Monday May 28 2012 - Top 10 risk and compliance management related news stories and world events that (for better or for worse) shaped the week's agenda, and what is next

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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.com

Top 10 risk and compliance management related news stories
and world events that (for better or for worse) shaped the week's
agenda, and what is next

George Lekatis
President of the IARCP
Dear Member,

Are you fit and proper?

Yes, risk and compliance management professionals, auditors, senior
managers and board members must be fit and proper, and the definition
is becoming more interesting.

For example, in Article 42 of the Solvency II Directive of the EU, we read:

Article 42

Fit and proper requirements for persons who effectively run the
undertaking or have other key functions

1. Insurance and reinsurance undertakings shall ensure that all persons
who effectively run the undertaking or have other key functions meet at
all times the following requirements:

(a) Their professional qualifications, knowledge and experience are
adequate to enable sound and prudent management (fit);

(b) They are of good repute and integrity (proper).

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

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2. Insurance and reinsurance undertakings shall notify the supervisory
authority of any changes to the identity of the persons who effectively run
the undertaking or are responsible for other key functions, along with all
information needed to assess whether any new persons appointed to
manage the undertaking are fit and proper.

3. Insurance and reinsurance undertakings shall notify their supervisory
authority if any of the persons mentioned in paragraphs 1 and 2 have been
replaced because they no longer fulfil the requirements referred to in
paragraph 1.

Later, we had some interesting technical measures where we can learn
more:

Persons who effectively run the undertaking or have other key functions
are not limited to the members of the administrative, management or
supervisory body, but could include other persons such as senior
managers.

The other “key functions” are those considered critical or important in
the system of governance and include at least the risk management, the
compliance, the internal audit and the actuarial functions.

Other functions may be considered key functions according to the nature,
scale and complexity of an undertaking’s business or the way it is
organised.

Minimum standards are therefore set concerning the fitness and propriety
of corporate officers who occupy key management positions.

Insurers need to demonstrate that these persons are adequately qualified
and proper to do their jobs.

This is the reason insurers and reinsurers compete to hire qualified
professionals, and Solvency ii is often called "The Risk and Compliance
Managers' Full Employment Act"

Insurers and reinsurers headquartered outside the EU ('third-country
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insurers') are also affected. Solvency ii includes specific rules for branches
of direct insurers headquartered outside the EU which are similar to those
applied to branches of insurers headquartered within the EU.

Many non-EU countries try hard to become Solvency ii Equivalent.
Equivalence assessments aim to ensure that the third country regulatory
and supervisory regimes provide a similar level of policyholder /
beneficiary protection as the one provided under the Solvency II
Directive.

In case of a positive equivalence determination Member States are
required to treat reinsurance contracts concluded with undertakings
having their head office in the third country whose regime has been
deemed equivalent, in the same manner as reinsurance contracts
concluded with an undertaking which is authorised under the Solvency II
Directive.

In case of a positive equivalence determination Member States shall not
require the localisation within the Community of assets held to cover the
technical provisions covering risks situated in the Community, nor assets
representing reinsurance recoverables.

***

Welcome to the Top 10 list.

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The fit and proper requirements…
Tribunal upholds FSA decision to ban and fine former UBS
advisers £1.3m for not being fit and proper in relation to an
unauthorised trading scheme
21 May 2012

Remarks by Thomas J. Curry
Comptroller of the Currency

Before the Exchequer Club

We welcome the Private Company Council (PCC)

The Financial Accounting Foundation
(FAF) Board of Trustees established a
new body to improve the process of
setting accounting standards for
private companies

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Speech by Andrea Enria, Chairperson of the
European Banking Authority
Financial integration and stability in Europe:
the role of the European Banking Authority
23 May 2012, at the 15th China Beijing International High Tech Expo
China Financial Summit 2012

Rasheed Mohammed Al Maraj:
Corporate governance and Shari’a
compliance in Bahrain
Welcome speech by His Excellency Rasheed Mohammed Al Maraj,
Governor of the Central Bank of Bahrain, at the AAOIFI (Accounting and
Auditing Organisation for Islamic Financial Institutions) Annual Shari’a
Conference, Manama, May 2012.

A route for Europe
Address by Mario Draghi, President of the ECB, at
the day in memory of Federico Caffè
organised by the Faculty of Economics and the
Department of Economics and Law at the Sapienza
University, Rome, 24 May 2012

Gabriel Bernardino, Chairman of EIOPA
EIOPA, Solvency II and the Loss Adjusting
Profession
General Assembly of the European Federation of
Loss Adjusting Experts
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Risk Management opportunities in the
public sector

Information implicit rather than
explicitly expressed
Can automated deep natural-language
analysis unlock the power of inference?

Testimony Before the US Senate Committee on Banking,
Housing and Urban Affairs, Washington, DC

CFTC Chairman Gary Gensler
May 22, 2012

Challenges facing the Swiss
National Bank
Speech by Mr Thomas
Jordan, Chairman of the Governing Board of the Swiss National Bank, to
the General Meeting of Shareholders of the Swiss National Bank, 27 April
2012.

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The fit and proper requirements…

Tribunal upholds FSA decision to ban and fine former UBS
advisers £1.3m for not being fit and proper in relation to an
unauthorised trading scheme
21 May 2012

The Upper Tribunal (Tax and Chancery Chamber) has directed the
Financial Services Authority (FSA) to fine Sachin Karpe £1.25 million and
Laila Karan £75,000 and ban them both from performing any role in
regulated financial services for failing to act with integrity, in breach of
Principle 1 of the FSA’s Statements of Principles and Code of Conduct for
Approved Persons (“APER”) and for not being fit and proper persons.

Between January 2006 to January 2008, Karpe was Desk Head of the Asia
II Desk at UBS AG (UBS) international wealth management business in
London.

Between February 2007 and January 2008, Karan worked as a Client
Advisor on the Asia II Desk, reporting directly to Karpe.

The Asia II Desk provided services to customers resident in India, or of
Indian origin.

Karpe
During the relevant period Karpe carried out substantial unauthorised
trading, predominantly in FX instruments, with a gross value of billions of
pounds across 39 customer accounts.

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He also made unauthorised transfers and loans between client accounts
in order to conceal losses arising from the unauthorised trading.
He directed others (including Karan) to assist him in arranging the
transfers and loans, and creating false documentation for the
unauthorised trading.
His scheme resulted in substantial losses for 21 customers.
UBS has since paid compensation to the affected customers in excess of
US$42 million.
Karpe also established an investment structure to enable a major (Indian
resident) customer (via an investment fund incorporated in Mauritius) to
breach Indian law in clear contravention of UBS guidelines.
Ultimately, the customer invested over US$250 million in the fund.
Karpe deliberately and repeatedly misled compliance in order to
accommodate his customer.
Karpe also misled UBS and senior management about paying
compensation to a customer using monies from another customer
account.
The Tribunal found that:
“Mr Karpe induced others serving on his desk to participate in what was
an obviously dishonest course of conduct...we infer that the whole
motivation was to benefit him indirectly and in the long term by obtaining
new clients through his apparent prestige, increasing funds under
management and thereby advancing his career and increasing his
bonuses.”
The Tribunal accepted that the compliance failings at UBS might have
created an environment within which staff could “get away with”
misconduct – however, this was no excuse for Karpe’s sustained
dishonesty.

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Karan
Karan did not instigate the unauthorised trading; however, she was aware
that unauthorised activity was occurring on some customer accounts for
which she was responsible.
Between February 2007 and January 2008, rather than escalating this
knowledge, Karan assisted Karpe in concealing the unauthorised activity.
In particular, Karan prepared false, handwritten telephone attendance
notes purporting to record customer instructions she had received when
she had taken no such instructions; routed transactions through a
suspense account in order to conceal their origin and destination; signed
a number of UBS documents recording the approval of transactions on
the accounts without having received instructions or authorisation from
the customers; and failed to escalate her knowledge of unauthorised loans
between customers.
Ms Karan also failed to escalate her knowledge that Mr Karpe had misled
UBS and senior management about paying compensation to a customer
using monies from another customer account.
The Tribunal noted that:
“We recognise that Ms Karan had been placed in an extremely awkward
situation through the manipulation of Mr Karpe.
The fact, however, is that over and over again she chose to go along with
and, on occasions, to facilitate Mr Karpe’s wrongdoing.”
Tracey McDermott, acting director of enforcement and financial crime,
said:
“Karpe exploited and abused his position of trust, and persuaded more
junior employees to engage in misconduct to assist him.
Such behaviour is in breach of his obligations to his employer, his clients
and his colleagues as well as to the regulator.
It has no place in the financial services industry.

