financial turmoil, in particular through their links with Western European banks which hold dominant stakes in the regions markets.Revised rules for markets in financial instruments (MiFID/MiFIR)

Proposal for a Directive of the EuropeanParliament and of the Council on markets in financial instruments repealing Directive 2004/39/EC of theEuropean Parliament and of the Council (Recast) (MiFID)

Proposal for a Regulation of the European Parliament and of the Council on markets in financial instruments and amending Regulation [EMIR] on OTC derivatives, central counterparties and trade repositories (MiFIR)International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 5APRA releases second consultation package for thesupervision of conglomerate groups

The Australian Prudential Regulation Authority (APRA) has released for consultation proposed risk management and capital adequacy requirements for the supervision of conglomerate groups.

Conglomerate groups, referred to as Level 3 groups, are groups comprising APRA-regulated institutions that perform material activities across more than one APRA-regulated industry and/or in one or more non-APRA-regulated industry.Governor Elizabeth A. DukeAt the Housing Policy Executive Council, Washington, D.C.

A View from the Federal Reserve Board: The Mortgage Market and Housing Conditions

Since joining the Board in 2008 amid a crisis centered on mortgage lending, I have focused much of my attention on housing and mortgage markets, issues surrounding foreclosures, and neighborhood stabilization.

In March of this year, I laid out my thoughts on current conditions in the housing and mortgage markets in a speech to the Mortgage Bankers Association.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 6The Need for Robust SEC Oversight of SROs

By Commissioner Luis A. AguilarU.S. Securities and Exchange Commission Washington, D.C.Proposal for a structural reform of EU banksThere are concerns that large EU banking groups, are difficult to manage, monitor, and supervise.

Furthermore, they may also be difficult to resolve, due to their complexity, interconnectedness, geographic scope, and ability to expand rapidly.

Also, the unrestricted co-mingling of deposits subject to government guarantees with market and trading activities may subject depositors to additional risks.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 7APRA releases second consultation package on Basel III liquidity reforms

The Australian Prudential Regulation Authority (APRA) has today released a second consultation package outlining its proposed implementation of the Basel III liquidity reforms for authorised deposit-taking institutions (ADIs) in Australia.

The package includes a discussion paper, a revised draft Prudential Standard APS 210 Liquidity (APS 210) and a draft Prudential Practice Guide APG 210 Liquidity.OTC derivatives statistics at end-December 2012

Monetary and Economic Department May 2013

Notional amounts for interest rate derivatives, the largest segment of the market, stood at $490 trillion at end-2012.

While the overall figure was more or less unchanged from end-June 2012, breakdowns showed offsetting movements.

For swaps, notional amounts dropped in the second half of 2012 by about 2% to $370 trillion, owing in part to the compression of trades through central counterparties (CCPs).International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 8Chairman Ben S. BernankeAt the 49th Annual Conference on Bank Structure and Competition sponsored by the Federal Reserve Bank of Chicago, Chicago, Illinois

Monitoring the Financial System

We are now more than four years beyond the most intense phase of the financial crisis, but its legacy remains.

Our economy has not yet fully regained the jobs lost in the recession that accompanied the financial near collapse.

And our financial system--despite significant healing over the past four years--continues to struggle with the economic, legal, and reputational consequences of the events of 2007 to 2009.

The crisis also engendered major shifts in financial regulatory policy and practice.

Not since the Great Depression have we seen such extensive changes in financial regulation as those codified in the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) in the United States and, internationally, in the Basel III Accord and a range of other initiatives.

This new regulatory framework is still under construction, but the Federal Reserve has already made significant changes to how it conceptualizes and carries out both its regulatory and supervisory role and its responsibility to foster financial stability.

In my remarks today I will discuss the Federal Reserve's efforts in an area that typically gets less attention than the writing and implementation of new rules--namely, our ongoing monitoring of the financial system.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 9

Of course, the Fed has always paid close attention to financial markets, for both regulatory and monetary policy purposes.

However, in recent years, we have both greatly increased the resources we devote to monitoring and taken a more systematic and intensive approach, led by our Office of Financial Stability Policy and Research and drawing on substantial resources from across the Federal Reserve System.

This monitoring informs the policy decisions of both the Federal Reserve Board and the Federal Open Market Committee as well as our work with other agencies.

The step-up in our monitoring is motivated importantly by a shift in financial regulation and supervision toward a more macroprudential, or systemic, approach, supplementing our traditional microprudential perspective focused primarily on the health of individual institutions and markets.

In the spirit of this more systemic approach to oversight, the Dodd-Frank Act created the Financial Stability Oversight Council (FSOC), which is comprised of the heads of a number of federal and state regulatory agencies.

The FSOC has fostered greater interaction among financial regulatory agencies as well as a sense of common responsibility for overall financial stability.

Council members regularly discuss risks to financial stability and produce an annual report, which reviews potential risks and recommends ways to mitigate them.

The Federal Reserve's broad-based monitoring efforts have been essential for promoting a close and well-informed collaboration with other FSOC members.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 10

A Focus on Vulnerabilities

Ongoing monitoring of the financial system is vital to the macroprudential approach to regulation.

Systemic risks can only be defused if they are first identified.

That said, it is reasonable to ask whether systemic risks can in fact be reliably identified in advance; after all, neither the Federal Reserve nor economists in general predicted the past crisis.

To respond to this point, I will distinguish, as I have elsewhere, between triggers and vulnerabilities.

The triggers of any crisis are the particular events that touch off the crisis--the proximate causes, if you will.

For the 2007-09 crisis, a prominent trigger was the losses suffered by holders of subprime mortgages.

In contrast, the vulnerabilities associated with a crisis are preexisting features of the financial system that amplify and propagate the initial shocks.

Examples of vulnerabilities include high levels of leverage, maturity transformation, interconnectedness, and complexity, all of which have the potential to magnify shocks to the financial system.

Absent vulnerabilities, triggers might produce sizable losses to certain firms, investors, or asset classes but would generally not lead to full-blown financial crises; the collapse of the relatively small market for subprime mortgages, for example, would not have been nearly as consequential without preexisting fragilities in securitization practices and short-term funding markets which greatly increased its impact.

Of course, monitoring can and does attempt to identify potential triggers--indications of an asset bubble, for example--but shocks of one kind or another are inevitable, so identifying and addressingInternational Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 11

vulnerabilities is key to ensuring that the financial system overall is robust.

Moreover, attempts to address specific vulnerabilities can be supplemented by broader measures--such as requiring banks to hold more capital and liquidity--that make the system more resilient to a range of shocks.

Two other related points motivate our increased monitoring.

The first is that the financial system is dynamic and evolving not only because of innovation and the changing needs of the economy, but also because financial activities tend to migrate from more-regulated toless-regulated sectors.

An innovative feature of the Dodd-Frank Act is that it includes mechanisms to permit the regulatory system, at least in some circumstances, to adapt to such changes.

For example, the act gives the FSOC powers to designate systemically important institutions, market utilities, and activities for additional oversight.

Such designation is essentially a determination that an institution or activity creates or exacerbates a vulnerability of the financial system, a determination that can only be made with comprehensive monitoring and analysis.

