Monday November 19 2012 - Top 10 Risk Management News

Page |1

International Association of Risk and Compliance
Professionals (IARCP)
1200 G Street NW Suite 800 Washington, DC 20005-6705 USA
Tel: 202-449-9750 www.risk-compliance-association.com

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

Dear Member,

Today we will start from something really
interesting: The compensation in financial
and nonfinancial sectors before the crisis.

We always try to predict the
future, and to figure out
when we will have the next
market bubble (which can
also be an opportunity).

A market bubble is forming.
Can we use the gap in the
compensation (together
with other information like
the growth to GDP ratio
etc.) to learn more about it?
How?

I wait for your comments.

We will share the best answer with all members, and we will give a
CRCMP program to the winner.

We will discuss something different now. The Federal Reserve will
approve dividend increases or other capital distributions only for
_____________________________________________________________
International Association of Risk and Compliance Professionals (IARCP)
www.risk-compliance-association.com

Page |2

companies whose capital plans are approved by supervisors and who are
able to demonstrate sufficient financial strength to continue to operate as
financial intermediaries under stressed macroeconomic and financial
market scenarios, even after making the planned capital distributions.

This is very interesting.

On one hand, under the Basel iii rules, banks need to have more common
equity Tier 1 capital. So banks must attract investors.

On the other hand, it becomes more and more difficult to pay dividends.
Is it a flaw, an oxymoron? Which are your thoughts?

We will share the best answer with all members, and we will give a
CRCMP program to the winner.

You can read more about the dividends at Number 1 below.

Also…

“A cyclist has made a strong start to the race.

But, as it happens, he has overestimated his strength.

After a while, he has to pedal harder just to avoid falling over.

His energies are flagging and he is on the point of collapsing from
exhaustion.

His mistake was to treat a long-distance race as a series of
ever-shortening sprints.

His horizon was too short; the cumulative effort is finally catching up.

And yet, he struggles on.

The global economy is not so different from this sportsman.

_____________________________________________________________

Page |3

It gained new force from a powerful wave of globalisation and the
suppression of inflation.

But the resurgence of the financial cycle made it feel, for a while, stronger
than it really was.

Market participants and policymakers did not see through this illusion.

And, every time that a financial boom turned to bust, they would simply
try harder, re-applying the same old nostrums.

Their horizons were too short; and the cumulative impact of their efforts
is catching up with them: stocks of private and sovereign debt have been
growing beyond sustainable levels and the policy room for manoeuvre has
been shrinking dramatically”

Who said that?

Claudio Borio, from the Bank for International Settlements, in one really
great presentation …
… where he covers economic cycles as well!

He continues - at Number 3 of our list:

“Our historian would go one level deeper.

He would ask: “Are banking crises, like Tolstoy’s famous unhappy
families, all different? Or are they more like his happy ones, which are all
alike?”

You must read it!!!

Welcome to the Top 10 list.

_____________________________________________________________

Page |4

Agencies Provide Guidance
on Regulatory Capital
Rulemakings
The U.S. federal banking agencies issued three notices of proposed
rulemaking in June that would revise and replace the current regulatory
capital rules.

The proposals suggested an effective date of January 1, 2013.

A full version of the Group of 20
communique:
“We, the G20 Finance Ministers and Central Bank
Governors, met to assess progress on the
fulfillment of the mandates given to us by our
Leaders, to promote robust growth and job
creation and to address ongoing economic and
financial challenges.”

On time, stocks and flows: Understanding the
global macroeconomic challenges

Claudio Borio
Bank for International Settlements

_____________________________________________________________

Page |5

PCAOB Regulatory Initiatives
James R. Doty, Chairman
Practising Law Institute, New York, NY

Introductory statement
Mario Draghi, President of the ECB,
Vítor Constâncio, Vice-President of the ECB,
Frankfurt am Main

Steven Maijoor, ESMA Chair
Developments in European Financial
Reporting Regulation and
Enforcement
Meet the Experts, London

Speech by the Chancellor of the
Exchequer, Rt Hon George
Osborne MP
(to the Royal Society)

_____________________________________________________________

Page |6

The Challenges of Understanding Labor Market
Trends
Dennis Lockhart, President and Chief Executive Officer
Federal Reserve Bank of Atlanta

Large Exposure Regime
Groups of Connected Clients and
Connected Counterparties
Interesting parts

AIMA ANNOUNCES AIFMD
IMPLEMENTATION PROJECT
The Alternative Investment Management
Association (AIMA), the global hedge fund
association, has announced its AIFMD Implementation Project ahead of
the release of the final implementation text of the Alternative Investment
Fund Managers Directive (AIFMD) by the European Commission.

_____________________________________________________________

Page |7

Agencies Provide
Guidance on
Regulatory Capital
Rulemakings
The U.S. federal banking agencies issued three notices of proposed
rulemaking in June that would revise and replace the current regulatory
capital rules.

The proposals suggested an effective date of January 1, 2013.

Many industry participants have expressed concern that they may be
subject to a final regulatory capital rule on January 1, 2013, without
sufficient time to understand the rule or to make necessary systems
changes.

In light of the volume of comments received and the wide range of views
expressed during the comment period, the agencies do not expect that
any of the proposed rules would become effective on January 1, 2013.

As members of the Basel Committee on Banking Supervision, the U.S.
agencies take seriously our internationally agreed timing commitments
regarding the implementation of Basel III and are working as
expeditiously as possible to complete the rulemaking process.

As with any rule, the agencies will take operational and other
considerations into account when determining appropriate
implementation dates and associated transition periods.

_____________________________________________________________

Page |8

The Federal Reserve Board on Friday launched the 2013 capital planning
and stress testing program, issuing instructions to firms with timelines for
submissions and general guidelines.

The program includes the Comprehensive Capital Analysis and Review
(CCAR) of 19 firms as well as the Capital Plan Review (CapPR) of an
additional 11 bank holding companies with $50 billion or more of total
consolidated assets.

The aim of the annual reviews is to ensure that large, complex banking
institutions have robust, forward-looking capital planning processes that
account for their unique risks, and to help ensure that institutions have
sufficient capital to continue operations throughout times of economic
and financial stress.

Capital is important to banking organizations, the financial system, and
the broad economy because it acts as a cushion to absorb losses and helps
to ensure that any such losses are borne by shareholders, not taxpayers.

Institutions in the CCAR and CapPR programs will be expected to have
credible plans that show they have sufficient capital to continue to lend to
households and businesses even under severely adverse conditions, and
are well prepared to meet Basel III regulatory capital standards as they
are implemented in the United States.

Firms' capital adequacy will be assessed against a number of quantitative
and qualitative criteria, including projected performance under the stress
scenarios provided by the Federal Reserve and the institutions' internal
scenarios.

Boards of directors of the institutions are required to review and approve
capital plans before submitting them to the Federal Reserve.

_____________________________________________________________

Page |9

"The Federal Reserve has been focused--and will remain focused--on
ensuring the nation's largest financial institutions have enough capital to
weather severe, unexpected conditions and still continue lending to
households and businesses," Gov. Daniel K. Tarullo said.

The 19 bank holding companies in the CCAR have increased their
aggregate tier 1 common capital to $803 billion in the second quarter of
2012 from $420 billion in the first quarter of 2009.

The tier 1 common ratio for these firms, which compares high-quality
capital to risk-weighted assets, has more than doubled to a weighted
average of 10.9 percent from 5.4 percent.

One part of the CCAR and CapPR reviews is an evaluation by the Federal
Reserve of institutions' plans to make capital distributions, such as
dividend payments or stock repurchases.

The Federal Reserve will approve dividend increases or other capital
distributions only for companies whose capital plans are approved by
supervisors and who are able to demonstrate sufficient financial strength
to continue to operate as financial intermediaries under stressed
macroeconomic and financial market scenarios, even after making the
planned capital distributions.

In a change from prior years, following the Federal Reserve's assessment
of the initial capital plans, CCAR firms will have one opportunity to make
a downward adjustment to their planned capital distributions from their
initial submissions before a final Federal Reserve decision is made.