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We welcome the Tribunal’s confirmation that as well as banning Karpe, a
significant financial penalty should also be imposed.
This sends a clear message of the consequences of such behaviour.
“Karan sought to categorise herself as a victim in this matter. The
Tribunal (as had the FSA) recognised that she did not initiate the
misconduct, and was placed in a difficult position by Karpe.
However, the findings and the resulting sanctions send a clear message
that an approved person must take responsibility for their own actions.
Where an approved person is aware that colleagues are engaging in
misconduct, we expect them to blow the whistle, not to become involved
themselves.
“Those who take on the responsibility of being an approved person
should be in no doubt about our commitment to take the strongest action
to tackle behaviour which falls below the high standards we expect.”
In November 2009 the FSA fined UBS £8million for systems and controls
failures in relation to the unauthorised activity which occurred on the Asia
II Desk.
In December 2011 Jaspreet Singh Ahuja and in November 2009 Andrew
Cumming, both former Asia II Desk client advisers, were banned and
fined £150,000 and £35,000 respectively.

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Remarks by Thomas J. Curry Comptroller of the Currency
Before the Exchequer Club
Thank you for inviting me back to the
podium of the Exchequer Club, which is
home to so many good friends and
colleagues.
It is a great honor to come before you as
Comptroller of the Currency. Twenty-nine
distinguished Americans have held the
office since the OCC was founded nearly 150
years ago, and I’m proud to be the bearer of
their legacy.

After all that has happened over the past
half-decade, I feel fortunate indeed to
assume the responsibilities of the office at a
time when the system of national banks and federal thrifts is on the mend
and returning to a satisfactory condition.

On average, balance sheets are stronger, earnings are improving, and the
number of problem institutions and institutional failures, while still too
high, is declining.

Asset quality has been improving over the past several years.

Among our largest banks, charge-off rates have fallen across all product
lines, with reductions of 50 percent or more from 2009 levels in credit
cards, commercial and industrial lending, and commercial real estate.

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Better asset quality has enabled banks and thrifts to trim new provisions
for loan-losses, increasing the resources available for their own and their
customers’ use.

Some asset concentrations remain embedded in institutions’ portfolios,
particularly in residential real estate, but they are mitigating the risks
such concentrations entail.

Capital now stands at its highest level in a decade, system-wide – the
result of increased earnings, low dividend payouts, new capital issuances,
and reductions in risk-weighted assets.

And with a strong base of deposits, banks and thrifts have the liquidity
they need to handle any reasonable contingency.

These improving measures of financial health do not mean that the
institutions we supervise are out of the woods.

Loan demand remains sluggish, as the economy continues to
under-perform.

Non-interest income is down, and the yield curve continues to be
unfavorable.

These factors all bear watching, keeping in mind that failures in the
fundamentals of sound credit underwriting and balanced growth drove
the decline from which we’re still recovering.

Our economic prospects – local, regional, national and international –
depend on a banking system that is both safe and sound.

But as the industry continues to heal from the credit and capital market
challenges of the financial crisis, it is evident that another type of risk is
gaining increasing prominence.

That is operational risk—generally defined as the risk of loss due to
failures of people, processes, systems, and external events.

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The risk of operational failure is embedded in every activity and product
of an institution – from its processing, accounting, and information
systems to the implementation of its credit risk management procedures.

Managing operational risk requires banks and thrifts to control the
straightforward things – like ensuring that legal documents are properly
signed and contain accurate information – as well as the more
multifaceted ones, like validating the inputs, assumptions, and
algorithms in their risk models.

Operational risk is heightened when these systems and procedures are
most complex.

Given the complexity of today’s banking markets and the sophistication
of technology that underpins it, it is no surprise that the OCC deems
operational risk to be high and increasing.

Indeed, it is currently at the top of the list of safety and soundness issues
for the institutions we supervise.

This is an extraordinary thing.

Some of our most seasoned supervisors, people with 30 or more years of
experience in some cases, tell me that this is the first time they have seen
operational risk eclipse credit risk as a safety and soundness challenge.

Rising operational risk concerns them, it concerns me, and it should
concern you.

We all know about the damage operational deficiencies can cause.

Inadequate systems and controls were a primary reason for the recent
problems in mortgage servicing and foreclosure documentation
practices—problems that have had a big impact on the reputation and
financial condition of the large banks that were implicated in those
practices, on the timely clearing of non-performing loans, and on the
general housing market.

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Those banks did a poor job supervising both their own internal processes
and the providers to which they outsourced some of these functions, and
they are paying the price for their mistakes.

Operational risk for institutions of all sizes can arise also from flawed risk
assessment and risk management systems within the institution.

For community institutions with credit concentrations, a flawed
assessment of risk can lead to inadequate controls and insufficient risk
management systems.

For the largest institutions, the challenges here can be exceedingly
complex.

One example takes the form of faulty risk assessment and risk
management of the inter-relationship of risks in different markets on the
value of the institution’s assets.

Too often, we have seen conspicuous and expensive examples of the toll
that one form of operational risk—flawed risk models—can take.

This so-called "model risk" is a species of operational risk, and is an
important supervisory issue.

Together with the Federal Reserve, we issued supervisory guidance on
model risk management about a year ago.

This replaced previous OCC guidance on model validation and
emphasized the importance of approaching model risk as an important
focus of risk management for institutions that make material use of
models.

The guidance stresses the need for ongoing monitoring and analysis to
ensure that models are likely to continue to perform as expected.

In line with that guidance, and in view of the complexity of some models,
institutions should be comparing their model results to the results of

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alternative approaches, and should supplement model results with other
information and analysis.

This helps avoid narrow reliance on single approaches, which can
increase the risk of model failures and the related operational losses.

The OCC has directed the institutions we supervise to comply with this
guidance, and we actively apply it through our ongoing supervisory
processes.

Yet, as banks and thrifts face greater resource constraints and higher
compliance costs, they may feel greater pressure to economize on
systems and processes in order to enhance their income and operating
economies—and therefore may be at greater danger of those systems and
processes breaking down.

All institutions, regardless of size, must resist the temptation to
under-invest in the systems and controls they need to prevent greater risk
and larger losses in the future.

They should take their cues from the cases in which such breakdowns
have occurred. Many examples exist in addition to those I’ve just
described.

For example, where financial institutions have been less than vigilant
about the IT security of processors with whom they contract to provide
merchant processing services, breaches have occurred, and millions of
credit and debit account holders were impacted.

Banks and thrifts lacking adequate controls over their third-party
marketing relationships have unwittingly given their blessing to
consumer financial products with unfair and deceptive characteristics,
exposing the institution to sanctions by the OCC for unfair and deceptive
practices.

And we’ve seen institutions outsourcing such functions as debt collection
but not taking adequate care to ensure that the third-party contracted to
perform those functions follows the laws and regulations governing them.
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The result has been regulatory penalties and reputational damage.

Let me say that the OCC is very supportive of efforts by the banks and
thrifts it supervises to operate efficiently and to offer a wide range of
products and services that provide value to the consumer.

That’s what a safe and sound banking system must do, and sometimes
those goals are best advanced through partnerships with third-parties.

But when a bank or thrift enters into a third-party relationship, it must
understand that it does not wipe its hand of responsibility for the quality
and characteristics of the products that are offered to its customers
through this channel—even if those products are not marketed with the
institution’s brand.

Due diligence in identifying, measuring, and monitoring the risk from
third-party relationships, and establishing mechanisms for controlling
and continuously monitoring those risks, is thus an essential part of
managing operational risk, which in turn affects its safety and soundness.

An area where the intersection of operational and other risks is very
evident today concerns Bank Secrecy Act and anti-money laundering
compliance.

When things go wrong in those areas, not only is the integrity of the
institution’s operations compromised, but national security and drug
trafficking interdiction goals can be undermined, as well.