The second motivation for more intensive monitoring is the apparent tendency for financial market participants to take greater risks when macro conditions are relatively stable.

Indeed, it may be that prolonged economic stability is a double-edged sword.

To be sure, a favorable overall environment reduces credit risk and strengthens balance sheets, all else being equal, but it could also reduceInternational Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 12

the incentives for market participants to take reasonable precautions, which may lead in turn to a buildup of financial vulnerabilities.

Probably our best defense against complacency during extended periods of calm is careful monitoring for signs of emerging vulnerabilities and, where appropriate, the development of macroprudential and other policy tools that can be used to address them.

The Federal Reserve's Financial Stability Monitoring Program So, what specifically does the Federal Reserve monitor?

In the remainder of my remarks, I'll highlight and discuss four components of the financial system that are among those we follow most closely: systemically important financial institutions (SIFIs), shadow banking, asset markets, and the nonfinancial sector.

Systemically Important Financial Institutions

SIFIs are financial firms whose distress or failure has the potential to create broader financial instability sufficient to inflict meaningful damage on the real economy.

SIFIs tend to be large, but size is not the only factor used to determine whether a firm is systemically important; other factors include the firm's interconnectedness with the rest of the financial system, the complexity and opacity of its operations, the nature and extent of its risk-taking, its use of leverage, its reliance on short-term wholesale funding, and the extent of its cross-border operations.

Under the Dodd-Frank Act, the largest bank holding companies are treated as SIFIs; in addition, as I mentioned, the act gives the FSOC the power to designate individual nonbank financial companies as systemically important.

This designation process is under way.

Dodd-Frank also establishes a framework for subjecting SIFIs to comprehensive supervisory oversight and enhanced prudential standards.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 13

For all such companies, the Federal Reserve will have access to confidential supervisory information and will monitor standard indicators such as regulatory capital, leverage, and funding mix.

However, some of these measures, such as regulatory capital ratios, tend to be backward looking and thus may be slow to flag unexpected, rapid changes in the condition of a firm.

Accordingly, we supplement the more standard measures with other types of information.

One valuable source of supplementary information is stress testing.

Regular, comprehensive stress tests are an increasingly important component of the Federal Reserve's supervisory toolkit, having been used in our assessment of large bank holding companies since 2009.

To administer a stress test, supervisors first construct a hypothetical scenario that assumes a set of highly adverse economic and financial developments--for example, a deep recession combined with sharp declines in the prices of houses and other assets.

The tested firms and their supervisors then independently estimate firms' projected losses, revenues, and capital under the hypothetical scenario, and the results are publicly disclosed.

Firms are evaluated both on their post-stress capital levels and on their ability to analyze their exposures and capital needs.

Stress testing provides a number of advantages over more-standard approaches to assessing capital adequacy.

First, measures of capital based on stress tests are both more forward looking and more robust to "tail risk"--that is, to extremely adverse developments of the sort most likely to foster broad-based financial instability.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 14

Second, because the Federal Reserve conducts stress tests simultaneously on the major institutions it supervises, the results can be used both for comparative analyses across firms and to judge the collective susceptibility of major financial institutions to certain types of shocks.

Indeed, comparative reviews of large financial institutions have become an increasingly important part of the Federal Reserve's supervisory toolkit more generally.

Third, the disclosure of stress-test results, which increased investor confidence during the crisis, can also strengthen market discipline in normal times.

The stress tests thus provide critical information about key financial institutions while also forcing the firms to improve their ability to measure and manage their risk exposures.

Stress-testing techniques can also be used in more-focused assessments of the banking sector's vulnerability to specific risks not captured in the main scenario, such as liquidity risk or interest rate risk.

Like comprehensive stress tests, such focused exercises are an important element of our supervision of SIFIs.

For example, supervisors are collecting detailed data on liquidity that help them compare firms' susceptibilities to various types of funding stresses and to evaluate firms' strategies for managing their liquidity.

Supervisors also are working with firms to assess how profitability and capital would fare under various stressful interest rate scenarios.

Federal Reserve staff members supplement supervisory and stress-test information with other measures.

For example, though supervisors have long appreciated the value of market-based indicators in evaluating the conditions of systemically important firms (or, indeed, any publicly traded firm), our monitoringInternational Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 15

program uses market information to a much greater degree than in the past.

Thus, in addition to standard indicators--such as stock prices and the prices of credit default swaps, which capture market views about individual firms--we use market-based measures of systemic stability derived from recent research.

These measures use correlations of asset prices to capture the market's perception of a given firm's potential to destabilize the financial system at a time when the broader financial markets are stressed; other measures estimate the vulnerability of a given firm to disturbances emanating from elsewhere in the system.

The further development of market-based measures of systemic vulnerabilities and systemic risk is a lively area of research.

Network analysis, yet another promising tool under active development, has the potential to help us better monitor the interconnectedness of financial institutions and markets.

Interconnectedness can arise from common holdings of assets or through the exposures of firms to their counterparties.

Network measures rely on concepts used in engineering, communications, and neuroscience to map linkages among financial firms and market activities.

The goals are to identify key nodes or clusters that could destabilize the system and to simulate how a shock, such as the sudden distress of a firm, could be transmitted and amplified through the network.

These tools can also be used to analyze the systemic stability effects of a change in the structure of a network.

For example, margin rules affect the sensitivity of firms to the conditions of their counterparties; thus, margin rules affect the likelihood of financial contagion through various firms and markets.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 16

Shadow Banking

Shadow banking, a second area we closely monitor, was an important source of instability during the crisis.

Shadow banking comprises various markets and institutions that provide financial intermediation outside the traditional, regulated banking system.

Shadow banking includes vehicles for credit intermediation, maturity transformation, liquidity provision, and risk sharing.

Such vehicles are typically funded on a largely short-term basis from wholesale sources.

In the run-up to the crisis, the shadow banking sector involved a high degree of maturity transformation and leverage.

Illiquid loans to households and businesses were securitized, and the tranches of the securitizations with the highest credit ratings were funded by very short-term debt, such as asset-backed commercial paper and repurchase agreements (repos).

The short-term funding was in turn provided by institutions, such as money market funds, whose investors expected payment in full on demand and had little tolerance for risk to principal.

As it turned out, the ultimate investors did not fully understand the quality of the assets they were financing.

Investors were lulled by triple-A credit ratings and by expected support from sponsoring institutions--support that was, in fact, discretionary and not always provided.

When investors lost confidence in the quality of the assets or in the institutions expected to provide support, they ran.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 17

Their flight created serious funding pressures throughout the financial system, threatened the solvency of many firms, and inflicted serious damage on the broader economy.

Securities broker-dealers play a central role in many aspects of shadow banking as facilitators of market-based intermediation.

To finance their own and their clients' securities holdings, broker-dealers tend to rely on short-term collateralized funding, often in the form of repo agreements with highly risk-averse lenders.

The crisis revealed that this funding is potentially quite fragile if lenders have limited capacity to analyze the collateral or counterparty risks associated with short-term secured lending, but rather look at these transactions as nearly risk free.

As questions emerged about the nature and value of collateral, worried lenders either greatly increased margin requirements or, more commonly, pulled back entirely.