As in 2012, the Federal Reserve will release summary results for the 19
CCAR firms including its projections of capital ratios, losses, and
revenues under the Federal Reserve's severely adverse scenario.

In 2013, the Federal Reserve will release two sets of post-stress data for
each firm.

_____________________________________________________________

P a g e | 10

One set will reflect the capital distribution assumptions prescribed in the
stress testing rule mandated by the Dodd-Frank Wall Street Reform and
Consumer Protection Act to enhance comparability of results.

The other will include ratios based on each firm's own planned capital
actions as proposed in their initial CCAR capital plan submissions, as
well as ratios based on any adjustments made to planned capital
distributions.

While the aims of CapPR are the same as CCAR, there are a number of
important distinctions.

For example, the Federal Reserve's assessment of capital plans under
CapPR will not be based on supervisory estimates derived from
independent supervisory models, but instead solely on an assessment of
the firms' own capital plans and internal capital planning and stress
testing practices that support them.

Further, the Federal Reserve will not publish a summary of bank-specific
results for CapPR in 2013.

The Federal Reserve wanted to give firms as much time as possible to
prepare their submissions and therefore is issuing the instructions ahead
of the release of the macroeconomic and financial market scenarios.

The Federal Reserve will require institutions to use the scenarios in both
the stress tests conducted as part of their capital plans and in the stress
tests that are part of the Dodd-Frank Wall Street Reform and Consumer
Protection Act.

The Federal Reserve expects to release the scenarios at 4 p.m. EST on
Thursday, November 15. Institutions will be required to submit their
capital plans no later than January 7, 2013.

_____________________________________________________________

P a g e | 11

The following is a full version of the Group
of 20 communique:
1. We, the G20 Finance Ministers and Central
Bank Governors, met to assess progress on the
fulfillment of the mandates given to us by our
Leaders, to promote robust growth and job
creation and to address ongoing economic and financial challenges.

2. We will do everything necessary to strengthen the overall health and
growth of the global economy.

Our main focus in the period ahead will be to rebuild confidence and to
reduce risks and volatility in international financial markets; contribute to
a faster pace of economic recovery and job creation, and promote the
foundations for strong, sustainable, and balanced growth.

We are firmly committed to open trade and investment, expanding
markets and resisting protectionism in all its forms.

3. We have made significant progress in implementing the commitments
established in the Los Cabos Growth and Jobs Action Plan.

Substantive measures have been adopted in Europe, including the launch
of the European Stability Mechanism, the decision of the ECB on
Outright Monetary Transactions, the agreement by European leaders to
establish a single supervisory mechanism for banks, the adoption and
ongoing implementation of the Compact for Growth and Jobs, and the
reforms and fiscal consolidation carried out by a number of European
countries.

Other countries with policy space have implemented actions to support
aggregate demand.

Major central banks have taken further unconventional measures in line
with their respective mandates which are welcomed.
_____________________________________________________________

P a g e | 12

4. Global growth remains modest and downside risks are still elevated,
including due to possible delays in the complex implementation of recent
policy announcements in Europe, a potential sharp fiscal tightening in
the United States, securing funding for this year's budget in Japan,
weaker growth in some emerging markets and additional supply shocks
in some commodity markets.

The reduction of global imbalances has not been sufficient, and in many
countries the process of necessary deleveraging by the private and public
sectors is ongoing and unemployment remains high.

Complete and timely implementation of all of our policy commitments is
critical in order to continue to reduce risks and secure a durable and
strong recovery.

5. We are committed to build on the policy measures taken in recent
months.

Current reform momentum in the EU on structural, fiscal and financial
fields needs to be continued with the view to improving competitiveness
and promoting financial stability.

In this respect, we welcome the recent decision by European leaders to
agree on a legislative framework by January 1st 2013 on a single
supervisory mechanism.

We look forward to the operational implementation of the single
supervisory mechanism in the course of 2013 and to the completion of the
technical discussions on the future of the ESM direct bank
recapitalization instrument, within a broader strategy of completing the
architecture of the EMU.

6. We will ensure our public finances are on sustainable paths, in line with
the medium-term Toronto commitments in the case of advanced
economies.

In light of the weak pace of global growth, they will ensure that the pace
of fiscal consolidation is appropriate to support the recovery.
_____________________________________________________________

P a g e | 13

Countries which have fiscal space will let the automatic fiscal stabilizers
operate as appropriate.

Those with sufficient space stand ready to support demand as needed in
the shortrun should economic conditions deteriorate.

The United States will carefully calibrate the pace of fiscal tightening to
ensure that public finances are placed on a sustainable long-run path
while avoiding a sharp fiscal contraction in 2013.

In Japan further progress in medium-term fiscal consolidation is needed.

By the next Summit, advanced economies agree to identify credible and
ambitious country-specific targets for the debt-to-GDP ratio beyond 2016,
where these do not currently exist, accompanied by clear strategies and
timetables to achieve them.

7. The weak pace of global growth also reflects limited progress towards
sustaining and rebalancing global demand.

We commit to achieving external and internal adjustment in a way that
supports and sustains growth and leads to global rebalancing.

In this regard, we reiterate our commitments to move more rapidly
toward more market-determined exchange rate systems and exchange
rate flexibility to reflect underlying fundamentals, avoid persistent
exchange rate misalignments and refrain from competitive devaluation of
currencies; to boost domestic sources of growth in surplus economies,
and boost national savings in deficit economies.

We reiterate that excess volatility of financial flows and disorderly
movements in exchange rates have adverse implications for economic
and financial stability.

We commit to the implementation of ambitious structural reforms aimed
at promoting output and employment.

_____________________________________________________________

P a g e | 14

We have also made progress in strengthening our Accountability
Assessment framework by agreeing on a set of measures to inform our
analysis of our fiscal, monetary and exchange rate policies.

We will consider a range of indicators and approaches to assess spillover
effects, progress towards commitments on structural reforms, and our
collective achievement of strong, sustainable and balanced growth.

8. We welcome the continuation of the process to strengthen IMF
resources to safeguard global financial stability and enhance the IMF's
role in crisis prevention and resolution.

Since the Los Cabos Summit, additional pledges have been received from
more members, and total commitments add up to US$461 billion.

Furthermore, we welcome the formalization of the first set of bilateral
borrowing agreements under the agreed modalities comprising
US$286bn, which represent more than half of the Los Cabos' 2012 pledge.

We call for the finalization of the remaining bilateral agreements.

9. We welcome IMF´s Executive Board decision on the use of US$2.7bn
of additional resources from the windfall gold sales profits for the Fund´s
Poverty Reduction and Growth Trust and call on the membership to
provide the assurances needed for this to take place.

This effort reinforces the international community´s will to reduce
poverty by boosting financial assistance to low income country members.

10. We remain committed to the full implementation of the 2010 Quota
and Governance Reform.

Although significant progress has been achieved, as of October 2012 the
conditions for the entry into force of the 2010 Quota and Governance
Reform have not been fully met.

_____________________________________________________________

P a g e | 15

We reaffirm the urgency of making these important reforms effective and
call on members who have yet to complete the process to do so as soon as
possible.

The process of IMF reform will enhance its legitimacy, relevance and
effectiveness.

11. We are committed to completing the comprehensive review of the
quota formula, to address deficiencies and weaknesses in the current
quota formula, by January 2013 and to complete the next general review of
quotas by January 2014.

We agree that the formula should be simple and transparent, consistent
with the multiple roles of quotas, result in calculated shares that are
broadly acceptable to the membership, and be feasible to implement
based on a timely, high quality and widely available data.

We reaffirm that the distribution of quotas based on the formula should
better reflect the relative weights of IMF members in the world economy,
which have changed substantially in the view of a strong GDP growth in
dynamic emerging markets and developing countries.

We reaffirm the importance of continuing to protect the voice and
representation of the poorest members of the IMF.

We call on the IMF membership to develop the consensus needed to
complete the review by January 2013.