This, too, affects institutions of all sizes, even though it’s large banks that
are most likely to make the headlines when they are found to have
BSA/AML deficiencies.

But the OCC also is finding a rising number of BSA/AML problems in,
and taking appropriate supervisory and enforcement actions against,
midsize and community institutions, for problems that include ineffective
account monitoring, inadequate tracking of high-risk customers and bulk
cash transactions, and lapses in monitoring suspicious activity.

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BSA/AML compliance is inherently difficult.

It combines the challenges of sifting through large volumes of
transactions to identify features that are suspicious, with the presence of
criminal and possibly terrorist elements dedicated to and expert in
concealing the nature of the transactions they undertake.

Rendering BSA/AML compliance more challenging is the fact that
BSA/AML risks are constantly mutating, as criminal and terrorist
elements alter their tactics to avoid detection and penetrate our defenses.

They move quickly from one base of operations to another, finding
sanctuary in places where law enforcement, or sympathy for U.S. policy
objectives are weakest.

Thus, success is often transient where BSA/AML is involved, and efforts
must be constantly re-energized.

Controls that may be entirely adequate today may prove inadequate for
tomorrow’s risks and threats.

However, it is critical that banks and thrifts instill strong cultures and
oversight processes.

Management needs to focus on key controls and maintain knowledgeable
and sufficient staff.

We can never underestimate the determination and ingenuity of our
adversaries—and we must be equal to that risk as it evolves.

This, I recognize, is a major challenge.

If we are to defend the security of our financial system and our nation—as
we must—industry and government cooperation is crucial.

As regulators, one of our most important jobs is to identify risk trends and
bring them to the industry’s attention in a timely way.

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No issues loom larger today than operational risk in all its dimensions,
the manner in which all risks interact, and the importance of managing
those risks in an integrated fashion across the entire enterprise.

These themes are a supervisory priority for us at the OCC today and they
should similarly command the attention of the industry.
Thank you.

Note:
Thomas J. Curry was sworn in as the 30th Comptroller of the Currency on
April 9, 2012.
The Comptroller of the Currency is the administrator of national banks
and chief officer of the Office of the Comptroller of the Currency (OCC).
The OCC supervises more than 2,000 national banks and federal savings
associations and about 50 federal branches and agencies of foreign banks
in the United States.
These institutions comprise nearly two-thirds of the assets of the
commercial banking system.

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We welcome the Private Company Council (PCC)

Financial Accounting Foundation Establishes New Council to
Improve Standard Setting for Private Companies

Washington DC, May 23, 2012—After seeking and considering extensive
public comment, the Financial Accounting Foundation (FAF) Board of
Trustees today established a new body to improve the process of setting
accounting standards for private companies.

The new group, the Private Company Council (PCC), will have two
principal responsibilities.

Based on criteria mutually developed and agreed to with the Financial
Accounting Standards Board (FASB), the PCC will determine whether
exceptions or modifications to existing nongovernmental U.S. Generally
Accepted Accounting Principles (U.S. GAAP) are necessary to address
the needs of users of private company financial statements.

The PCC will identify, deliberate, and vote on any proposed changes,
which will be subject to endorsement by the FASB and submitted for
public comment before being incorporated into GAAP.

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The PCC also will serve as the primary advisory body to the FASB on the
appropriate treatment for private companies for items under active
consideration on the FASB’s technical agenda.

“The Trustees believe that the plan approved today will improve the
standard-setting process and give private company stakeholders
additional assurance that their concerns will be thoroughly considered
and addressed,” said FAF Board of Trustees Chairman John J. Brennan
following a meeting of the Trustees in Washington DC.

“This structure represents a significant improvement over our original
proposal because of the very valuable suggestions we received from a
broad cross section of concerned and interested constituents.”

FAF President and CEO Teresa S. Polley said: “The plan approved by
the Trustees strikes an important balance.

On one hand, the plan recognizes that the needs of public and private
company financial statement users, preparers, and auditors are not always
aligned.

But at the same time, the plan ensures comparability of financial
reporting among disparate companies by putting in place a system for
recognizing differences that will avoid creation of a ‘two-GAAP’ system.”

The private company plan approved today generally follows the outline
of the initial Trustee proposal announced last October, but includes
several significant changes and improvements.

In response to stakeholder concerns, the Trustees changed the process
through which FASB considers Council recommendations for private
company exceptions or modifications to GAAP from one of ratification to
one of endorsement.

The final plan stipulates that the Council Chair will not be a FASB
member; that the Council will hold meetings more frequently than
originally proposed; and that its size will be smaller than initially
suggested.
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“The establishment of the PCC will help the FASB improve upon the
efforts already under way to better serve the needs of private company
financial statement users, preparers, and practitioners,” said FASB
Chairman Leslie F. Seidman.

Key elements of the Private Company Council responsibilities and
operating procedures include:

Agenda Setting

Working jointly, the PCC and the FASB will mutually agree on criteria for
determining whether and when exceptions or modifications to GAAP are
warranted for private companies.

Using the criteria, the PCC will determine which elements of existing
GAAP to consider for possible exceptions or modifications by a vote of
two-thirds of all sitting members, in consultation with the FASB and with
input from stakeholders.

FASB Endorsement Process
If endorsed by a simple majority of FASB members, the proposed
exceptions or modifications to GAAP will be exposed for public
comment.

At the conclusion of the comment process, the PCC will redeliberate the
proposed exceptions or modifications and forward them to the FASB,
who will make a final decision on endorsement, generally within 60 days.

If the FASB endorses the proposals, they will be incorporated into GAAP.

If the FASB does not endorse, the FASB Chairman will provide the PCC
Chair with a written explanation, including possible changes for the PCC
to consider that could result in FASB endorsement.

Membership and Terms

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The PCC will comprise 9 to 12 members, including a Chair, all of whom
will be selected and appointed by the FAF Board of Trustees.

The PCC Chair will not be a FASB member.

Membership of the PCC will include a variety of users, preparers, and
practitioners with substantial experience working with private
companies.

Members will be appointed for a three-year term and may be reappointed
for an additional term of two years.

Membership tenure may be staggered to establish an orderly rotation.

The PCC Chair and members will serve without remuneration but will be
reimbursed for expenses.

FASB Liaison and Staff Support

A FASB member will be assigned as a liaison to the PCC. FASB technical
and administrative staff will be assigned to support and work closely with
the PCC.

Dedicated full-time employees will be supplemented with FASB staff
with specific expertise, depending on the issues under consideration.

Meetings

During its first three years of operation, the PCC will hold at least five
meetings each year, with additional meetings if determined necessary by
the PCC Chair.

Deliberative meetings of the PCC will be open to the public, although the
Council may hold closed educational and administrative sessions.

Most of the meetings will be held at the FAF’s offices in Norwalk,
Connecticut, but up to two meetings each year may be held elsewhere.
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All FASB members will be expected to attend and participate in
deliberative meetings of the PCC, but closed educational and
administrative meetings may be held with or without the FASB.

Oversight

The FAF Board of Trustees will create a special-purpose committee of
Trustees, the Private Company Review Committee (Review Committee),
which will have primary oversight responsibilities for the PCC.

The Review Committee will hold both the PCC and the FASB
accountable for achieving the objective of ensuring adequate
consideration of private company issues in the standard-setting process.

The Review Committee will be chaired by a Trustee with substantial
experience in private company accounting issues.

Oversight activities will be ongoing, and will include monitoring of PCC
meetings, among other activities.

FAF Trustees’ Three-Year Assessment

The PCC will provide quarterly written reports to the FAF Board of
Trustees.

The FAF Trustees will conduct an overall assessment of the PCC
following its first three years of operation to determine whether its
mission is being met and whether further changes to the standard-setting
process for private companies are warranted.

The complete report establishing the PCC, including background
materials, key discussion issues considered by the Trustees, and PCC
responsibilities and operating procedures, will be available on the FAF
website next week.

The FAF Board of Trustees will issue a call for nominations for members
of the PCC via the FAF website in the next few weeks.
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About the Financial Accounting Foundation

The FAF is responsible for the oversight, administration, and finances of
both the Financial Accounting Standards Board (FASB) and its
counterpart for state and local government, the Governmental
Accounting Standards Board (GASB).

The Foundation is also responsible for selecting the members of both
Boards and their respective Advisory Councils.