Borrowers unable to meet margin calls and finance their asset holdings were forced to sell, driving down asset prices further and setting off a cycle of deleveraging and further asset liquidation.

To monitor intermediation by broker-dealers, the Federal Reserve in 2010 created a quarterly Senior Credit Officer Opinion Survey on Dealer Financing Terms, which asks dealers about the credit they provide.

Modeled on the long-established Senior Loan Officer Opinion Survey on Bank Lending Practices sent to commercial banks, the survey of senior credit officers at dealers tracks conditions in markets such as those for securities financing, prime brokerage, and derivatives trading.

The credit officer survey is designed to monitor potential vulnerabilities stemming from the greater use of leverage by investors (particularly through lending backed by less-liquid collateral) or increased volumes of maturity transformation.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 18

Before the financial crisis, we had only very limited information regarding such trends.

We have other potential sources of information about shadow banking. The Treasury Department's Office of Financial Research and Federal Reserve staff are collaborating to construct data sets on triparty and bilateral repo transactions, which should facilitate the development of better monitoring metrics for repo activity and improve transparency in these markets.

We also talk regularly to market participants about developments, paying particular attention to the creation of new financial vehicles that foster greater maturity transformation outside the regulated sector, provide funding for less-liquid assets, or transform risks from forms that are more easily measured to forms that are more opaque.

A fair summary is that, while the shadow banking sector is smaller today than before the crisis and some of its least stable components have either disappeared or been reformed, regulators and the private sector need to address remaining vulnerabilities.

For example, although money market funds were strengthened by reforms undertaken by the Securities and Exchange Commission (SEC) in 2010, the possibility of a run on these funds remains--for instance, if a fund should "break the buck," or report a net asset value below 99.5 cents, as the Reserve Primary Fund did in 2008.

The risk is increased by the fact that the Treasury no longer has the power to guarantee investors' holdings in money funds, an authority that was critical for stopping the 2008 run.

In November 2012, the FSOC proposed for public comment some alternative approaches for the reform of money funds.

The SEC is currently considering these and other possible steps.

With respect to the triparty repo platform, progress has been made in reducing the amount of intraday credit extended by the clearing banks inInternational Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 19

the course of the daily settlement process, and, as additional enhancements are made, the extension of such credit should be largely eliminated by the end of 2014.

However, important risks remain in the short-term wholesale funding markets.

One of the key risks is how the system would respond to the failure of a broker-dealer or other major borrower.

The Dodd-Frank Act has provided important additional tools to deal with this vulnerability, notably the provisions that facilitate an orderly resolution of a broker-dealer or a broker-dealer holding company whose imminent failure poses a systemic risk.

But, as highlighted in the FSOC's most recent annual report, more work is needed to better prepare investors and other market participants to deal with the potential consequences of a default by a large participant in the repo market.

Asset Markets

Asset markets are a third area that we closely monitor.

We follow developments in markets for a wide range of assets, including public and private fixed-income instruments, corporate equities, real estate, commodities, and structured credit products, among others.

Foreign as well as domestic markets receive close attention, as do global linkages, such as the effects of the ongoing European fiscal and banking problems on U.S. markets.

Not surprisingly, we try to identify unusual patterns in valuations, such as historically high or low ratios of prices to earnings in equity markets.

We use a variety of models and methods; for example, we use empirical models of default risk and risk premiums to analyze credit spreads incorporate bond markets.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 20

These assessments are complemented by other information, including measures of volumes, liquidity, and market functioning, as well as intelligence gleaned from market participants and outside analysts.

In light of the current low interest rate environment, we are watching particularly closely for instances of "reaching for yield" and other forms of excessive risk-taking, which may affect asset prices and their relationships with fundamentals.

It is worth emphasizing that looking for historically unusual patterns or relationships in asset prices can be useful even if you believe that asset markets are generally efficient in setting prices.

For the purpose of safeguarding financial stability, we are less concerned about whether a given asset price is justified in some average sense than in the possibility of a sharp move.

Asset prices that are far from historically normal levels would seem to be more susceptible to such destabilizing moves.

From a financial stability perspective, however, the assessment of asset valuations is only the first step of the analysis.

Also to be considered are factors such as the leverage and degree of maturity mismatch being used by the holders of the asset, the liquidity of the asset, and the sensitivity of the asset's value to changes in broad financial conditions.

Differences in these factors help explain why the correction in equity markets in 2000 and 2001 did not induce widespread systemic disruptions, while the collapse in house prices and in the quality of mortgage credit during the 2007-09 crisis had much more far-reaching effects:

The losses from the stock market declines in 2000 and 2001 were widely diffused, while mortgage losses were concentrated--and, through various financial instruments, amplified--in critical parts of the financial system, resulting ultimately in panic, asset fire sales, and the collapse of creditmarkets.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 21

Nonfinancial Sector

Our financial stability monitoring extends to the nonfinancial sector, including households and businesses.

Research has identified excessive growth in credit and leverage in the private nonfinancial sector as potential indicators of systemic risk.

Highly leveraged or financially fragile households and businesses are less able to withstand adverse changes in income or wealth, including those brought about by deteriorating conditions in financial and credit markets.

A highly leveraged economy is also more prone to so-called financial accelerator effects, as when financially stressed firms are forced to lay off workers who, in turn, lacking financial reserves, sharply cut their own spending.

Financial stress in the nonfinancial sector--for example, higher default rates on mortgages or corporate debt--can also damage financial institutions, creating a potential adverse feedback loop as they reduce the availability of credit and shed assets to conserve capital, thereby further weakening the financial positions of households and firms.

The vulnerabilities of the nonfinancial sector can potentially be captured by both stock measures (such as wealth and leverage) and flow measures (such as the ratio of debt service to income).

Sector-wide data are available from a number of sources, importantly the Federal Reserve's flow of funds accounts, which is a set of aggregate integrated financial accounts that measures sources and uses of funds for major sectors as well as for the economy as a whole.

These accounts allow us to trace the flow of credit from its sources, such as banks or wholesale funding markets, to the household and business sectors that receive it.

The Federal Reserve also now monitors detailed consumer- andbusiness-level data suited for picking up changes in the nature ofInternational Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 22

borrowing and lending, as well as for tracking financial conditions of those most exposed to a cyclical downturn or a reversal of fortunes.

For example, during the housing boom, the aggregate data accurately showed the outsized pace of home mortgage borrowing, but it could not reveal the pervasive deterioration in underwriting that implied a substantial increase in the underlying credit risk from that activity.

More recently, gains in household net worth have been concentrated among wealthier households, while many households in the middle or lower parts of the distribution have experienced declines in wealth since the crisis.

Moreover, many homeowners remain "underwater," with their homes worth less than the principal balances on their mortgages.

Thus, more detailed information clarifies that many households remain more financially fragile than might be inferred from the aggregate statistics alone.

Conclusion

In closing, let me reiterate that while the effective regulation and supervision of individual financial institutions will always be crucial to ensuring a well-functioning financial system, the Federal Reserve is moving toward a more systemic approach that also pays close attention to the vulnerabilities of the financial system as a whole.

Toward that end, we are pursuing an active program of financial monitoring, supported by expanded research and data collection, often undertaken in conjunction with other U.S. financial regulatory agencies.