12. We welcome the strengthening of the IMF's surveillance framework
through the adoption of the new Integrated Surveillance Decision, and we
welcome the introduction of the Pilot External Sector Report to
strengthen multilateral analysis and enhance the transparency of
surveillance.

A transparent and evenhanded framework of surveillance is key to achieve
ownership and traction of policy recommendations by the IMF, thus
making surveillance more effective.

_____________________________________________________________

P a g e | 16

13. We note the World Bank and other International Organizations' (IOs)
progress report on implementation of the G20 action plan to support the
development of local currency bond markets.

We look forward to full implementation of the action plan in 2013 to
ensure a broad ownership of the diagnostic tool among potential users,
and further reporting on progress by the World Bank.

We welcome ongoing regional initiatives to promote local currency bond
markets.

We will deepen work on these issues under Russia´s Presidency.

14. We acknowledge the importance of long term financing, particularly
for infrastructure investment, recognizing that work on this subject will
foster an environment more conducive to long-term investment,
effectively helping to boost jobs and growth.

We ask that the World Bank, IMF, OECD, FSB, UN and relevant IOs
undertake further diagnostic work to assess factors affecting long-term
investment financing including its availability.

We look forward to receiving this work in early 2013 to provide a sound
basis for any future G20 work.

15. We remain committed to the full, timely and consistent
implementation of the financial regulation agenda, and discussed the
latest FSB reports on the progress in implementation of agreed reforms.

We endorse the conclusions and recommendations of the fourth progress
report on the implementation of the G20 commitments to OTC
derivatives reforms and the BCBS report on implementation of Basel III.

We agree to put in place the legislation and regulation for OTC
derivatives reforms promptly and act by end-2012 to identify and address
conflicts, inconsistencies and gaps in our respective national frameworks,
including in the cross-border application of rules.

_____________________________________________________________

P a g e | 17

We agree to take the measures needed to ensure full, timely and effective
implementation of Basel II, 2.5 and III and its consistency with the
internationally agreed standards.

We look forward to receiving for our April meeting the BCBS report on
the consistency of measurement of risk-weighted assets.

We endorse the Charter for the Regulatory Oversight Committee which
will act as the governance body for the global Legal Entity Identifier
system to be launched in March 2013.

16. We acknowledge progress made in the design and implementation of
policy measures to strengthen the resilience of the financial system and
reduce systemic risks.

In particular, we welcome the publication by the FSB of an updated list of
global systemically important banks, the BCBS framework for dealing
with domestic systemically important banks, and the International
Association of Insurance Supervisors (IAIS) consultation paper on policy
measures for global systemically important insurance companies.

We commit to make the necessary changes to resolution regimes to
enable authorities to resolve SIFIs.

We welcome the initial integrated set of policy recommendations to
strengthen the oversight and regulation of shadow banking together with
expanded data monitoring.

We call for finalized policy measures by the St. Petersburg Summit for
oversight and regulation for shadow banking that can be peer-reviewed.

17. We also welcome the recommendations to increase the intensity and
effectiveness of SIFI supervision, and the FSB's roadmap to accelerate
implementation of the FSB Principles for Reducing Reliance on Credit
Rating Agency Ratings.

_____________________________________________________________

P a g e | 18

We encourage further work to enhance transparency of and competition
among credit rating agencies and ask IOSCO to provide a report on
ongoing work at our meeting in April.

We support measures to strengthen the transparency of financial
institutions and recognize the contribution of the Enhanced Disclosure
Task Force.

Recognizing the need for adequate statistical resources, we endorse the
progress report of the FSB and the IMF on closing information gaps, and
in particular look forward to the implementation of the data reporting
templates for global systemically important financial institutions.

We are concerned about the slow progress achieved toward a single set of
high quality accounting standards.

We encourage the International Accounting Standards Board (IASB) and
Financial Accounting Standards Board (FASB) to complete work
promptly, and report to our next meeting.

In relation to LIBOR, EURIBOR and other financial benchmarks, we
welcome actions taken and ongoing reviews to identify measures to
address weaknesses and restore confidence in benchmark and index
setting practices and welcome the coordinator role of the FSB as agreed.

We ask IOSCO to provide by our April meeting a report on the next steps
on the functioning of credit default swaps markets.

We expect the FSB to continue monitoring, analyzing and reporting on
the unintended consequences of regulatory reforms on EMDEs.

18. We welcome the FSB's progress in implementing the measures
endorsed at Los Cabos to strengthen its capacity, resources and
governance.

We look forward to its establishment as a legal entity by our next meeting
and its full implementation by September 2013.

_____________________________________________________________

P a g e | 19

We call on the FSB to report back on how it intends to keep under review
the structure of its representation.

19. We welcome the observed increase in jurisdictions' adherence to
international regulatory and supervisory cooperation and information
exchange standards, as stated in the FSB status report, and call for further
progress.

20. We remain committed and encourage the FATF to continue to pursue
all its objectives, and notably to continue to identify and monitor
high-risk jurisdictions with strategic Anti-Money Laundering
/Counter-Terrorist Financing (AML/CFT) deficiencies.

We look forward to the completion in 2013 of the revision of the FATF
assessment process.

We encourage all countries to adapt their legal framework with a view to
complying with the revised FATF's Recommendations, in particular the
necessity to identify the beneficial owner of corporate vehicles, and we
look forward to the assessment of the effectiveness of the measures
countries take and their compliance with the global standards in the next
round of Mutual Evaluations.

21. We commend the signings of the Multilateral Convention in Cape
Town and further progress made towards transparency as reported by the
Global Forum whose membership has increased.

We look forward to a progress report by the Global Forum on the
effectiveness of information exchange practices by April 2013.

We welcome and endorse the improved OECD standard with respect to
information requests on a group of taxpayers and encourage all countries
to adopt it when appropriate.

We will continue to implement practices of automatic exchange of
information and call on the OECD to analyze the safeguards,
mechanisms and milestones necessary to increase its use and efficient
implementation in a multilateral context.
_____________________________________________________________

P a g e | 20

We also welcome the work that the OECD is undertaking into the
problem of base erosion and profit shifting and look forward to a report
about progress of the work at our next meeting.

22. We welcome the work stated in the final 2012 Global Partnership for
Financial Inclusion (GPFI) progress report on implementing the five
recommendations set out in 2011 and the progress on implementing the
G20 Principles for Innovative Financial Inclusion, including through
concrete actions by developing and emerging countries to meet their
commitments to the Maya Declaration.

We commend the additional commitments to the Maya Declaration made
in Cape Town in 2012, and encourage countries to measure progress
through national data collection efforts.

We welcome the decision to establish the Alliance for Financial Inclusion
(AFI) as a permanent network for knowledge creation, exchange and
policy dialogue.

23. We welcome the first GPFI Conference on Standard-Setting Bodies
and Financial Inclusion as a substantial demonstration of growing
commitment among Standard Setting Bodies (SSBs) to provide guidance
and to engage with the GPFI to explore the linkages among financial
inclusion, financial stability, financial integrity and financial consumer
protection.

We also commend the work done to continue improving SMEs financing
and their environment.

24. Together with the implementing partners, we look forward to updates
on the G20 Financial Inclusion Peer Learning Program and encourage
the commitment to other initiatives that promote Financial Inclusion.

25. For advancing the financial consumer protection agenda, we
acknowledge the work done by the International Financial Consumer
Protection Network (FinCoNet) to support the exchange of best practices
and look forward for a progress report by the G20 Summit in St.
Petersburg in 2013.
_____________________________________________________________

P a g e | 21

We also welcome the implementation of the action plan by the G20
OECD Task Force on Financial Consumer Protection and progress
achieved in Cartagena, including in the field of national strategies and
financial education for women, by the OECD International Network on
Financial Education (INFE).

26. We welcome the number of proposals received in response to the 2012
Mexico Financial Inclusion Challenge: Innovative Solutions for
Unlocking Access.

We congratulate the finalists and the winner.

27. In Los Cabos, Leaders recognized that excessive commodity price
volatility has significant implications for countries, increasing uncertainty
in the economy, and endorsed the conclusions of a report on the
macroeconomic impacts of excessive commodity price volatility on
growth.