About the Financial Accounting Standards Board

Since 1973, the Financial Accounting Standards Board has been the
designated organization in the private sector for establishing standards of
financial accounting and reporting.

Those standards govern the preparation of financial reports and are
officially recognized as authoritative by the Securities and Exchange
Commission and the American Institute of Certified Public Accountants.
Such standards are essential to the efficient functioning of the economy
because investors, creditors, auditors, and others rely on credible,
transparent, and comparable financial information.

For more information about the FASB, visit our website at www.fasb.org.

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Speech by Andrea Enria, Chairperson of the European Banking Authority
Financial integration and stability in Europe: the role of the
European Banking Authority
23 May 2012, at the 15th China Beijing International High Tech Expo
China Financial Summit 2012

Dear CHITEC host, Ladies and Gentlemen,

It is a pleasure to have been invited to address you
this morning at the China Financial Summit 2012.

Given the very difficult environment we are facing
in the financial markets, and especially in the
European banking sector, this conference
provides an excellent opportunity to give this
international gathering some insight into the recently established
European Banking Authority, the EBA, including the role it plays in
tackling the crisis, and in strengthening the regulatory framework for
European banks.

While the immediate challenges are dominating our thoughts at present,
it is also important that we continue to develop the structural changes
necessary to deliver a more secure and stable banking environment for
the long term.

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The extent of the problems which have beset the global financial system
over the last five years are unprecedented in modern times and have
exposed serious weaknesses in financial regulation and supervision.

In his February 2009 report, Jacques de Larosière pointed to the belief
that in the run up to the commencement of the crisis in 2007, financial
regulation and supervision had been too weak and provided the wrong
incentives.

Lack of adequate macro-prudential supervision, ineffective early warning
mechanisms, lack of frankness and cooperation between supervisors and
lack of common decision making process were among the key lessons
learned from the crisis.

We had a Single Market, closely integrated especially after the
introduction of the euro, but the regulatory and supervisory environment
has remained very diverse, notwithstanding the efforts for harmonisation.

A key component of the European response to addressing these
deficiencies was the establishment of the European System of Financial
Supervision on 1 January 2011.

This includes the European Systemic Risk Board (ESRB), in charge of
macroprudential supervision, and the three European supervisory
authorities, the EBA for banking, ESMA for securities and markets and
EIOPA for insurance and occupational pensions.

The EBA has been given a wide-ranging mandate. In the field of
supervision, while the day-to-day oversight of banks’ safety and
soundness remains a responsibility of national authorities, the EBA has
been entrusted with key responsibilities.

These include the regular conduct of risk assessments, which should also
lead to the establishment of a risk dashboard, and of area-wide stress
tests, aimed at ensuring the resilience of European banks in front of
adverse shocks.

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The EBA also fosters cooperation between home and host authorities and
actively participates in and oversees the work of supervisory colleges for
cross-border groups.

Additional tasks are envisaged in the area of crisis management where the
EBA is in charge of coordinating recovery and resolution plans for the
major European banking groups.

In the area of rule making, the EBA plays a major role in the
establishment of the so-called Single Rulebook – i.e. technical rules truly
uniform throughout the European Union, adopted through legal
instruments that are directly binding in all the 27 Member States of the
Union.

Last but not least, we have been entrusted with the responsibility for
monitoring and tackling consumer issues.

Let me first give you an overview of the EBA’s role and activities in
relation to micro prudential supervision, and namely to the Authority’s
efforts in tackling the financial crisis.

The EBA’s efforts in tackling the crisis
The EBA’s initial priorities were centered on the challenges raised by the
deterioration of the financial market environment.

In the first part of 2011, we conducted a stress test exercise, aimed at
assessing the capital adequacy of the largest European banks in front of
adverse macroeconomic developments.

The exercise focused on credit and market risks and also, in recognition
of the risks that subsequently crystallised, incorporated sensitivity to
movements in funding costs.

Banks were required also to assess the credit risk in their sovereign
portfolios.

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In many respects, I believe the exercise was successful: in order to
achieve the tougher capital threshold, anticipating many aspects of the
new Basel standards, banks raised €50bn in fresh capital in the first four
months of the year; we set up a comprehensive peer review exercise,
which ensured consistency of the results across the European Single
Market, notwithstanding the many differences in national regulatory
frameworks; the exercise included an unprecedented disclosure of data
(more than 3200 data points for each bank), including, amongst other
things, detailed information on sovereign holdings.

However, the progress of the stress test was tracked by a significant
further deterioration in the external environment.

The main objective of restoring confidence in the European banking
sector was not achieved, as the sovereign debt crisis extended to more
countries, thus reinforcing the pernicious linkage between sovereigns and
banks.

Soon after the completion of the stress test, most EU banks, especially in
countries under stress, experienced significant funding challenges.

In this context, the IMF and the European Systemic Risk Board (ESRB),
called for coordinated supervisory actions to strengthen the EU banks’
capital positions.

The EBA assessment was that without policy responses, the freeze in
bank funding would have led to an abrupt deleveraging process, which
would have hurt growth prospects and fuelled further concerns on the
fiscal position of some sovereigns, in a negative feedback loop.

We then called for coordinated action on both the funding and the
capitalisation side.

While advising the establishment of an EU-wide funding guarantee
scheme, the EBA focused its own efforts on those areas where it had
control, primarily bank capitalisation.

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To this end, the EBA’s Board of Supervisors, comprising the heads of all
27 national supervisory authorities, discussed and agreed that a further
recapitalisation effort was required as part of a suite of coordinated EU
policy measures.

This resulted in the EBA issuing a Recommendation that identified a
temporary buffer to address potential concerns over EU sovereign debt
holdings and required banks to reach 9% Core Tier 1.

The total shortfall identified was €115 bn.

The measure, agreed in October 2011 and enacted in December 2011,
seeks that Supervisory Authorities should require those banks covered by
its Recommendation to strengthen their capital positions by end of June
2012.

The Recommendation was swiftly followed by the ECB’s long term
refinancing operations (LTROs), arguably the key “game changer” in
this context.

The LTROs allowed banks to satisfy their funding needs in front of a
significant amount of liabilities to roll over in 2012, thus preventing a
massive credit crunch.

The recapitalisation was a necessary complementary measure: while
banks needed unlimited liquidity support, to keep supporting the real
economy, they had to be asked to accelerate their action to repair balance
sheets and strengthen capital positions.

When the process is completed, European banks will be in a much
stronger position, also vis-à-vis their main peers at the global level.

The EBA is, in general, satisfied with the progress made in the fulfilment
of this Recommendation and notes that the actions taken by the bulk of
banks include capital strengthening and adequate recognition of losses.

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In addition, three banks identified as having weaknesses have
subsequently undergone restructuring processes and will no longer exist
in the same form as at the moment of the stress test.

We have put a lot of efforts to avoid that banks reached the target ratio by
cutting asset levels instead of raising capital, thus reducing credit
availability for corporates, especially small and medium enterprises and
households.

However, a deleveraging process is needed in the banking sector.

It has already started, with a different pace in different areas of the global
financial system and needs to be accomplished in an ordered fashion.

The first step has been the increase in capital levels, long overdue and one
of the cornerstones of the regulatory reforms endorsed by the G20
Leaders.

The second step requires a reduction in size of balance sheets, especially
by addressing non-performing assets and de-risking in areas such as
capital market activities and real estate lending, which grew too much in
the run-up to the crisis.

The third step entails a refocusing of business models, especially towards
more stable funding structures and the gradual exit from the
extraordinary support measures put in place by central banks.

I am convinced that without an ordered deleveraging process, through a
significant strengthening of capital and a selective downsizing of asset
levels, we would fail addressing the fragilities that are preventing banks
from performing their fundamental functions.

Supervisory Colleges
The misalignment between the international nature of the major banking
groups and a national system of supervision has been a contentious
subject for many years.

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In the years preceding the crisis and in an effort to improve supervision,
colleges of supervisors were established, to varying extents, for major
banking groups.

However, as the financial stresses developed in 2008, these structures did
not work effectively in a large number of cases.

The already difficult situation was compounded by the lack of dialogue
and information exchange between supervisory authorities, as national
priorities took precedence in the decision making process.