Our stepped-up monitoring and analysis is already providing important information for the Board and the Federal Open Market Committee as well as for the broader regulatory community.

We will continue to work toward improving our ability to detect and address vulnerabilities in our financial system.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 23Erkki Liikanen: Banking structure and monetary policy what have we learned in the last 20 years?

Presentation by Mr Erkki Liikanen, Governor of the Bank of Finland and Chairman of the Highlevel Expert Group on the structure of the EU banking sector, at the conference Twenty years of transition experiences and challenges, arranged by the National Bank of Slovakia, Bratislava.

How is todays perspective on monetary policy different from what prevailed 20 years ago?

Twenty years ago, the world of today was being formed in many ways.

1993 was the year when the Economic and Monetary Union project was becoming political reality: the Maastricht treaty had been signed and was in the process of being ratified.

It was also the time when the mainstream approach to monetary policy was beginning to converge to the flexible inflation targeting framework.

A number of countries had then just adopted an explicit inflation targeting strategy.

In the sphere of banking regulation, too, a new era was beginning.

A significant reorientation was going on, away from regulating the conduct of banks and towards the new risk-based approach.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 24

The regulatory trend, based on increased freedom for banks but subject to risk based capital requirements, would continue all the way to the eruption of the financial crisis in 2008.

In the EU, the second banking directive took effect from the beginning of 1993, creating a single market in banking.

The directive sought to prevent discrimination and to increase efficiency through competition.

There was discussion on the implications of this for supervision, but little action.

So, while European banking markets were being integrated, financial supervision remained a national competence.

In the U.S., deregulation was also moving forward.

For instance the Glass-Steagall Act, separating banking from securities and insurance, was under growing criticism and would be ultimately repealed in 1995.

One reason for the dissatisfaction with the Glass-Steagall system in the US was competition from European banks which were less restricted in what they could do.

Twenty years ago, the striking improvement in macroeconomic performance, later named the great moderation by chairman Bernanke, was spreading to the whole developed world.

The almost surprising success of monetary policy in improving price stability and reducing fluctuations in economic activity, while also keeping interest rates at historically low levels, was interpreted as a major victory for the art of economic policy making.

Now we know that there was trouble brewing under the surface.

The underpinnings of global financial stability were becoming weaker.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 25

Global indebtedness increased, fuelled by current account balances and the deepening of international financial markets (read: recycling the same funds several times over).

The decline of inflation was not only due to monetary policy, but also the avalanche of cheap consumer goods from the emerging economies such as China contributed to it.

For banks, the new financial environment was characterized by low interest rates and low perceived risks.

It also turned out that the new risk-based capital requirements allowed the banks to expand their balance sheets enormously without increasing their equity capital in the same proportion.

So, gradually the large banking groups started to increase their trading portfolios.

This development happened in a gradual fashion in the 1990s but accelerated dramatically from about 2004.

Banks redirected their business focus from interest margins to fee-based and trading activities.

Universal banking, as it had been known in Europe, started to change.

The asset mix of the largest banks changed so that securities portfolios activities grew more and more important.

Only now, from the perspective given by the worst financial crisis since the Second World War, do we see clearly the fragility and weakness of the regulatory arrangements which came into force in the 1990s.

From todays point of view, they performed well only as long as no major systemic risks materialized.

Even worse, they allowed risks to accumulate in the financial system which were only waiting to be realized.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 26

Then came 2007 and the collapse of the US property market; 2008 and the collapse of interbank money markets following the Lehman Brothers crisis; and 2009 with The Great Recession.

The painful process of competitive deleveraging started.

The reassessment of economic policies followed in the last two decades has also started.

Especially financial regulation has been reconsidered and is being strengthened.

We need to think of monetary policy, too, especially in its connection to financial stability.

Monetary policy and financial stability

There is a common dictum that a stable financial system is a necessary condition for successful monetary policy, and that price stability in turn creates the best preconditions for financial stability.

I agree.

Still, the experience of this crisis has thought us a lot more.

First of all, we now know that price stability does not by itself guarantee financial stability.

Risks can accumulate in the banking system even if monetary policy succeeds in maintaining price stability and controlling inflationary expectations really well.

Second, we also know that central banks can maintain an admirable degree of price stability even when financial stability is under a lot of strain.

Do these two points mean that financial stability and monetary policy arenot connected after all?International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 27

No.

They are very closely related.

Independence of monetary policy

One of the lasting lessons learned in the last decades is the value of the independence of monetary policy.

The independence of central banks has been essential keeping inflation expectations as well anchored as they have been in this crisis despite all the turmoil in the financial markets.

Independence has also made it easier for central banks to act quickly when it has been necessary in order to maintain financial stability.

It is especially important to avoid two threats to independence: fiscal dominance and financial dominance.

Fiscal dominance is the older concept of the two.

It would arise if the government financing constraint would become an overriding influence on monetary policy.

The idea of fiscal dominance was formalized by Tom Sargent and Neil Wallace in 1981, but of course the worry that deficit financing may cause inflation has much longer roots in monetary thought.

The idea that tight monetary policy may become impossible without accompanying fiscal adjustment was also well understood when the blueprints for the EMU were being prepared.

This is why the Maastricht treaty had its fiscal policy clauses and also why the Stability and Growth Pact was concluded.

Also the prohibition of direct central bank credit to the government and the institutional independence of the central banks are in effect protections against fiscal dominance.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 28

Now we know, of course, that the fiscal framework as put in place before the start of the EMU was not strong enough to prevent fiscal problems from emerging.

Some have argued that fiscal dominance has taken hold in the in the big industrialized countries during the crisis when the central banks have used government bond purchases in order to stabilize the markets (as the ECB) or to produce additional monetary stimulus when the interest rate instrument has already been used to the maximum (like the Federal Reserve and the Bank of Japan).

As to the euro area, for me there is now no evidence of fiscal dominance. Fiscal dominance implies that monetary policy would break its price stability objective for the sake of maintaining the solvency of the government sector.

This is not the case.

Price stability has not and will not be abandoned.

We have well known fiscal problems in some of the euro area countries.

Still, the ECBs ability to go on maintaining price stability has not been weakened.

In particular the inflation expectations, which are the most essential indicators of the credibility of monetary policy, have remained well in line with the price stability objective.

The parallel idea of financial dominance is more recent than fiscal dominance.

Financial dominance refers to the possibility that the condition of the banking system could become a constraint, or dominant influence, on monetary policy, effectively forcing the central bank to pursue second- or third-best monetary policies in order to maintain financial stability.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 29

Is the spill-over from financial instability to monetary policy a realistic threat?

Can financial stability considerations lead the central banks to tolerate too high inflation, just to keep the banking sector afloat?

In principle it is easy to see why it could be.

One can imagine a central bank which would have to tighten its monetary policy for price stability reasons, but is prevented from doing so for the fear that the value of the assets of the banking system would decrease and a financial crisis could ensue.

Episodes which fit the description of financial dominance have been observed in emerging economies after some banking crises in the past.

But looking at recent experience, this has not been the case in the developed economies.

The bust of the credit boom has not led monetary policy to tolerate a higher-than-mandated rate of inflation.

Instead, in the large developed economies at least, the bursting of the bubble has coincided with a sudden contraction of private demand and a deep recession.