Ahead of the 2013 Summit, we will report progress on the G20's
contribution to facilitate better functioning of commodity markets,
considering possible areas for further work outlined in the report.

28. We reaffirm our commitment to improve transparency and
functioning of commodity markets.

We welcome the progress made in the implementation of the Agricultural
Market Information System (AMIS) which will provide more
transparency on physical markets for agricultural commodities.

We welcome the IEF's recommendations to improve the reliability of the
JODI-Oil database.

We welcome the report prepared by the IEA, the IEF and the OPEC on
increasing transparency in international gas and coal markets and ask
these organizations to propose practical steps by mid-2013 that G20
countries could take to implement them.

_____________________________________________________________

P a g e | 22

We welcome progress on the JODI-Gas database and look forward to
working with it in 2013.

We welcome the report on recommendations to improve the functioning
and oversight of oil Price Reporting Agencies, and ask IOSCO to liaise
with the IEA, IEF and OPEC to assess the impact of the principles on
physical markets and report back.

We also ask IOSCO to report progress on the implementation of the
principles in 2013.

We reaffirm our commitment to enhance transparency and appropriate
regulation in financial commodity markets, and thus we welcome
IOSCO's report on the implementation of its Principles for the
Regulation and Supervision of Commodities Derivatives Markets.

29. In Los Cabos, Leaders highlighted that green growth and sustainable
development policies have strong potential to stimulate long term
prosperity.

We will voluntarily self-report again in 2013 on our efforts to incorporate
green growth and sustainable development policies into structural reform
agendas, taking into account the outcome of the UN Conference on
Sustainable Development (Rio+20).

We will report back to our leaders on the progress made to rationalize and
phase-out over the medium-term inefficient fossil fuel subsidies that
encourage wasteful consumption, while providing targeted support for
the poorest.

We will develop a voluntary peer review process on such fossil fuel
subsidies and present a report on the outcomes to our Leaders in 2013.

We welcome the OECD report on pension funds financing green
initiatives.

30. Recognizing that the UNFCCC is the forum for climate change
negotiations and decisionmaking at the international level, we
_____________________________________________________________

P a g e | 23

acknowledge that climate finance is a relevant issue to be discussed
amongst G20 Finance Ministers and Central Bank Governors.

We welcome the progress report by the G20 Climate Finance Study Group
on ways to effectively mobilize resources for climate finance.

We will continue working towards building a better understanding of the
underlying issues among G20 members taking into account the
objectives, provisions and principles of the UNFCCC, and report back to
our Leaders in 2013.

31. We recognize that disaster risk financing policies are necessary for an
overall Disaster Risk Management (DRM) strategy.

We appreciate and welcome the combined efforts made by the World
Bank and the OECD, with the support of the United Nations, to broaden
the participation in the discussion on DRM by highlighting the central
role that financial policymakers play to support other areas of
Government and civil society in dealing with disasters.

We welcome the G20/OECD voluntary framework for disaster risk
assessment and risk financing which provides a detailed guideline that
aims to facilitate the implementation of more effective DRM strategies.

We encourage further efforts by the World Bank and OECD in
cooperation with other relevant international organizations to leverage
the voluntary framework in order to address remaining challenges.

32. We commend Mexico for chairing the G20 in 2012 and look forward to
Russia's presidency in 2013.

The Finance Track

The Finance Track in the G20 focuses on financial and economic issues;
these include providing solutions to the current economic problems,
economic stabilization and structural reforms, increasing international
coordination for crisis prevention, correction of external, fiscal and
_____________________________________________________________

P a g e | 24

financial imbalances, providing resources to increase global liquidity, and
strengthening the international financial system.
The Finance Track is composed of all G20 Finance Ministers and Central
bank Governors who meet regularly during the year to discuss the current
economic global problems and take coordinated actions towards their
solutions; these meetings are attended also by International
Organizations such as the IMF, World Bank, OECD or the Financial
Stability Board.
Organizationally, the track operates with working groups formally
established within the G20 but also through close cooperation with
international financial entities.
Currently the Finance Track of the G20 is organized in the following
major areas:
I. Framework for Strong, Sustainable and Balanced Growth Working
Group (Co-chaired by Canada and India)
II. Financial Regulation
III. Financial Inclusion, Financial Education and Consumer Protection
IV. International Financial Architecture Working Group (Co-chaired by
Australia and Turkey)
V. Energy and Commodities Markets Working Group (Co-chaired by
Indonesia and United Kingdom)
a. Commodities Markets Subgroup (Co-chaired by Brazil and United
Kingdom)
b. Energy and Growth Subgroup (Co-chaired by Korea and United States)
VI. Disaster Risk Management
VII. Climate Finance Study Group (Co-chaired by France and South
Africa)
The G20 has been a very effective forum of international coordination and
cooperation for crisis mitigation and to foster economic growth and
strengthen financial regulation.
It has also increased its scope to other relevant economic issues such as
financial inclusion and education, disaster risk management, green
growth or climate finance.
_____________________________________________________________

P a g e | 25

Under the Mexican presidency, the Finance track launched the 2012 G20
Agenda on December 13-14th 2011 with a seminar in Mexico City.

In preparation to the Leaders Summit in Los Cabos in June, Finance
Ministers and Central Bank Governors have met on February and April to
discuss current relevant economic problems and have taken coordinated
actions for their solution.

_____________________________________________________________

P a g e | 26

On time, stocks and flows:
Understanding the global
macroeconomic challenges

Claudio Borio
Bank for International Settlements

Introduction

It wasn’t meant to be like this.

The financial crisis that began in 2007
shattered the illusion of uninterrupted prosperity that had prevailed in
much of the Western world.

It was not the first time that this had happened.

Doubtless, it will not be the last.

Five years on, much of the advanced country world is still struggling to
return to robust, sustainable growth.

And the crisis has kept morphing before our eyes; it has now engulfed
sovereigns too.

The euro area is the new epicentre.

But will the tremors stop there?

In what follows, I will seek to provide a broad framework for thinking
these issues through.

How did we get here? Why? Where might we go from here? How might
we extricate ourselves from our predicament?

_____________________________________________________________

P a g e | 27

These are hard questions.

No one really knows the answers.

But all of us have a perspective and a narrative that goes with it.

This is just another one – one that draws heavily on work done at the BIS.

I will try to look below the busy and at times chaotic surface of the world
economy.

The idea is to identify what one might call the shifts in its “tectonic
plates” – those deep forces that, slowly but cumulatively, can
fundamentally reshape what we see on the surface and that economists
call “economic regimes”.

I will highlight three such forces: financial liberalisation, the
establishment of credible anti-inflation monetary frameworks, and the
globalisation of the real side of the world economy.

Each of them, taken in isolation, is undoubtedly a good thing.

All of them together are worth having and fighting for.

Yet I will argue that a failure of policy to adjust to them has played an
important role in the crisis and its aftermath.

It has given rise to the re-emergence of powerful financial cycles, whose
booms and busts have caused havoc in the economy and have left us
where we are today.

But what is the link between all this and the title of my remarks? In fact,
the title highlights two key aspects of the story.

First, time.

_____________________________________________________________

P a g e | 28

As the three deep forces gained full strength from the mid-1980s, they
shaped an environment where, in Burns and Mitchell’s terminology,
economic time has slowed down relative to calendar time.

That is, the macroeconomic developments that matter take much longer
to unfold.

The length of the financial cycle is much longer that of the traditional
business cycle, of the order of 16 to 20 years or more compared with up to
eight years.

Yet the planning horizons of market participants and policymakers have
not adjusted accordingly – indeed, if anything, they have shrunk.

This is a critical reason why the current problems have arisen and why it
has proved so hard to solve them.

And it has major implications for the sustainability of growth, for financial
regulation, for fiscal policy and for monetary policy.

We then come to stocks and flows.

In the new environment, stocks have come to dominate economic
dynamics, in particular the large stocks of assets and, above all, debt.

Stocks build up above trend during financial booms, as credit and asset
prices grow beyond sustainable levels, and generate stubborn overhangs
once the boom turns to bust. Stocks raise serious policy challenges.