Given the problems which this lack of cooperation presented, there was a
clear need to radically overhaul the voluntary structures which existed.

This need has manifested itself in legislative changes to the Capital
Requirements Directive (CRD), the primary European legislation that
implements the Basel accord for banking in the EU, and in specific
provisions incorporated into the mandate of the EBA.

Supervisory colleges are now required for all cross border banking groups
operating in the European Economic Area and the EBA has been granted
full participation rights as a competent authority.

The EBA staff are attending supervisory colleges of the major
systemically important groups in Europe and go to these meetings with a
clearly defined goal of promoting and monitoring the efficient, effective
and consistent functioning of colleges as well as fostering the coherent
application of the EU law by supervisors.

Also, since 2011, European colleges are the forum in which the
consolidating supervisor and the competent authorities responsible for
the supervision of subsidiaries are required to reach a joint decision on
the capital of the group and the relevant subsidiaries.

The formal system of joint risk assessments, which underpins this
process, and the drive to make the core supervisory decision on capital,
represents a major step forward in the coordination of cross border
supervisory processes.
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I am glad to say that in many of these meetings for banking groups which
have operations outside the European Union, consolidating supervisors
will often invite supervisors from countries outside the EU so that they
can give a first hand account of the risks being run in the entities they
oversee.

The EBA strongly believes the work to implement these arrangements
has to be strengthened in order to improve the effectiveness of
supervision for cross-border groups.

Good progress has been made in many quarters.

For instance, national authorities are coming to their joint decisions on
the capital of a banking group using the common structures and
templates set out in guidelines issued by the EBA.

However, there is still a long way to go to enhance consistency in
supervisory outcomes and to achieve adequate levels of information
exchange and cooperation.

Crisis Management
It is at these times of intense challenge, that structures and relationships
are most tested, and we actually see how well coordination of supervision
works at an international level- and see most clearly where fault lines
continue to exist.

Before I give you some views on what is happening within the EU
regulatory community, I need to forcefully make the point that primary
responsibility to enhance preparedness for a crisis situation lies with the
banks themselves.

Banks must learn the lessons of the crisis and materially improve their
risk management processes.

They must embed into their processes the capacity to perform real stress
tests and make sure they are well equipped to withstand severe adverse
market developments.
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Part of this process will involve the development of effective Recovery and
Resolution Plans (RRPs) and the identification of the steps to be taken
when the viability of the firm is at risk.

The guidance of the Financial Stability Board is a key benchmark in this
area.

For cross-border groups in the European Union, colleges of supervisors
will develop plans for the coordination of supervisory action in emergency
situations.

Colleges are supplemented by the Cross-Border Stability Groups (or
“crisis colleges”), which bring together fiscal authorities, central banks
and supervisors.

But the lesson of the crisis is that voluntary cooperation arrangements are
not enough.

Stronger legal and institutional underpinnings are needed to enforce
effective crisis management and resolution tools in the European Single
Market.

An important step has already been taken to strengthen the European
institutional setting with the provisions set out in our founding
Regulation, which gives the EBA responsibilities in areas such as the
monitoring of colleges, the development of Recovery and Resolution
Plans and the conduct of EU-wide stress tests.

In addition, when an emergency situation is declared by the European
Council, the EBA has been given the power to address specific
recommendations to national supervisory authorities with a view to
coordinating their actions and, if necessary, apply European decisions
directly to individual institutions in case of inaction by national
authorities.

Nonetheless, the structures are not complete and a more formal role for
the EBA in crisis management will depend on the outcome of the

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European Commission’s work on new legislation for bank recovery and
resolution, due out soon.

The legal underpinning for crisis resolution needs to be fully harmonised
in order to allow for an integrated process, with close cooperation
between the authorities involved.

This should allow interconnecting national resolution procedures so as to
ensure an integrated approach for cross-border firms, ensuring an
equitable treatment of creditors in all jurisdictions.

At the same time, mechanisms should be in place to constrain the actions
of national authorities and drive towards coordinated, firm-wide
solutions.

Over time, the EBA’s role in this area is likely to grow substantially,
including its role in mediating between conflicting interests of national
authorities as serious problems emerge.

Rule Making and the Single Rulebook
As proposed by de Larosière in his report, the EBA now has the capacity
to draft directly applicable rules, by means of regulatory and
implementing standards that will then be adopted by the European
Commission as EU Regulations and thereby become directly binding in
the whole EU, without the need for national implementation.

This process will help eliminate many of the inconsistencies which have
arisen from options, national discretions, and the different interpretations
adopted when previous rules were transposed into national legislation by
the 27 EU Member States.

Materially reducing the fragmentation in the EU regulatory regime will
provide greater certainty to market participants and stronger foundations
for convergence in supervisory practices.

Based upon the current legislative proposals for the implementation of
Basel 3, about 200 deliverables will be expected from the EBA, including
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proposals for around 100 Technical Standards such as on the definition of
capital, capital buffers, liquidity, remuneration, and the leverage ratio.

This will be essential to ensure level playing field and avoid in the future
that the regulatory lever is used to attract business in national market
places or to favour national champions, a process that has played a great
role in the relaxation of regulatory standards in the run up to the crisis.

The EBA can also issue Guidelines and Recommendations which are not
legally binding, albeit the EU national supervisory authorities need to
indicate publicly whether they intend to comply, and if this is not the case
they will need to publicly explain the reasons.

The EBA can also conduct peer reviews in order to make sure that the
common standards and guidelines are effectively applied in a consistent
and effective fashion.

Conclusions
Ladies and gentlemen,

Today I tried to convey to you an overview on the difficult challenges the
EBA is facing.

In our first 16 months of activity, we have already done a huge effort to
strengthen the capital position of EU banks and to restore confidence in
their resilience.

The work is not over in this area.

The liquidity support provided by the ECB avoided an abrupt
deleveraging process, but banks are still in the process of repairing and
downsizing their balance sheets and of refocusing their core business.

We, as supervisors, need to accompany this process and do our utmost to
ensure that it occurs in an ordered fashion, without adverse consequences
on the financing of the real economy.

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In the coming months we have to complete the preparation for the
implementation of the reforms agreed by the G20 Leaders, in particular
Basel 3.

It is a major challenge for regulators across the world and the EBA is
establishing close contacts with fellow supervisors in other countries,
including China, to ensure that there is always an open dialogue and a
common commitment to strengthening the safety and soundness of
banks.

In the EU, this challenge is compounded with our resolve to set up a
much more uniform regulatory setting for all the banks operating in the
Single Market, with the so called Single Rulebook.

Strengthening regulation is not enough if it is not coupled with more
effective supervision, especially for those large and complex groups that
are active on a cross-border basis and may generate systemic risks across
jurisdictions.

This requires identifying best supervisory practices and ensuring
convergence towards these benchmarks, as well as strengthening
cooperation within colleges of supervisors.

This has surely a strong European dimension, due to the relevance of
cross-border business within the Single Market, but requires also close
cooperation with supervisors in other regions.

We are surely committed to bringing our contribution to the success of
this endeavour.

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Rasheed Mohammed Al Maraj: Corporate governance and
Shari’a compliance in Bahrain
Welcome speech by His Excellency Rasheed Mohammed Al Maraj,
Governor of the Central Bank of Bahrain, at the AAOIFI (Accounting and
Auditing Organisation for Islamic Financial Institutions) Annual Shari’a
Conference, Manama, 7 May 2012.

Excellencies, distinguished guests, ladies and gentlemen, this conference
comes at an important time for the Islamic financial sector.

This conference is focussing on six key areas that both the standard
setters and the financial sector must work together upon if Islamic
finance is to continue to grow and achieve its full potential.

So I thought in this Welcome Address I would talk about one area where
the Central Bank, as a regulator and as a member of AAOIFI has a special
interest. And that subject is Governance.

AAOIFI currently has issued seven standards relating to governance and
two standards with respect to ethics.

Deficiencies in Governance at financial institutions have been repeatedly
highlighted in the past five years following the commencement of the
Global Financial Crisis in 2007.

Three of the standards issued by AAOIFI specifically refer to governance.

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The first of these standards concerns the Audit & Governance
Committee.

In practice, this standard requires the Audit Committee to do rather more
than just to review a financial institution’s accounting practices and audit
plan.

It requires the Committee to review the use of Restricted Investment
Accounts’ funds.