The negative effect of the bust on economic activity has actually reduced inflationary pressures and in some cases (such as in Japan in the 1990s) created a real danger of deflation.

The main problem has then become how to prevent the credit contraction from starting a deflationary spiral.

In such conditions, the same monetary policy will then both ease the strain on the banking sector and support price stability.

This observation does not mean that financial instability would not pose a serious challenge to monetary policy.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 30

On the contrary, the downward impact of a bust, if it is large, may be more difficult to control than the preceding period of credit expansion.

There was a famous discussion on how monetary policy should relate to asset prices in the Jackson Hole conference of 2007, where Rick Mishkin introduced the topic.

At that time, the prevalent thinking in central banking circles was what professor Issing later called the Jackson Hole consensus, meaning that it is better for monetary policy only to clean (up afterwards) than to lean (against the wind).

After the hard lessons we learned over the last five years the case for benign neglect of asset booms and only picking up the pieces afterwards is not so strong any more.

The crisis experience supports rather the idea that financial excesses are better prevented as they happen than only managed after they have caused a recession.

This would be the best way to prevent downward financial dominance which could arise if monetary policy could not effectively counteract credit contraction.

Unconventional tools and the independence of monetary policy

Recent experience shows that the central banks box of potential tools is actually very deep, and if it has become necessary to utilize unconventional tools, as in the present crisis, these new tools have been developed and deployed.

In the case of the ECB, the new tools have included the transition to full allotment auctions, the long term refinance operations up to three years, widening of the scope of eligible collateral, and the various bond purchase programmes.

The most recent of these is the OMT programme announced last summer but not yet commenced in practice.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 31

The development of new tools has been justified.

The slip of the depressed economies to dangerous deflation has been averted, and the debt and banking problems have not developed into systemic financial meltdowns in the affected countries.

We have seen that central banks can pursue successful price stability policy also under very difficult conditions.

The events around the world since the collapse of Lehman Brothers are evidence of that.

Deflation has been avoided despite a severe recession in many countries.

However, there are also certain problems with relying on the enlarged toolkit of the central banks.

The ability to act in crisis has led to the central banks being even called the only game in town.

We should resist this idea and beware of the danger that problems which are fundamentally political could be pushed to central banks to solve.

A division of responsibilities between appointed officials and elected politicians should be preserved.

Monetary policy cannot administer the needed structural transformation in the real sector of the economy or solve excessive deficit problems of governments.

There are situations where the central banks just have to act and do their best to stabilize the economy, even if they would have to use tools which go beyond just adjusting the short rate of interest or the aggregate liquidity of the banking system.

The present financial crisis has constituted one such situation.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 32

Avoiding the busts which seem to follow credit booms and periods of financial exuberance would make the tasks of monetary policy much easier and protect the independence of central banks.

But there are also difficulties with the leaning against the wind.

One has to do with the problem of detecting the credit cycle in time, and correctly timing the monetary policy response.

Another problem is that price stability might get less attention.

To mitigate these problems, something else besides more vigilant interest rate policy is needed to prevent low and stable interest rates from leading to excesses in banks and financial markets.

One development can be the development of macro-prudential instruments which are designed to improve the stability of the financial system as a whole.

The major work in this field was done by the de Larosire group.

Otmar Issing was a member of the group.

Especially interesting are those macro-prudential instruments which have a time dimension so that they can be adjusted according to the changing situation in the credit markets.

Such instruments include, in particular, the countercyclical capital requirements, as well as the adjustable restrictions on Loan-to-Value ratios.

The CRD IV directive will make the former instrument obligatory in the EU countries; implementation of the latter is left to national discretion.

Now it is very important to establish an effective toolkit for both European and national authorities.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 33

We must also create institutional conditions which do not prevent these tools to be used when needed.

Therefore, we need clear decision making competences at all levels.

The connection between macro-prudential policy and its time dimension with monetary policy is so intimate that central banks must be closely involved in macro-prudential analysis and decision making.

Macro-prudential policy is important, but it needs to be supported by structural reforms which would make the banking system more resilient, and - I emphasise - less prone to unstable behaviour.

The Structural reform proposals

In order to prevent the present crisis from being ever repeated, governments and authorities have started a large-scale overhaul of financial regulation.

The regulatory agenda can be broadly divided into the following areas:

Strengthening of the prudential regulation of solvency and liquidity

Improving the institutional basis for supervision and crisis management

Introduction of macro-prudential instruments to prevent systemic risks in the banking system and financial markets

Regulating the structure of the banking sector

The structural reform proposals which appear as the last item on this list aim to separate the riskiest securities and derivatives business from the deposit banking activities.

This is the essential content of the proposals by the EU High Level Expert Group, which I chaired, published last autumn.

It is also at the core of the Volcker rule which is being implemented inInternational Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 34

the US, and the Vickers proposal in the UK.

The current legislative proposals which are underway in France and Germany are also in the same vein.

A particular concern of these proposals has been to limit the extent of explicit or implicit public guarantees, so that they would not induce additional risk taking.

This kind of competitive distortion could result in securities trading getting concentrated in the largest deposit banks, and these deposit banks becoming enormous risk concentrations built on implicit or even explicit public guarantees.

Separation proposals try to isolate securities business from the sources of this distortion and reduce the incentives to excessive risktaking and risk concentration.

In must be emphasized that the structural reform we proposed is not a cure-all but should be seen as a part of a comprehensive regulatory agenda which is already moving forward.

This includes better solvency and liquidity rules.

Also, the EU will finally get supervision and resolution frameworks at the union level.

The different components of the current regulatory agenda complement and support each other.

In this European context, the structure and stability of the banking sector is of vital importance to the economy.

It is imperative to improve its resiliency.

The High Level Expert Group report contains five main recommendations on how to reform the banking sector.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 35

I will just refer to three of them here:

The first is to separate any significant proprietary trading in securities and derivatives from deposit banks.

These activities could be carried out in a separately capitalized and funded subsidiary, a trading entity, which could belong to the same banking group as the deposit bank.

We proposed that also market making be allocated to the trading subsidiary in order to prevent the use of trading inventory to circumvent the prohibition on proprietary trading.

The use of trading subsidiaries would allow the banking groups to offer one-stop banking to their clients, but without the possibility of funding trading activities with insured retail deposits.

Financial linkages between the deposit bank and the trading unit would have to be restricted in accordance to normal large exposure rules.

Another of our proposals is to develop specific, designated bail-in instruments to improve the loss absorbency of banks.

A requirement to issue such bail-in debt would help ensure the participation of investors to the recapitalization of a bank if this should become necessary.

Such designated bail-in instruments would clarify the hierarchy of debt commitments and allow investors to predict the eventual treatment of the respective instruments in case of recapitalization or resolution.

The group also proposed that the capital requirements on trading assets and real estate related loans be reviewed.

Both of these asset categories came to have very low risk weights in the Basel II regime, mostly because the way internal models were applied.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 36

Why banking structure matters for monetary policy

Let me recapitulate my main points.

First, for monetary policy, financial stability is very important.

While monetary policy has proven to be able to pursue price stability even under rather strained financial conditions, the central banks are not able to insulate the real economy completely from the after-effects of financial crises.