In the presence of policy responses that react too little to booms and too
much to busts – in jargon, that are asymmetric – stocks grow over
consecutive business cycles.

It takes longer to deal with them.

And doing so is also politically more difficult, because of the serious
impact on income and wealth distribution, both within and across
generations.
_____________________________________________________________

P a g e | 29

This is true of both private and public debt.

Failure to deal with stocks effectively could entrench instability in the
system.

If this diagnosis is right, the remedy is not hard to find, although it may
be extraordinarily difficult to implement.

In a nutshell, it is to lengthen policy horizons, to put in place more
symmetrical policies, and to tackle the debt problems head-on.

Much of my discussion will seek to make these guidelines more concrete.

The ultimate risk of a failure to adjust is that of yet another
epoch-defining shift in the tectonic plates – the risk of a reversal that will
take us back to an era of financial and trade protectionism as well as
inflation.

The structure of my remarks is as follows.

The first section lays out the broad canvas.

It considers the changing character of economic fluctuations,
highlighting the role of the financial cycle and its link to structural
institutional arrangements, policy decisions and horizons.

The second section turns to the policy challenges.

It begins with a brief summary of the current situation, seen through the
lens of the financial cycle.

It then explores, in turn, the immediate or more conjunctural challenge of
how to return to self-sustaining and sustainable growth and then the
longer-term or more structural challenge of how to adjust policy
frameworks to address the financial cycle – not to be interpreted
sequentially, though.

_____________________________________________________________

P a g e | 30

The discussion covers financial (specifically prudential) regulation and
supervision, fiscal and monetary policies.

While my focus is on the global economy, I will also note the specificities
of the European situation.

I. The broad canvas
Stylised facts: an economic historian’s perspective
Imagine a future economic historian looking back at the big
macroeconomic trends from the first oil shock of the early 1970s to our
present day.

What would he see as he cast his gaze over a longer historical timespan?

Consider, in turn, the most salient outcomes, the intellectual backdrop,
the features of banking crises, and institutional setups.

In terms of outcomes, he would no doubt be struck by the major shift in
the behaviour of inflation: from high and variable to low and stable, with
the inflexion point around the early 1980s.

At the same time, he would also note a major increase in financial crises,
especially banking crises, with serious macroeconomic consequences, in
both advanced and emerging market economies.

Reading the contemporary economic texts to understand the intellectual
backdrop, he would surely find it ironic that the view prevailing at the
time had regarded price stability as a guarantee of macroeconomic
stability.

And that, in much of the West during the early 2000s, there had even been
talk of a so-called Great Moderation: a golden age of stable output and
low inflation.

This conviction had hardly been dented by the banking crises that had hit
emerging market economies and even some advanced ones during the
1980s and 1990s, not least the Nordic countries and Japan.
_____________________________________________________________

P a g e | 31

To paraphrase Reinhart and Rogoff, what seemed to be at work was not
just the “this-time-is-different” syndrome but the no less insidious
“we-are-different” syndrome.

It had taken the Great Financial Crisis, as contemporaries had quickly
called it, which had erupted in 2007 to shake this complacency.

The historian would also note that the experience of those years had been
by no means unique.

Similar economic fluctuations, where low inflation had coexisted with
occasional banking crises, had been quite common in the Gold Standard
days, when countries had pegged their currencies to gold.

Indeed, a long economic boom with low and stable inflation had ushered
in that other defining moment in economic history – the Great
Depression in the United States in the early 1930s.

Then, just as later on, there had been talk of permanent prosperity, of an
end to the tyranny of the business cycle.

Our historian would then go one level deeper.

He would ask: “Are banking crises, like Tolstoy’s famous unhappy
families, all different? Or are they more like his happy ones, which are all
alike?”

It is all too easy, he would note, to spot the idiosyncratic features of a
crisis.

Structured products, for instance, had not existed in the early 1930s.

Or, to take just another example, the crises in Japan and Nordic countries
had caused havoc in bank-based financial systems; by contrast, the
subsequent Great Financial Crisis had originated in the United States,
with its securitisation-intensive, capital markets-based financial system.

_____________________________________________________________

P a g e | 32

Or, again, the crisis in Finland had followed the collapse of its main
trading partner, the Soviet Union; but no obvious external shock had been
at work in 2007.

And he could go on.

Yet, he would quickly realise that focusing on idiosyncrasies would mean
falling victim to the “we-are-different” syndrome in another guise.

A fuller understanding of crises requires a focus on what they have in
common, not on how they differ.

Only then can one find reliable remedies.

After all, had not the Japanese bank-based financial system been hailed as
superior ahead of the country’s banking crisis?

And had not much the same been said of the US market-based financial
system ahead of its own meltdown?

Our historian would then look for common patterns.

Soon enough, an obvious one would leap out at him: crises tend to be
preceded by major financial booms and followed by protracted busts that
leave deep scars in the economic tissue.

In other words, they are closely associated with peaks in the financial
cycle.

The joint behaviour of credit and asset prices, in particular property
prices, capture these cycles remarkably well.

And since banking crises are rare events in any given country, it is natural
for these cycles to be very long.

Their order of magnitude is between 15 and 20 years.

_____________________________________________________________

P a g e | 33

As he read further, our historian would realise that the close association
between crises and financial booms and busts had, in fact, been
recognised early on in the economics profession, as far back as the 19th
century.

During the post-war period, economists such as Kindleberger and
Minsky had kept the concept alive at the margins of the field.

Their work had inspired policy-oriented research ahead of the Great
Financial Crisis.

But it had gone largely unheeded, drowned in the contagious enthusiasm
for the Great Moderation.

Memories are short; hubris long.

But our historian’s intellectual curiosity could not stop there. He has
established that financial cycles foment banking crises, with damaging
macroeconomic consequences.

He has also noted that financial cycles were a common feature both of the
gold standard era and of the period running from the mid-1980s to our
present day.

Could the two periods have yet more in common?

“Yes”, would be our historian’s answer.

And this conclusion would refer to the tectonic plates of the global
economy – to the institutions that embody its “economic regimes”.

The two eras had seen the coexistence of monetary policy frameworks
that delivered reasonable price stability with liberalised financial markets
and highly integrated markets for goods, capital and labour.

In fact, they had come to be known as the first and second waves of
globalisation.

_____________________________________________________________

P a g e | 34

The successful fight against inflation dated back to the early 1980s, and
had gradually spread across the world thereafter.

By the mid-1980s policymakers had largely liberalised domestic financial
markets, and by the end of that decade, in the words of Padoa-Schioppa
and Saccomanni, the global financial system had turned from
government-led to market-led.

The integration of goods and factor markets had started much earlier in
the post-war period, but it had taken a quantum leap in the 1990s, when
the former communist countries had entered the capitalist production
system.

As Thomas Friedman had put it, the world had become flat – once again,
he should have added.

Stylised facts: an interpretation

Is this similarity between deep structures and economic outcomes just a
coincidence?

I would suggest not.

But now it is best to part company with our economic historian, as we
move further away from the realm of stylised facts to that of (we hope)
informed conjectures and their policy implications.

It stands to reason that the three powerful forces have interacted so as to
deeply shape economic fluctuations.

Their conjunction has made economies more vulnerable to large and
prolonged financial booms and busts – financial cycles – that can inflict
severe damage on the economy.

During the boom “financial imbalances” develop: (private sector)
balance sheets become overextended on the back of aggressive
risk-taking.

_____________________________________________________________

P a g e | 35

The imbalances sow the seeds of their own destruction, and hence of
economic weakness, unwelcome disinflation and financial strains down
the road.

The boom can turn to bust either because incipient inflation eventually
does emerge, forcing the central bank to tighten or, more often, because
the imbalances collapse under their own weight.

One may call this property of the economy “excess elasticity”.

The analogy is with an elastic band, which one can stretch further and
further until at some point it snaps.

These financial booms and busts necessarily take a long time to unfold.

As they emerge, they slow down economic time relative to calendar time.