It emphasises the need to ensure that funds are invested in accordance
with terms agreed with the customer.

Too often over the past five years we have seen how the interests of
customers at both conventional and Islamic banks have been neglected
as bank management have focussed on bonuses and share price.

If banks neglect customers’ interests, then they will lose those customers.

This theme of looking after the interests of customers is carried on in the
AAOIFI Governance Principles paper issued in 2005.

In particular Principle 3 of this paper warns against inequitable treatment
of fund providers.

The 2009 AAOIFI Corporate Social Responsibility paper also focuses on
dealing responsibly with clients and “par excellence” customer service.

If you couple the governance standards with the ethics paper for
employees of financial institutions, you find a formidable set of
requirements, principles and standards relating to putting the interests of
customers first.

So against this background of improving levels of disclosures, the CBB
will be making further efforts through its review of its corporate
governance and business conduct rules to raise the bar for corporate
governance.

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The review of the CBB corporate governance requirements has already
finished its first stage of internal review.

The next will be consultation with the financial sector.

Coupled with governance is Shari’a. This is one of the themes of this
conference.

From the perspective of the CBB as a regulator, we have noted that all too
often, the approach of banks, particularly conventional banks has been to
start with a conventional transaction or product and then try to give it a
finishing coat of Shari’a compliant paint.

Financial institutions must not regard Shari’a compliance as the finishing
touch to product development.

Instead, product development needs to start from Shari’a principles: i.e.
Islamic financial institutions must become Shari’a driven.

And that is why this conference and the next set of consultations by
AAOIFI are going to be so important.

If financial institutions and standards setters can address the interest of
customers, governance and Shari’a compliance satisfactorily then we can
look forward to Islamic finance continuing its growth and reaching its full
potential.

Notes
The Accounting and Auditing Organization for Islamic Financial
Institutions(AAOIFI) is an Islamic international autonomous
non-for-profit corporate body that prepares accounting, auditing,
governance, ethics and Shari'a standards for Islamic financial institutions
and the industry.

Professional qualification programs (notably CIPA, the Shari’a Adviser
and Auditor "CSAA", and the corporate compliance program) are

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presented now by AAOIFI in its efforts to enhance the industry’s human
resources base and governance structures.

AAOIFI was established in accordance with the Agreement of
Association which was signed by Islamic financial institutions on 1 Safar,
1410H corresponding to 26 February, 1990 in Algiers.

Then, it was registered on 11 Ramadan 1411 corresponding to 27 March,
1991 in the State of Bahrain.

As an independent international organization, AAOIFI is supported by
institutional members (200 members from 45 countries, so far) including
central banks, Islamic financial institutions, and other participants from
the international Islamic banking and finance industry, worldwide.

AAOIFI has gained assuring support for the implementation of its
standards, which are now adopted in the Kingdom of Bahrain, Dubai
International Financial Centre, Jordan, Lebanon, Qatar, Sudan and Syria.

The relevant authorities in Australia, Indonesia, Malaysia, Pakistan,
Kingdom of Saudi Arabia, and South Africa have issued guidelines that
are based on AAOIFI’s standards and pronouncements.

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A route for Europe
Address by Mario Draghi, President of the
ECB, at the day in memory of Federico Caffè
organised by the Faculty of Economics and the
Department of Economics and Law at the
Sapienza University, Rome, 24 May 2012

A teacher, says Eco, “teaches that everyone
must become individual and different”.

Professor Federico Caffè, albeit with a coherent
vision and deeply held convictions, was a teacher.

He taught his students to think for themselves and did not pass on a
binding creed.

He helped his students – economists, thinkers, servants of the state and of
the institutions, alert citizens – to discover themselves.

I’ll start with the subject which, without a doubt, was the most precious to
Caffè, namely welfare.

Probably nothing in his intellectual heritage is more topical than this
painful protest of his: one cannot, he would say, “ accept the idea that an
entire generation of young people should consider themselves as having
being born at the wrong time and having to suffer job insecurity as an
inevitable fact”.

Work: a European matter

“ Full employment is not only a means of increasing production..., it is an
end in itself, since it leads to overcoming the servile attitude of those who
find it hard to obtain a job opportunity or live in constant fear of being
deprived of one.

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In other words, the benefits of full employment are considered as well,
and above all, in terms of human dignity.”
These words of Caffè do not surprise those who knew him and those who
have read his works.
They express the fundamental inspiration of his professional and public
life: it is a duty of economic policy to act so that the economy can get as
close as possible to full employment.
In 1975, he formulated it more precisely:
“ The goal of dignified work for all, however, is not compatible either with
situations of privilege, which have now become destabilising, nor with
excessive labour and social security rights, which results in job
opportunities evaporating away” .
The issue that Caffè raises here is one of fairness. We find it again today:
the international crisis has affected everyone, and young people
especially.
In the European Union, between 2007 and 2011 the unemployment rate
rose by 5.8 percentage points among the 15-24 year olds, by 3.5 points
among the 25-34 year olds and by 1.8 points in the 35-64 age range.
Qualitatively, the profile is similar almost everywhere; the clear exception
is Germany, where the unemployment rate among 15 to 24 year olds in the
first quarter of 2012 was 8%; in Italy it was 34.2%, in Spain 50.7% and the
euro area average was 21.9%.
These trends reflect a fundamental question: they confirm the particular
vulnerability of this essential part of our workforce.
The unequal sharing of the “cost of flexibility”, only affecting young
people, an eternal flexibility with no hope of stabilisation, leads among
other things to companies not investing in young people, whose skills and
talents often decline in jobs with low added value.
The underuse of their resources reduces growth in various ways: it makes
the creation of start-ups less likely – and they are on average more
innovative than others – it causes a decline in skills in the long run,
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slowing down the assimilation of new technology and acting as a brake
on efficient production processes. In addition to undermining society’s
sense of fairness, it is a waste that we cannot afford.
I think it’s essential to ask how economic policy conducted in various
Member States has done its duty in the way desired by Caffè.
Social progress is one of the key objectives of the European integration
process:
“The Union shall work for the sustainable development of Europe based
on balanced economic growth and price stability, a highly competitive
social market economy, aiming at full employment and social progress …
It shall combat social exclusion and discrimination, and shall promote
social justice and protection, equality between women and men,
solidarity between generations and protection of the rights of the child”.
(Article I-3 of the draft European Constitution). Welfare is not only a
remedy for the failure of insurance markets, but also a tool to promote
inclusion, solidarity and a sense of fairness.
In the three post-war decades (the so-called “Golden Age”), which
especially in Europe were marked by high growth rates, use of advanced
technologies, high growth employment, stable lifetime employment,
welfare started to emerge, at different times and on different scales
depending on the country, as an integrated system that protects its
citizens from significant risks.
The European model redistributes many more resources for social
purposes than the US and Japanese systems: on the eve of the crisis, the
total expenditure on pensions, unemployment benefit, for children and
families was, in relation to GDP, more than twice that of the US and
Japan.
This can take different forms as regards the composition of social policies
and the degree of labour protection.
In Italy, with an overall welfare spending ratio of GDP in line with that of
the rest of Europe, spending on support for the unemployed, for
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households, particularly those at risk of falling into poverty, is at a level
less than half that of elsewhere in Europe, while spending on pensions is
significantly higher.
The weakness of the “social shock absorbers” is that relatively high job
protection for those in employment is accompanied by weaker protection
for those out of work, contrary to what happens in the Nordic models,
where the so-called “flexisecurity” combines an extensive social safety
net with less job protection.
In some countries, even if, 40 years on, the assumptions of that model are
still valid, reflections on it began some time ago.
Structural factors have changed the context within which the European
social model operates: the growing competition from emerging countries,
the reorganisation of production processes on a global basis, the speed of
innovation, the increasing fragmentation of career paths with ever looser
ties to a “permanent position”, the greater instability of families,
declining fertility, the prospective decrease in the workforce, an ageing
population.
The set of risks faced by individuals throughout their life has changed
significantly.
The social protection systems are therefore constantly evolving;
substantial corrections have taken place in recent years in many
countries, including France, the United Kingdom and Germany, the
country where the reform process began a decade ago.
In Italy, the recent pension reform which approves the full transition to a
contribution system completes the necessary correction of the pension
spending dynamics which was started years ago.
As Germany shows very well, large and effective welfare systems can be
made more efficient without compromising social goals.
We are living at a critical juncture in the history of the Union.