A more stable banking sector which is less prone to crisis will reduce the likelihood of crises and therefore protect the balance sheets of the central bank from financial risks and thereby protect its independence and credibility.

Second, the most important part of stability policy is crisis prevention.

Improving loss absorbency of banks and the crisis management powers of the authorities are necessary, but it is even more important to make sure that excessive growth of credit and indebtedness can be better controlled in the future.

In this way, credit crunches and banking crises can be made less likely and milder, should they happen.

Third, financial stability would benefit from structural reform of the banking system.

By separating the most risky securities and derivative activities from deposit banking, the spill over from deposit protection to speculative risk taking would be prevented.

This would reduce the distorted incentives to expand trading activities and concentrate risks in deposit banks because of their privileged position in the deposit market.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 37

Finally, the structural reform of banking is a complement, not a substitute for other regulatory improvements.

For central banks, the development of macro-prudential policies and instruments is especially relevant.

Those macro-prudential instruments which can be adjusted over time to manage the conditions in the credit market will offer a way to better control the accumulation of excess risk and help prevent future crises.

These instruments operate so close to monetary policy that central banks should be very closely involved, if not themselves responsible, in developing and using them.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 38The impact of the crisis on financial integration in Central and Eastern Europe

Speech by Mr Ignazio Visco, Governor of the Bank of Italy, at the conference Twenty yearsof transition experiences and challenges, hostedby the National Bank of Slovakia, Bratislava.

I wish to thank for useful discussion and help Emidio Cocozza, Paolo Del Giovane and Valeria Rolli.

Introduction

The global financial crisis has been severe and widespread, and has affected different economies in different and long-lasting ways.

The transition countries of Central and Eastern Europe were no exception: their quite rapid financial integration over the pasttwenty-years brought about lasting economic benefits, but also left themrelatively exposed to the global financial turmoil, in particular through their links with Western European banks which hold dominant stakes in the regions markets.

Financial stability has once again become a fundamental objective of policy making, and central banks are being heavily involved in this endeavor.

This calls for a substantial overhaul in financial regulation and supervision.

The financial system of tomorrow will be different from the one that has developed over the last two decades.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 39

Global financial integration during the past decade

In the decade before the financial crisis both the size of the financial system and its role and pervasiveness in the economy increased dramatically.

The process has only slowed down since the crisis.

In the euro area, the overall amount of financial resources collected by the private sector (bank credit, bonds issued domestically and stock market capitalization) rose from 160 per cent of GDP in 1996 to 240 in 2007, and then declined to 230 in 2011.

A similar pattern is found for the United States, where the ratio rose from 230 per cent in 1996 to 330 in 2007 and then declined to 260 in 2011 (Fig. 1).Driven by the breakthroughs in information technology and telecommunications and the process of financial integration, the supply of derivatives products, the securitization of banks assets, together with the growth of so-called structured financial instruments, expanded considerably.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 40

The total outstanding notional amount of over-the-counter (OTC) and exchange-traded derivatives has risen from about 94 trillion U.S. dollars at the end of 1998 to around 670 trillion at the end of 2007, hovering around that level afterwards (Fig. 2).An important dimension of this process has been the increased international financial integration.

In the last decade industrial countries gross external financial assets and liabilities more than doubled in proportion to GDP, reaching 440 per cent at the end of 2007 (Fig. 3).International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 41The development of financial markets in emerging economies has also been dramatic.

The overall amount of financial resources collected by the private sector (outstanding stocks of bank credit, domestic debt securities and equity market capitalization) increased from about 120 to 230 per cent of GDP between 1996 and 2007 for the average of emerging Asia, and from about 40 to almost 100 per cent for the average of CEE countries (Fig. 4).International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 42International financial integration with foreign direct and portfolio investments and the involvement of foreign banks in domestic financial systems was helped by the removal of earlier obstacles: macroeconomic instability, vulnerable external positions and inefficient institutional and regulatory setups.

Since the mid 2000s, this process was hugely supported by exceptionally favorable global financial conditions, with abundant liquidity, low risk aversion, and falling long-term interest rates.

Financial integration in Central and Eastern Europe

The transition countries in Central and Eastern Europe were the recipients of a large influx of international capital, mostly flowing in from Western Europe.

Between 2003 and 2008 capital inflows reached sustained levels more than 12 percent of GDP on average well above the overall average for emerging market countries (about 6 percent) (Fig. 5).International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 43Transition countries were perceived as attractive outlets: potential high returns, underpinned by relatively low wages and capital-output ratios, were magnified by the prospects for faster income convergence entailed by the economic and institutional developments in the context of EU membership, and by the expectations of rapid interest rate convergence linked to the eventual euro adoption.

Financial integration in the CEE has tended to be quite unique.

International banks played a fundamental role indeed in spurring financial integration in the region.

In the years running up to the global financial crisis, Western European banks expanded rapidly, gaining large market shares through their subsidiaries and branches, up to about 80 percent of total banking assets by 2008.

The entry of foreign intermediaries with long-term strategic goals and the ensuing profound transformation of the ownership structure of banking systems in CEE countries was a crucial element of discipline and stability in breaking the vicious cycle of systemic banking crises and macroeconomic volatility that had characterized the early years of transition.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 44

It is generally accepted that international financial integration has tended to play a positive role in the long-term economic convergence process in CEE transition countries:

Long-term per capita GDP growth in the region before the crisis was positively correlated with conventional measures of financial integration, such as the ratio of gross foreign assets and liabilities to GDP (Fig. 6).The corresponding evidence for other emerging areas tends to be less clear cut.

The aforementioned favourable feature possibly reflects the interaction with institutional convergence, implicit in the EU accession process, as a key contributing factor.

Thanks to this unique and favourable combination, financial integration in itself most likely acted as a catalyst for the development of the domestic financial sector and the adoption of structural reforms to strengthen the institutional framework.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 45

Yet a balanced account of the process of financial integration in this region should not overlook its drawbacks in terms of excessive, cheap lending, currency mismatches and demand overheating in the years running up to the crisis.

Between 2003 and 2008, many economies recorded rapid import growth, real estate bubbles and wage increases well above productivity gains sometimes rooted in overly optimistic expectations of fast income convergence.

Inflationary pressures spilled over into the tradable sector and worsened export performance.

Balance of payments current account deficits widened (Fig. 7).Several countries built up high external debt levels (Fig. 8), largely private and denominated in foreign currency, making them vulnerable to capital flow reversals and currency depreciation.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 46When the effects of the global crisis reached the CEE countries, their economies were hit by a sharp decline in capital inflows and the ensuing slowdown in bank credit (Fig. 9).Notwithstanding concerns regarding a possible meltdown of domestic financial systems driven by a run for the exit of foreign banks, aInternational Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 47

fully-fledged financial crisis similar to the ones which occurred in East Asia in 199798 did not materialize.

Overall, the region even experienced, in the first phase of the crisis, a less severe reversal of capital flows than other emerging areas.

In some cases (Hungary, Latvia and Romania) large international financial support by the EU and the main international financial institutions (IFIs) was a key factor in avoiding the worst; coordination efforts by home and host country authorities, IFIs and multinational banks, in the context of the Vienna Initiative, also helped prevent collective action problems that could have triggered the dreaded massive withdrawal from these markets by foreign banks.