How might the tectonic forces interact to produce this outcome?

First, financial liberalisation makes it more likely for financial factors in
general, and booms and busts in credit and asset prices in particular, to
drive economic fluctuations.

Rather than being tightly bound by cash flow constraints, the economy is
propelled by loosely anchored perceptions of asset values and risks,
critically supported by easier credit availability.

Indeed, the link between financial liberalisations and subsequent credit
and asset price booms is well documented.

Second, the establishment of regimes yielding low and stable inflation,
underpinned by central bank credibility, can make it less likely for signs
of unsustainable economic expansion to show up first in rising inflation
and more likely for them to emerge first as unsustainable increases in
credit and asset prices (the “paradox of credibility”).

_____________________________________________________________

P a g e | 36

After all, stable expectations make prices and wages less sensitive to
economic slack: this is precisely what policymakers and economists have
expected all along.

Finally, the globalisation of the real economy has given a major boost to
global potential growth – what economists would call a sequence of
pervasive positive “supply shocks” or an outward shift in the global
economy’s production possibility frontier.

Think of the huge boost to production capacity as China and other former
communist countries joined the world trading system.

By the same token, however, it has surely helped to keep inflation down
and provided fertile ground for credit and asset price booms.

Policy and horizons: pre-crisis role

So much for the big picture – the tectonic plates, so to speak. But what
about the role of decisions made by the policymakers who were
confronted with these forces?

With hindsight at least, it has become clear that policymakers
inadvertently added fuel to the fire ahead of the Great Financial Crisis.

They put too much faith in markets’ ability to self-correct.

They failed to fully understand that the changing landscape called for
adjustments in policy frameworks.

And, even when they did understand, they found it too hard to change
course: too much reputational capital was at stake and, anyway, why fix
what ain’t broken?

Consider, in turn, prudential, monetary and fiscal authorities.

Prudential authorities converged on frameworks that concentrated too
much on the safety and soundness of individual institutions and too little

_____________________________________________________________

P a g e | 37

on that of the system as a whole – frameworks in which the
macroeconomy and the financial cycle hardly figured.

They focused too much on individual trees and too little on the wood.

In current jargon, they had too much of a “microprudential” focus, as
opposed to a “macroprudential” one.

Monetary authorities, still burnt by the Great Inflation experience,
focused narrowly on stabilising near-term inflation.

They could not justify raising interest rates if inflation was low and stable,
let alone falling, even if financial imbalances were building up.

As a result, the imbalances proceeded to grow unchecked.

And fiscal authorities failed to realise that financial booms were hugely
flattering the fiscal accounts and that the busts would at some point
present them with a huge bill – a burden over and above the better known,
but just as intractable, one resulting from ageing populations.

Underlying these failings was a natural tendency to overestimate
sustainable output and growth.

The notion that inflation was the sole harbinger of unsustainability was
especially insidious.

Financial factors, again, did not figure in this picture.

That was the relentless message of the prevailing intellectual
macroeconomic paradigm, both a reflection of the Zeitgeist and a
contributor to it.

Short policy horizons played a key role in all this.

Much of macroeconomic policy centres on the notion of the business
cycle.

_____________________________________________________________

P a g e | 38

As conceived and measured, the business cycle has a duration of eight
years at most.

And yet we have seen that the financial cycle lasts at least twice as long.

Since the financial cycle’s booms and busts have major consequences for
economic activity, not taking them into account can create serious biases
in policymaking.

It is as if, on the open sea, sailors successfully rode out the smaller waves
but remained blissfully unaware of the tsunami rolling beneath them – a
wave that would surge and crash only once it reached the shore.

To illustrate this, consider the experience of several advanced economies
in the mid-1980s to early 1990s and in the period 2001–07.

In both episodes, policymakers reacted strongly to collapses in equity
prices – the global stock market crashes of 1987 and 2001 that ushered in
economic slowdowns or actual recessions.

They cut policy rates and, to a varying and smaller degree, loosened the
fiscal reins.

In both episodes, however, credit and property prices – the most relevant
indicators of the financial cycle – continued to increase, as if getting their
second wind.

Financial imbalances built up further.

And a few years later, the credit and property price booms collapsed, in
turn, causing serious financial damage and dragging down the economy
with them.

This is what happened to Japan in the first episode and to the United
States and United Kingdom in both.

_____________________________________________________________

P a g e | 39

From a medium-term perspective, consistent with the length of the
financial cycle, the slowdowns or contractions in 1987 and 2001 can thus
be regarded as “unfinished recessions”.

The initial “over-reaction” to short-term macro-economic developments,
followed by an under-reaction to the further build-up of financial
imbalances, caused more serious problems down the road.

But short horizons are not just an issue for policymakers. They are an
even bigger one for the private sector, especially for financial market
participants.

Here, traders’ horizons may be as short as a day, or minutes or even
microseconds. More generally, horizons rarely extend beyond one year,
constrained by the rhythm of financial reporting conventions.

Moreover, they have, if anything, been shrinking: technology has been
surging ahead; the spread of fair value accounting has telescoped the
indefinite future into the ephemeral present; tighter monitoring has come
to mean more frequent monitoring.

These short horizons are embedded in risk measurement tools, such as
value-at-risk, in common trading strategies, such as momentum trading,
and in credit techniques, such as securitisation.

For instance, risk models rely on extraordinarily short data histories,
hardly ever extending beyond a few years, and they project outcomes over
a very short future, mostly days and at the very most one year.

Short horizons are probably best captured by the famous words of Chuck
Prince, then CEO of Citigroup, to the effect that “as long as the music is
playing, you have to get up and dance”.

This was just before the crisis broke.

The end result is that market participants’ expectations, once embedded
in market prices, appear highly extrapolative: they follow the trend until it
is too late.
_____________________________________________________________

P a g e | 40

Hence what one might call the “paradox of financial instability”: the
financial system looks strongest precisely when it is most vulnerable.

Credit growth and asset prices are unusually strong, leverage measured at
market prices is artificially low, and risk premia and volatilities sag to
rock-bottom levels precisely when risk is at its highest.

What looks like low risk is, in fact, a sign of aggressive risk-taking.

The recent crisis has simply confirmed this all over again.

A vicious cycle has set in.

The interaction between market participants’ instincts, the relentless
24/7 media razzmatazz and the response of policymakers becomes ever
stronger; as a result, horizons become ever shorter.

So, the search for the culprits for the Great Financial Crisis brings very
much to mind Agatha Christie’s famous thriller, Murder on the Orient
Express.

Who was the murderer then? As it turns out, all the passengers on the
train were.

Who is the culprit now?

As it turns out, we all are.

II. Post-crisis challenges
The legacy of the crisis: a balance sheet recession

The foregoing analysis casts light on the recession that followed the
financial crisis.

Not all recessions are born equal.

The typical postwar recession was triggered by tighter monetary policy to
stop rising inflation or a balance of payments crunch.
_____________________________________________________________

P a g e | 41

By contrast, a post-financial crisis recession is a balance sheet recession,
linked to a financial bust against the backdrop of low and stable inflation.

This means that the preceding expansion is much longer, the subsequent
debt and sectoral capital stock overhangs much larger, and the damage to
the financial sector much greater.

It also means that the policy room for manoeuvre is very limited: unless
policy has actively leaned against the financial boom, policy buffers will
be depleted.

The capital and liquidity cushions of financial institutions will rupture;
gaping holes will open up in the fiscal accounts; and policy interest rates
will sag to near zero.

Think of Japan in the 1990s.

A growing body of evidence suggests that balance sheet recessions are
particularly costly.

They tend to be deeper, to give way to weaker recoveries, and to result in
permanent output losses: output may return to its previous long-term
growth rate but not to its previous growth path.

Several factors are no doubt at work here: the overestimation of both
potential output and growth during the boom; the misallocation of
resources, notably the capital stock but also labour, during that phase; the
oppressive effect of the debt and capital overhangs during the bust; and
the disruptions to financial intermediation once financial strains emerge.

A full five years after the beginning of the financial crisis, the symptoms of
a balance sheet recession are all too evident.