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The sovereign debt crisis has exposed serious weaknesses in the
institutional framework; in this context, the difficulties in finding
common solutions are having a negative impact on market valuations.
The extraordinary measures taken by the ECB have gained us time; they
have preserved the functioning of monetary policy.
But we have now reached a point where European integration, in order to
survive, needs a bold leap of political imagination.
It is in this sense that I have referred to the need for a “growth compact”
alongside the well-known “fiscal compact”.
A growth compact rests on three pillars and the most important one, from
a structural viewpoint, is political: the economic and financial crisis has
challenged the myopic belief that monetary union could remain just that,
and not evolve into something closer, more binding, into an arrangement
whereby national sovereignty on economic policy is replaced by the
Community ruling.
If the governments of the Member States of the euro define jointly and
irrevocably their vision of what the political and economic construct that
supports the single currency will be and what the conditions to reach that
goal together should be.
This is the most effective answer to the question everyone is asking:
“Where will the euro be in ten years’ time?”.
The second pillar is that of structural reforms, especially, but not only, in
the product and labour markets.
The completion of the single market and the strengthening of
competition are crucial for growth and employment. Labour market
reforms that combine flexibility and mobility with a sense of fairness and
social inclusion are essential.
Growth and fairness are closely connected: without growth, and the
events of recent months also reflect this, the temptation to “circle our
wagons” gains strength, and solidarity weakens.

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Without fairness, the economy breaks up into multiple interest groups, no
common good emerges as a result of social and economic interaction,
and there are negative effects on the capacity to grow.
Recent Italian history has no shortage of examples.
These reforms have long been indispensable in a global economy very
different to the one which witnessed the creation of the institutions still
operating today.
In the political structure that will emerge from the crisis it is likely and
desirable that for these reforms a system of European rules will be
introduced similar to that for the fiscal compact, a discipline leading over
time to the European harmonisation of objectives and tools.
The third pillar is the revival of public investment: the use of public
resources to push forward investment in infrastructure and human
capital, research and innovation at national and European levels.
(The proposed strengthening of the EIB and the reprogramming of
Union structural funds in favour of less-developed areas go in this
direction).
Thus, a growth compact complements the fiscal compact, because there
can be no sustainable growth without orderly public finances.
In this regard I have noted on other occasions the extraordinary progress
made by all governments of the euro area in terms of fiscal consolidation,
but, once the emergency is overcome, they need to make improvements
by cutting current spending and taxation.
Let me now consider some issues more directly related to the ECB’s
monetary policy and action.
Objectives and instruments
The first issue involves the relationship between objectives and
instruments of economic policy in a macroeconomic reference model that
changes over time.

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For Caffè, one of the first scholars of Frisch and Tinbergen, the optimal
allocation of tools and objectives occurred in the reference model
prevalent in the 1970s, in which the goal of economic policy was to make
best use of the available resources, in particular full employment.
In pursuit of this goal, monetary policy was subordinated to fiscal policy,
with an ancillary role for the central bank vis-à-vis the Treasury.
The reference macro-model was based on a static mechanism of
elaborating expectations, which were formed by extrapolating from past
observations to the future.
This mechanism amplified the immediate effect of public spending on
aggregate demand.
Monetary policy – in charge of credit conditions – was entrusted with the
task of alleviating, through a careful policy of accommodation, the impact
that government borrowing would have exerted on the cost of private
debt.
The central bank was financing the Treasury by creating money.
Under these conditions, an increase in public spending could “add
demand” – where this would be lacking for the goal of full employment –
without taking away resources from other uses.
Since then, the theory of economic policy has followed two paths that
have led it to invert the ranking of relative potential of tools and to
enhance the definition and measurement of the objective.
As for the instruments, a different theory of the formation of expectations
– no longer extrapolative – has highlighted the strong impact of monetary
policy and has weakened the expected effects of fiscal policy.
In the models that we use today, agents, when formulating their
expectations, are attentive to the sustainability conditions of the choices
in the long term.
Economic policies deemed unsustainable in the long run are ineffective.
For example, an active deficit-financed fiscal policy is limited by fears

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P a g e | 48

about the government’s ability to refinance the debt from which that
policy originates.
These fears may lead to behaviours that weaken the private sector – or, at
worst, completely neutralise – the impact of public spending as a means
of controlling demand.
Monetary policy, by contrast, is strengthened by this.
Acting through the expectations channel, it can have a lasting effect on
the expected flows of financial revenue.
Affecting the real rate of intertemporal discount, it can deeply affect
decisions on savings and consumption.
The definition of the objective is now wider.
Price stability has become an essential parameter in defining and
measuring prosperity.
From taking a relaxed approach to inflation and considering it secondary,
nowadays low and predictable inflation is a pre-eminent criterion of
economic performance.
Why?
High inflation hits savings – and therefore investment and future
consumption – with a tax on real returns that rewards the risk of uncertain
inflation.
Low inflation, however, frees up resources that individual choices can
allocate to increasing the fixed capital.
A policy that neglects inflation gradually destabilises the economy.
The costs of uncertainty about the value of the money, initially
unimportant, then overlooked, subsequently become evident, and then
are judged intolerable.
At that point, voters express a strong preference for policies that promise
rapid disinflation.

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P a g e | 49

But such policies impose high costs in terms of job losses, which have to
be included in the dynamic calculation of the costs of inflation.
Also, it should not be forgotten that inflation affects the poor more than
the rich, and is therefore a tax on the weaker members of society.
Under the influence of the neo-classical synthesis of Samuelson and
Solow, the long-term correlation between inflation and growth was
perceived as positive in the early 1970s: a slight increase in inflation would
have led – within limits – to an increase in employment and growth.
But by the end of that decade, studies by Bob Lucas and Tom Sargent
were to show that long-term inflation and growth are not correlated.
Monetary policy, while very effective in the short term, only affects
inflation in the medium and long term. It is, in other words, neutral.
Today, new models and advanced computational techniques allow us to
simulate the effects of inflation on incentives to save and to work, on the
formation of physical capital, and therefore on the prospects for growth.
The correlation has become negative: higher inflation reduces growth
and employment.
For example, vector autoregressive models with non-constant parameters
allow the identification of a range of values that quantify the cost in terms
of growth failure for every two percentage point increase in steady-state
inflation.
This cost implies lower growth of between 3 and 5 percentage points over
a period of ten years.
Finally, monetary policy is a powerful tool.
When used improperly, it may cause permanent damage.
But it can become an effective, stabilising factor and contribute to
collective prosperity in an independent and active way.

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P a g e | 50

The sine qua non for this is to build monetary policy decisions into a
systematic and predictable strategy, based on price stability, which drives
expectations and guides the economy but doesn’t shock it.
This is perhaps the most important practical difference to what was
studied in the early 1970s.
The ECB’s monetary policy strategy
The ECB’s monetary policy strategy is based on the new theory of the
instruments I have tried to outline, and takes into account the enrichment
of the theory of objectives, which emphasises the contributions of price
stability to the “general prosperity”.
It also provides continuity for a monetary tradition in continental Europe
that has ensured inflation-free growth for more than 60 years.
The strategy is based on the objective of “maintaining price stability” that
the Treaty has entrusted to the central bank and the quantitative
definition that the Governing Council subsequently gave the objective.
The studies I have mentioned helped to define a range within which
inflation is no longer a factor that distorts economic choices.
The ECB pursues, as an objective of monetary stability in the medium
term, an inflation rate below, but close to, 2%, which is the upper limit of
this range.
The macroeconomic model on which the ECB’s monetary policy strategy
rests is imbued with contemporary macroeconomics, based on dynamic
optimisation and on the centrality of forward-looking expectations.
At the same time, the model is broader and well structured and corrects
the simplifications of the pre-crisis neo-Keynesian paradigm with its
prescriptive approach to optimal monetary policy.
The weakness of this paradigm was, and is, its inability to recognise the
importance of financial frictions and the role of credit and money.