There is evidence that foreign banks that participated in the Vienna Initiative were relatively stable lenders.

Moreover, the distinctive model of financial integration in the CEE region where foreign banks operate mainly through their local subsidiaries and branches in the retail market probably provided a high degree of risk sharing and stability during the crisis, as parent banks were generally less sensitive to information asymmetry and counterparty credit risk and more committed to long-term market prospects, given the important sunk costs associated to these structures.

This compares favourably to the pattern prevailing in the other EU countries, where external borrowing by domestic banks occurs mainly via crossborder wholesale markets.

The different intensity of the boom-bust cycle observed across the CEE countries suggests that, in addition to the influence of specific structural features (such as differences in starting income levels, international trade and financial links), domestic policy had a role, although capital inflows of the magnitudes observed in the region in the run up to the global crisis would certainly have strained any toolkit available to national policy makers.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 48

Monetary and exchange rate regimes most likely played a critical role in determining the countrys ability to counteract the effects of capital inflows, as there were differences in the size of the internal and external imbalances between fixed and floating exchange rate countries.

Indeed, countries adopting a fixed exchange regime experienced more pronounced credit booms, higher inflation rates and larger account deficits than the average for floating exchanges regime countries.

Yet, the assessment of the contribution of the exchange rate regime remains an open issue, as it is unclear to what extent the most pronounced boom-bust cycle was mainly driven by the fixed exchange regime per se or by the inconsistency of the overall policy mix pursued in countries where this setting was in place; in particular, a stricter fiscal stance and a better framework of macroprudential policy could have at least partly compensated for the absence of exchange rate flexibility.

As for monetary policy, the experience of CEE countries tends to confirm that in small, financially open economies it is a less effective lever for restraining credit booms.

This is the case even for floating exchange regimes, as a numbers of factors currency substitution in the form of balance sheet effects associated with initial high euroization, or the shifts toforeign-currency-denominated lending could restrain the effectiveness of monetary policy tightening, or even reverse its intended effects.

This underscores the importance of maintaining prudent fiscal stances during credit booms.

Indeed, in the run up to the crisis, headline fiscal positions remained broadly balanced in most CEE countries; yet these outcomes were frequently the result of exceptional revenues associated to cyclical demand and asset price booms.

Once adjusted for the latter underlying fiscal positions looked much less healthy.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 49

One recognizes, in retrospect, the need for a conservative approach in the assessment of tax revenues during a boom phase, and the useful role of automatic stabilizers (particularly income taxes and welfare spending) in order to increase fiscal policy flexibility and dampen economic fluctuations.

In addition to standard macro policy tools, CEE countries also adopted a wide range of prudential actions before the last global crisis.

Prudential instruments have the potential to prevent or contain systemic financial risks in the upswings (affecting the incentives associated with asset price booms, foreign exchange lending, excessive risk taking and the erosion of lending standards) and also to build buffers that can cushion the impact of downturns.

In general the evidence is that these measures produced the intended effects in the short run, but they sometimes failed to have a long lasting impact on credit dynamics.

Indeed, in some instances circumvention through direct cross-border financing and/or lending from nonbank (unregulated) financial intermediaries proved to be a major issue; this has been the case for example for measures consisting in direct limits on credit growth.

A more effective role in containing systemic financial risks has been played by measures specifically devised to build liquidity andloss-absorbing capital buffers, such as reserve and capital requirements.

Moreover, when appropriately formulated, prudential regulations helped to curb the growth of foreign exchange loans and to keep related default rates lower during the crisis.

Lessons learnt from the global crisis: in search of better regulation

Global financial deepening and international integration has allowed greater risk sharing and has made finance accessible to larger numbers ofInternational Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 50

countries, households and firms, thus being instrumental to broadening economic development.

But an interlinked and more connected financial system heightens the risk that contagion sets off and spreads more widely.

Most importantly, the crisis has shown that market participants were not capable of mastering the inherent complexity of the system that they themselves had contributed to develop.

And it has highlighted the limits of the idea that self-regulation and market discipline are sufficient to ensure stable financial systems.

In this regard, accepting the idea that benign neglect was the right course of action was a critical mistake on the part of regulators.Rather, financial regulation and supervision must keep pace withdevelopments in the financial industry.

Moreover, national authorities need to be aware of the risk that their powers may become narrow compared to the sphere of influence of the global financial players.

The coordination of financial supervision across borders and across sectors is a key condition for the stability of the global financial system.

A major effort is required, at a national but especially at an international level, in order to strengthen the regulatory and supervisory framework.

At the international level, under the political impulse of the G-20, the Financial Stability Board (FSB) and the Basel Committee on Banking Supervision (BCBS) have introduced substantial regulatory changes to prevent new financial crises and increase the resilience of economic systems.

Much has been already achieved.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 51

The quantity and quality of capital that banks need to hold has been significantly enhanced to ensure that they operate on a safe and sound basis.

There also have been introduced international standards for bank liquidity and funding, designed to promote the resilience of banks to liquidity shocks.

Initiatives have been promoted to strengthen the regulation of the OTC derivatives market, aimed at reinforcing market infrastructures, in order to minimize contagion and spill-over effects among players that have become more and more interconnected.

However, further progress is needed in important areas, as bank capital and liquidity regulation must be accompanied by improvements in internal risk control arrangements and actions aimed at correcting incentives to excessive risk-taking.

Moreover, a level playing field must be achieved, as countries relaxing rules in order to attract financial intermediaries generate negative externalities for other countries.

The transition to a uniform system of rules and oversight of the financial sector must be hastened.

In the euro area, and in the European Union at large, the plan for a banking union is ambitious, but it goes in the right direction.

It would, among other things, limit regulatory arbitrage, help remove national bias in supervision, reduce the phenomenon of regulatory capture by powerful cross-border banks, at the same time reducing costs of compliance for cross-border banks and enhancing the functioning of the Single market for financial services.

The envisaged European banking union would also benefit CEE economies: it would work against the fragmentation of the European financial markets along national lines; moreover by enhancing the financial resilience of the euro area it would reduce the risks of negativeInternational Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 52

spill-over effects from the euro area to CEE banking systems.

Final remarks

The recovery of CEE economies remains fragile.

With few exceptions, output has not yet returned to pre crisis levels, dragged by debt overhang and direct and indirect exposure to the eurozone debt crisis.

Import demand by the euro area remains at depressed levels.

Financial conditions, although improved compared to the end of 2011, remain volatile.

Bank credit dynamics remain weak, reflecting subdued domestic demand and high non-performing loans.

The banking systems of most CEE countries, however, remain well capitalized and can therefore withstand the lingering deterioration of their asset quality.

Moreover, the financial legacy of the crisis will not be transitory.

The evolution of the international banking sector over the coming years will continue to shape financial conditions also in CEE countries.

The regulatory and supervisory responses adopted at global level will imply more stringent prudential requirements for capital and liquidity.

In response to these more demanding rules, as well as to spontaneous market forces, international banks are adapting their business strategies, unwinding pre-crisis unsustainable practices and shifting to longer-term financing sources.