Banks in Europe and, to a lesser extent, the United States remain weak–
although in the United States it is Government Sponsored Enterprises
(GSEs) that are more exposed to the mortgage market.

To be sure, banks have significantly beefed up their capital ratios.
_____________________________________________________________

P a g e | 42

But their credit default swaps, gauges of perceived creditworthiness, have
returned to levels that are not that far away from those that prevailed when
Lehman Brothers collapsed.

Meanwhile, their shares have lost ground against the rest of the stock
market, and they have incurred downgrades across the board in both
standalone and all-in ratings.

Private sector debt-to-GDP ratios, a measure of aggregate leverage, are
still very high. Sovereign debt has ballooned and sovereigns have been
downgraded.

The policy rates of leading economies languish at their effective zero
lower bound while the balance sheets of their central banks have swelled
enormously.

Globally, though, there are significant differences between countries.

Those that have experienced domestic financial booms and busts have
faced serious strains in both non-financial sector and bank balance
sheets; to varying degrees, they are seeing deleveraging in both sectors.

Clear examples are the United States, the United Kingdom, Spain and
Ireland.

Those whose financial institutions were exposed to financial booms
elsewhere have also seen serious strains in their banks, but their
non-financial private-sector debt-to-GDP ratios have typically risen
further on the back of credit expansion.

Notable examples are Germany, France and Switzerland.

Indeed, in Switzerland a strong and possibly unsustainable housing
boom is under way, despite rather weak economic growth.

Those whose banks were not directly exposed to the financial busts in
mature economies, after a brief slowdown, have proved very resilient;

_____________________________________________________________

P a g e | 43

many of them have continued to see financial booms, sometimes eerily
reminiscent of the pre-crisis ones in mature economies.

These include several emerging market economies and some
commodity-based advanced countries, among others.

The situation is particularly worrying in the euro area.

It is there that the perverse feedback loop between the weaknesses in the
balance sheets of banks and sovereigns has been most intense.

An obviously incomplete economic and monetary union has brought it
into the open and exacerbated it.

That said, one should not confuse the symptoms with the disease.

Markets can and do lull policymakers into a false sense of security.

They are far too slow to react and, when they do, they react violently.

There are other major countries whose underlying fiscal positions are
hardly more sustainable than those in the euro area.

And yet bond markets seem to be oblivious, at least for now.

The immediate policy challenge: returning to self-sustaining
and sustainable growth

The immediate global policy challenge is to return to self-sustaining and
sustainable growth.

Seen through the lens of the financial cycle, this raises different issues
across countries, depending on their specific situation.

At one end, for those largely spared by the crisis, and that have been
seeing signs of unsustainable financial booms, the challenge is to contain
these excesses and to avoid overestimating the strength of fiscal
positions.
_____________________________________________________________

P a g e | 44

Where the cycle might have turned already, it is to contain the damage.

At the other end, for those that were at the epicentre of the crisis and have
experienced a domestic financial boom and bust, the challenge is to deal
with twin weaknesses in the financial and non-financial sector balance
sheets.

Somewhere in between, for those whose banks have suffered from losses
on exposures to financial busts elsewhere, the challenge is to solve the
banks’ problems, even as the non-financial sector may be in the process of
leveraging up further.

For all, the challenge is to ensure that the sovereign remains creditworthy
or regains its lost creditworthiness.

In what follows, I will leave it to the reader to draw implications for
specific countries.

Instead, I will focus on the general challenges that balance sheet
recessions raise, ie on how to address financial busts.

I will then discuss how to address booms in the following sub-section,
which considers the longer-term challenge of how to adjust policy
frameworks: how to address booms is by now better understood and
requires less elaboration.

The main policy challenge in a balance sheet recession is to prevent a
stock problem from morphing into a long-lasting flow problem, weighing
down on income, output and expenditures.

It is therefore critical to distinguish two phases, crisis management and
crisis resolution, which differ in terms of their priorities.

In crisis management, the priority is to prevent the implosion of the
financial system, so as to ward off the threat of a self-reinforcing
downward spiral in economic activity.

Restoring confidence is essential.
_____________________________________________________________

P a g e | 45

If there is scope to do so, policies should be deployed aggressively.

This is the phase historically linked to central banks’ lender-of-last resort
function; together with interest rate cuts, such a course of action can be
especially helpful in boosting confidence.

In crisis resolution, by contrast, the priority is balance sheet repair, so as
to lay the basis for a self-sustaining recovery.

Here it is essential to tackle the debt overhang head-on.

And policies need to be adjusted accordingly.

Consider, sequentially, the roles of prudential, fiscal and monetary policy
in this phase.

The priority for regulation and supervision should be to induce the
thorough repair of banks’ balance sheets and to support banks’ return to
sustainable profitability.

This means:

Enforcing full recognition of losses (writedowns);

Recapitalising institutions (subject to tough tests), including possibly via
temporary public ownership;

Sorting institutions according to their viability;

Dealing with bad assets (including through disposal);

Reducing excess capacity in the financial system; and promoting
operational efficiencies.

This is precisely what the Nordic countries did when they faced their
banking crises in the early 1990s; and it is what Japan failed to do around
the same time.

_____________________________________________________________

P a g e | 46

This difference was no doubt a key factor behind their divergent
economic performance subsequently.

Before the recent crisis, the response of the Nordic countries to their
crisis was universally regarded as the right way to go.

Such a policy would have several benefits.

It would restore confidence in the banking system.

At present, for instance, market-to-book values are well below 1 and there
is little uncollateralised funding on offer to banks, especially for European
ones.

Such a policy would also unblock interbank markets and relieve pressure
on central banks – just think of the Eurosystem’s extraordinary long-term
unconditional liquidity support to banks.

And it would restore incentives for allocating credit properly and avoiding
inappropriate risk-taking.

It is hardly a coincidence that volatile trading profits have been the main
source of income since the crisis and that one global bank has recently
made sizeable trading losses on its credit portfolio.

Unless losses are fully recognised, viable institutions are recapitalised and
unviable ones induced to exit, the incentives will stay in place for banks to
take on the wrong risks at the expense of the good ones, and to
overcharge healthy borrowers to the benefit of unhealthy ones.

When the level of debt in an economy is too high and must be cut back to
set the scene for a self-sustaining recovery, the allocation of credit is more
important than its overall amount.

The priority for fiscal policy should be to create the scope for using the
public sector balance sheet to support the repair of private sector balance
sheets.

_____________________________________________________________

P a g e | 47

This applies to the balance sheets of financial institutions, through
injections of public sector money (capital) subject to strict conditionality
on loss recognition and possibly through temporary public ownership.

But it applies also to the balance sheets of the non-financial sectors, such
as households, including through various forms of debt relief.

Such a prescription contrasts sharply with a widespread view among
macroeconomists, who would regard pump-priming (increases in
expenditures or tax cuts) as more effective during slumps.

That view, however, assumes that people wish to borrow and cannot.

But if they have already taken on too much debt, they are more likely to
wish to cut that burden.

Debt repayment would take priority over more spending.

If so, even the short-term effect of untargeted fiscal expansion (the
so-called “fiscal multiplier”) is likely to be small.

Rather than jump-starting the economy, it could end up building bridges
to nowhere, as the Japanese experience suggests.

By contrast, the targeted use of the fiscal room for manoeuvre to support
the balance sheet repair of the financial and non-financial sectors, as
needed, could remove a key obstacle to a self-sustaining recovery.

Moreover, as an owner or co-owner, the sovereign could actually make
capital gains in the longer term, as was the case in some Nordic
countries.

Importantly, this is not a passive strategy, but a very active one.

It inevitably substitutes public sector debt for private sector debt.

_____________________________________________________________

P a g e | 48

It requires a forceful approach to addressing the conflicts of interests
between borrowers and lenders, between managers, shareholders and
debt holders, and so on.

And it raises tricky distributional questions.

It is not pure fiscal policy in the traditional macroeconomic sense: it calls
for a broader set of measures, including legal adjustments, supported by
the public purse.