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P a g e | 51

This has to do with the fragility of the theoretical foundations that
formalise the links between the real economy, financial imbalances and
the level of confidence.
Ignoring money is tantamount to assuming an absence of risk and
uncertainty.
Without risk, Keynes would have said, there would be no money.
The preference for liquidity is not justified in an economy without
uncertainty.
But the neo-Keynesian model excludes the possibility of default.
In it, risks in the financial sector can be isolated and therefore have no
effect on the real economy.
The financial crisis has clearly highlighted the weaknesses of this system.
Macroeconomic theory has begun to reflect on the neo-Keynesian system
and these studies are now one of the liveliest areas of analysis.
These studies – at least their early results – confirm the farsightedness of
some of strategic choices of the ECB.
Liquidity, money, credit have always been – since 1998, when the Bank
received its mandate from the founders of the monetary union –
qualifying variables of the ECB’s reference model and its strategy.
The monetary analysis requires a constant monitoring of banks’ assets
and liabilities as sources of information on the assessment of risk in the
markets and the economy as a whole.
This analysis commits the Governing Council to adjust the tenor of
monetary policy to ensure the long-term growth of monetary aggregates
and credit consistent with the potential for economic expansion.
In this sense, the monetary pillar of the strategy can be interpreted as a
strategic reinforcement that helps to prepare correction mechanisms in
situations where macroeconomic imbalances are having difficulty in
manifesting themselves in inflationary pressures.
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P a g e | 52

The monetary analysis gave important warning signals in the years
preceding the crisis regarding the existence of deep macroeconomic and
financial imbalances.
In the autumn of 2005, in conditions of inflation observed and projected
to be “normal”, the ECB’s monetary analysis began to record a change in
the composition of M3 growth: from a model of growth explained by
money demand factors – that we would define as irrelevant to the
evolution of spending and prices – to a dynamic associated with increased
credit creation – that is, to banks’ money supply factors.
These changes were accepted as indications that the tenor of monetary
policy, despite the moderation of inflationary pressures observed and
projected, had become too lax.
A new cycle of monetary policy tightening was initiated in December of
that year, based on considerations inspired by the monetary pillar, where
monetary and financial stability is an intermediate objective for attaining
a more balanced development of macroeconomic variables and hence
price stability over the long term.
In a globalised world, the international financial crisis has not spared the
euro area. But today we know that preventive action by the ECB,
implemented mainly by considering monetary indicators, has mitigated
the impact on incomes and inflation.
The two operations of three-year refinancing (LTROs)
The monetary analysis has also been an essential strategic tool in
diagnosing and managing the crisis.
In this regard, the analysis that led to the more recent non-standard
monetary policy measures can illustrate how the systematic monitoring of
banks’ liabilities – money in its broadest sense – can provide guidance on
the risks faced by the economy as a whole.
Towards the end of 2011, with a decision unprecedented in the history of
the euro, the ECB’s Governing Council decided to conduct two three-year
refinancing operations.

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P a g e | 53

At the end of February, or when the second three-year operation was
completed, the net increase in loans granted to counterparties was around
€520 billion.
The motivation for the two operations can be summarised by the
following strategic view.
A central bank is mandated with the crucial task of ensuring the sufficient
supply of liquidity to sound bank counterparties in return for adequate
collateral.
In normal times, “sufficient liquidity” means a volume of refinancing in
line with the need for banks to meet the obligatory reserve requirements
and the financing of other independent factors which explain the growth
over time in the demand for money.
In times of increased financial instability, “sufficient liquidity” indicates
a volume of available central bank money which avoids the risk that –
under such market conditions – the temporary inability of banks to
provide refinancing leads to insolvency and thus to a situation of
widespread default.
In neither of the two cases – normal times or crisis periods – can the
central bank be considered responsible for the survival of bank
counterparties that are close to bankruptcy.
The two long-term refinancing operations achieved the purpose for which
they were intended.
In an environment of a near-shutdown of private credit markets, banks
were not able to refinance their assets and were unable to maintain their
level of exposure to households and businesses.
The extensive long-term refinancing allowed for the partial and
temporary substitution of private credit with central bank money and thus
avoided a disorderly process of credit to the economy running dry.
Nevertheless, these operations were not without their criticism. These
can be summarised in three points:

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P a g e | 54

1. The growth in liquidity following the two operations will ultimately
lead to inflation;
2. The Eurosystem’s balance sheet is exposed to unprecedented and
uncontrollable risks;
3. Such operations have reinforced the perverse link between banks
and sovereign debtors and may be considered a violation of the
prohibition of financing public debt with central bank money, laid
down in Article 123 of the Treaty.
And, the opposite – but conceptually equivalent – criticism that
these operations did not provide the economy with finance.
As regards the first point, it is again pertinent to refer to strategy: in the
medium to long term, the inflation dynamic reflects developments in
broader monetary aggregates.
Conditions that encourage the creation of inflation or speculative bubbles
are generated by strong and sustained growth in money and credit, not
necessarily as a result of an increase in liquidity granted by the central
bank to the banking sector.
This liquidity constitutes a precautionary supply for sight liabilities that
the banks have towards households, non-financial corporations and other
banks.
The sight liabilities, i.e. deposits, and not the supply of liquidity,
demonstrate a high statistical correlation to the price dynamics of goods
and assets.
Today, monetary developments do not allow for the identification of risks
of inflation or pressure on asset prices in the medium term.
As regards the second point, the main criticism related principally to the
expansion of collateral accepted by the national central banks of the
Eurosystem as a guarantee in return for liquidity extended to credit
institutions.
In particular, doubts were raised regarding credit claims that became
eligible with the decisions taken in December 2011.
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P a g e | 55

These doubts are founded on an incorrect understanding of the
guarantees that are requested by the national central banks to protect
against the risk that central bank liquidity is not repaid.
In particular, the discount applied to the nominal value of credit claims
provided as security in refinancing operations is very high.
This means that, for credit claims deposited as collateral with a nominal
value of €100, the national central banks accepting the new collateral
provide, on average, the equivalent of around €47 in liquidity.
This discounting represents a powerful method for absorbing the credit
risk involved in such operations.
It is also worth highlighting the fact that the main elements of risk control
continue to be shared by the Eurosystem: the criteria for acceptance and
measures for controlling risk are approved by the Governing Council,
which is also responsible for the continuous monitoring of the
effectiveness of all of the measures for mitigating risk.
With regard to the third point, it is undeniable that, in some countries in
particular (especially Spain and Italy), banks used some of the liquidity
acquired via the three-year long-term refinancing operations for
temporary investments in government bonds.
Today, central banks do not have an instrument for the precise and
targeted allocation of credit to a sector or in favour of a specific financial
use.
Those who accuse the ECB of an indirect violation of the prohibition on
financing public debt with central bank money are making the same
conceptual mistake as those who accuse the ECB of not having forced the
banks to the use the funds acquired via the LTROs to supply credit to the
private sector.
In the first case, banks would have had to have been forced not to
purchase government securities, and in the second case, to give credit to
the private sector.

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P a g e | 56

Both groups of accusers forget that the policy of precise allocation of
credit was a norm in various countries until the end of the 1970s.
In the 1980s the operational system for monetary policy was radically
redefined, principally on account of the heavily distorting effects of such
an operational framework on economic activity.
Moreover, legal arguments relating to the Treaty and to the current
contractual form of repos underlying the LTROs, as well as
considerations relating to feasibility, would make it difficult to reinstate
such a framework.
Finally, the behaviour of credit institutions with respect to households
and businesses is not uniform across countries: while some countries saw
negative credit developments, others saw growth in credit, in some cases
even significant growth.
In Italy, but also in the vast
majority of euro area countries,
the fall in loans recorded in
December has come to a halt,
avoiding a much more severe risk
of credit restriction which would
have had far more serious
consequences for growth and
monetary stability than the ones
we are seeing currently.
The Bank Lending Survey
registered a gradual normalisation
of interest rates set by banks and
of the criteria for granting loans to
companies.
The continued anaemic
developments in lending reflect the weakness in demand and the
worsening of creditworthiness resulting from an adverse economic cycle.
Furthermore, in the countries most adversely affected by the crisis, banks
are rationing credit on account of certain prevalent contractual structures.
_____________________________________________________________

Monday May 28 2012 - Top 10 risk and compliance management related news stories and world events that (for better or for worse) shaped the week's agenda, and what is next

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