In this context the main European banks with large stakes in CEE markets are gradually switching to more decentralized business models,International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 53

where subsidiaries would have to rely more on local sources of funds, setting lending conditions accordingly.

Although orderly and even desirable for the resiliency of the global financial system, this process may exert significant pressures on emerging countries that are highly dependent on external financing owing to underdeveloped domestic financial systems and structurally low national savings rates.

Indeed, this process calls for decisive reforms to bolster the development and deepening of local money and capital markets, including local currency denominated bonds.

This is a long-term and complex process, which involves a suitable legal framework, adequate infrastructures, a large institutional investor base, stable macroeconomic conditions and predictable policy making, as exemplified in extensive analysis and ensuing guidelines carried out at the Bank of International Settlements (BIS), the World Bank and the G20.

Several of these conditions have already been achieved in the process of integration in the EU.

Against this changing financial environment, there is the risk that, on the grounds of preserving financial stability at domestic level, national regulators could adopt ring fencing measures, hampering the smooth functioning of the EU single market.

As the long-term benefits of free capital mobility and international financial integration remain sizable, this risk calls for a stronger role by the EU institutions, notably the European Commission (EC) and the European Banking Authority (EBA), in monitoring these measures and enhancing coordination among national regulators, in order to avoid a fragmentation of the European financial markets.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 54Revised rules for markets in financial instruments (MiFID/MiFIR)

Proposal for a Directive of the European Parliament and of the Council on markets in financialinstruments repealing Directive 2004/39/EC of theEuropean Parliament and of the Council (Recast) (MiFID)

Proposal for a Regulation of the European Parliament and of the Council on markets in financial instruments and amending Regulation [EMIR] on OTC derivatives, central counterparties and trade repositories (MiFIR)

INTRODUCTION

The Commission transmitted the above mentioned proposals to amend the current MiFID to the Council on 20 October 2011.

The objective of this legislative package is, inter alia, to further the integration, competitiveness, and efficiency of EU financial markets by responding to the challenges created by developments in financial markets, and dealing with the weaknesses the financial crisis has exposed.

The legislative package amending MiFID has two parts:

- A Regulation sets out requirements in relation to the disclosure of trade transparency data to the public and transaction data to competent authorities, removing barriers to nondiscriminatory access to clearing facilities, the mandatory trading of derivatives on organised venues, specific supervisory actions regarding financial instruments and positions in derivatives.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 55

- A Directive amends specific requirements regarding the provision of investment services, the scope of exemptions from the current Directive, organisational and conduct of business requirements for investment firms, organisational requirements for trading venues, the authorisation and ongoing obligations applicable to providers of data services, powers available to competent authorities, sanctions, and rules applicable to third-country firms operating via a branch.

Intensive negotiations have been going on during the PL, DK, CY and IE Presidencies aiming at an agreement on the Council's general approach, which would allow the Presidency to start negotiations with the European Parliament with a view to reaching a first reading agreement.

The EP ECON Committee voted on its reports on 26 September 2012, and the EP position was further confirmed by the Plenary on 26 October 2012.

During the discussions at the Working Party on Financial Services the Presidencies have tabled several overall compromise proposals and other texts in order to make progress on the file.

II. STATE OF PLAY

While significant progress has been made towards achieving agreement on a Council general approach, during the latest meeting of the Working Party on Financial Services (Attachs) on 11 April 2013, there was not yet a qualified majority supporting an overall compromise in particular because of the key outstanding issue of access to trading venues and central counterparties (CCP) (MiFIR, Articles 28-30).

Access (Articles 28-30 MiFIR)

To avoid any discriminatory practices and to remove various commercial barriers that can be used to prevent competition in the clearing of financial instruments, the Commission Proposal provided in the Regulation (MiFIR) that CCPs should accept to clear transactions executed in different trading venues, to the extent that those venues comply with the operational and technical requirements by the CCP.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 56

Access should only be denied if certain access criteria are not met (Article 28 MiFIR).

Trading venues should also be required to provide access including data feeds on a transparent and non-discriminatory basis to CCPs that wish to clear transactions executed on the trading venue (Article 29 MiFIR).

In addition, access to licences of, and information relating to, benchmarks that are used to determine the value of financial instruments should be provided to CCPs and trading venues (Article 30 MiFIR).

The non-discriminatory clearing access for financial instruments has proved to be a difficult issue throughout the negotiations on MiFIR, with delegations being split into two groups.

One group is in favor of maintaining the provisions of Articles 28 and 29, as proposed by the Commission, for the reasons mentioned above, whereas the other group is in favor of deleting these Articles as they believe that non-discriminatory access will lead to fragmentation at the trading level and to reduction in liquidity.

Furthermore, some delegations have doubts on the relationship between Article 30 (nondiscriminatory access and obligation to licence benchmarks) and intellectual property rights whereas other delegations consider that Article 30 is necessary as it tackles the issue of monopolies and thus enhances competition.

The Presidency has proposed a compromise solution in Articles 28-30 of MiFIR (doc. 7743/13 REV 2), which is based on a non-discriminatory access to CCPs, trading venues and licence benchmarks, providing at the same time necessary safeguards related to orderly functioning of the markets and liquidity fragmentation.

This solution is acceptable to several delegations, but there are, however, a number of delegations which have outstanding concerns, and to whom the deletion of Articles 28-30 would be the preferred option.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 57

In these circumstances, the Presidency considers that its compromise solution is the only viable option to address this issue.

However, the Presidency acknowledges that there are still serious concerns.

If these concerns are not resolved the Presidency suggests that at the time of the agreement on the general approach, a statement as set out in the Annex would be entered into the minutes of Coreper.

Apart from the abovementioned issue there are certain other issues that require further work.

The Presidency considers that this work can be completed at Working Party level, if an agreement on Articles 28-30 in MiFIR can be achieved at Coreper.III. CONCLUSION

9. The Presidency therefore suggests that the Permanent Representatives Committee:

agrees on Articles 28-30 in MiFIR as set out in doc. 7743/13 REV 2;

in the event that agreement is not reached on articles 28-30 MiFIR, agrees on the content of the statement set out in Annex, which is to be entered into the minutes of Coreper at the time of final agreement on the general approach, and

invites the Working Party on Financial Services (Attachs) to finalise the the text, and submit the general approach for agreement by Coreper in the very near future .

Statement by the Council

The Council notes the divergent positions of Member States on certain aspects of the Presidency's proposed general approach, in particular as regards to clearing access provisions (articles 28-30).International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 58

It invites the Presidency to start negotiations with the European Parliament on the basis of this general approach, taking into account the need for further work to try to resolve outstanding issues.International Association of Risk and Compliance Professionals (IARCP) www.risk-compliance-association.comP a g e | 59APRA releases second consultation package for the supervision of conglomerate groups

The Australian Prudential Regulation Authority (APRA) has today released for consultation proposed risk management and capital adequacy requirements for the supervision of conglomerate groups.

Conglomerate groups, referred to as Level 3 groups, are groups comprising APRA-regulated institutions that perform material activities across more than one APRA-regulated industry and/or in one or more non-APRA-regulated industry.

The consultation package released today includes a response to submissions received on APRAs March 2010 discussion paper on the super