But what if the country is already facing a sovereign crisis? My sense is
that, even where immediate fiscal consolidation is necessary, this use of
public money is critical.

The Nordic countries did it, even as they cut elsewhere.

One way of alleviating the trade-offs is to obtain targeted external
support.

There is a clear potential for that option in the euro area, especially as part
of a well sequenced and comprehensive shift towards a more complete
economic union.

And even as short-term steps are taken, a long-term horizon is essential.

The evidence indicates that any contractionary effects of fiscal policy
dissipate over time.

And restoring the creditworthiness of the sovereign is paramount.

The sovereign is the ultimate backstop for the financial system and the
economy.

There cannot be lasting financial and macroeconomic stability if public
finances remain on an unsustainable path.

What about monetary policy?

_____________________________________________________________

P a g e | 49

The priority is to recognise its limitations and to avoid overburdening it.

Monetary policy is likely to be less effective in a balance sheet recession.

This applies as much to changes in short-term interest rates and guidance
about future rates (“interest rate policy”) as it does to an aggressive use of
the central bank balance sheet, such as through large-scale asset
purchases and liquidity support (“balance sheet policy”).

Overly indebted agents unwilling to borrow and a banking system unable
to function blunt the impact of such policies on expenditure.

As a result, as policymakers press harder on the gas pedal, the engine revs
up without traction.

And this exacerbates any side effects that policy may have in the crisis
resolution stage.

Several possible side effects may arise from a long period of
extraordinarily accommodative monetary policy.

First, easing can mask underlying balance sheet weaknesses.

It makes it easier to underestimate the private and public sector’s ability
to repay in more normal conditions and delays the recognition of losses
(eg evergreening).

Second, it can blur incentives to reduce excess capacity in the financial
sector and even encourage betting for resurrection.

Third, it can undermine the earnings capacity of financial intermediaries,
by compressing banks’ interest margins and sapping the strength of
insurance companies and pension funds.

This, in turn, weakens the balance sheets of non-financial corporations,
households and the sovereign.

_____________________________________________________________

P a g e | 50

It is no coincidence that Japan’s insurance companies came under
serious strain a few years after its banks did.

Fourth, it can atrophy markets and mask market signals, as central banks
take over financial intermediation functions.

Interbank markets tend to shrink and risk premia become unusually
compressed as policymakers become large-scale asset buyers.

Fifth, while it can help repair balance sheets by weakening the currency,
this may be unwelcome elsewhere, as it may be seen as having a
beggar-thy-neighbour character – a point to which I will return later.

Finally, over time it may compromise the operational autonomy of the
central bank, as political economy considerations loom ever larger.

This is especially important for central banks’ balance sheet policy,
because of its quasi-fiscal nature.

The key risk is that central banks become overburdened and a vicious
circle develops.

Monetary policy can gain time, but it can also make it easier to waste
time, because of the incentives it generates.

As the policy fails to produce the desired effects and adjustment is
delayed, central banks come under growing pressure to do more.

An “expectations gap” yawns open, between what central banks are
expected to deliver and what they can deliver.

All this makes the eventual exit more difficult and may ultimately threaten
the central bank’s credibility.

One may wonder whether some of these forces have not been at play in
Japan, a country where the central bank has not yet been able to exit.

_____________________________________________________________

P a g e | 51

Recent evidence squares broadly with the view that macroeconomic
policies are less effective in balance sheet recessions.

BIS colleagues find that, when considering recessions and the
subsequent recoveries, monetary policy has a smaller impact on output if
recessions are linked to financial crises.

Moreover, in normal recessions, a more accommodative monetary policy
in the downturn is followed by a stronger recovery, but this relationship is
no longer apparent if a financial crisis occurs.

In addition, the same study finds that in balance sheet recessions a faster
pace of debt reduction ushers in a stronger
recovery.

And it concludes that, when used to alleviate a balance sheet recession,
fiscal policy has limitations that are similar to those of monetary policy.

The longer-term policy challenge: adjusting frameworks
The longer-term policy challenge is to adjust frameworks to fully reflect
the implications of the financial cycle.

The financial cycle unfolds over a much longer horizon than the one that
normally underpins policy decisions concerning output and inflation.

Addressing its implications, therefore, requires lengthening the horizon
and shifting the focus from period-by-period flows to their cumulative
crystallisation in stocks.

Let’s first consider national policy frameworks and then broaden the view
to the global context.

The overall strategy for national policy frameworks would be to ensure
the build-up of buffers in the boom phase of the financial cycle so as to
draw them down in the bust phase.

The buffers would make the economy more resilient to a downturn.
_____________________________________________________________

P a g e | 52

And by acting as a kind of dragging anchor they could also curb the
boom’s intensity.

Put differently, the strategy would make policy less procyclical by making
it less asymmetric with respect to the boom and bust phases of the
financial cycle.

For prudential policy, it would mean strengthening the systemic or
macroprudential orientation of the frameworks, by adjusting instruments,
such as capital standards or loan to value ratios, to reduce procyclicality.

For monetary policy, it would mean providing for the option to tighten
even if near-term inflation appears under control whenever financial
imbalances show signs of building up.

And for fiscal policy, it would mean extra caution when assessing fiscal
strength during financial booms and taking remedial action.

Post-crisis, policies have indeed moved in this direction, but to varying
degrees.

Prudential policy is furthest ahead.

Basel III, in particular, has introduced a countercyclical capital buffer for
banks as part of a broader trend to put in place macroprudential
safeguards.

Monetary policy has shifted somewhat.

It is now generally recognised that price stability is no guarantee of
financial stability, and a number of central banks have been adjusting
their frameworks to incorporate the option of tightening during booms.

A key element has been to lengthen policy horizons.

That said, no consensus exists as yet on the desirability of such
adjustments.

_____________________________________________________________

P a g e | 53

And the side effects of prolonged and aggressive easing after the bust
remain controversial.

Fiscal policy is probably furthest behind.

There is so far little recognition of the need to incorporate the impact of
the financial cycle in assessments of fiscal sustainability or to explore the
limitations of expansionary fiscal policy in balance sheet recessions.

The main risk is that policies that fail to recognise the financial cycle will
be too asymmetric, thus generating a serious bias over time.

Failing to tighten policy in a financial boom but strong, if not
overwhelming, incentives to loosen it during the bust would erode both
the economy’s defences and the authorities’ room for manoeuvre.

In the end, policymakers would be left with a much bigger problem on
their hands and without the ammunition to deal with it.

This is what economists call a “time inconsistency” problem.

The root cause here is horizons that are too short and a failure to
appreciate the cumulative impact of flows on stocks.

This would entrench instability in the system.

There are all-too-evident symptoms that this has been happening.

Banks’ pre-crisis capital and liquidity buffers have proved woefully
inadequate; post-crisis, there have been calls not to raise them and to
delay the implementation of the new regulatory standards.

Sovereign debt levels have reached record peace-time highs; the crisis
and countermeasures have left a gaping hole in fiscal positions, which
were already gradually deteriorating.

No less worrying, most of the costs arising from ageing populations still
loom ahead of us.
_____________________________________________________________

P a g e | 54

And monetary policy has been far from immune.

In many advanced economies interest rates are now effectively at zero; in
both advanced and emerging market economies, central banks’ balance
sheets have expanded to record highs.

At the global level, policy rates, even adjusted for inflation, have been
trending down for decades, even as the trend growth of the world
economy – a common yardstick to gauge their appropriate level – has
picked up.

Likewise, more refined yardsticks that seek to take into account output
and inflation – so-called “Taylor rules” – indicate that policy rates are
globally unusually low.

And partly as a result of purchases at the long end of the yield curve and
foreign exchange intervention, bond yields have never been as low as they
are now.

This brings us to the global implications of national policies. In a highly
integrated world, any tendencies in national policies can easily spread
worldwide through a variety of channels, including other countries’
responses.

In the case of monetary policy, exchange rates are a critical channel.

Pre-crisis, easy monetary policy in the mature economies, notably in the
United States, spread elsewhere, especially to emerging market
economies such as China, partly through resistance to exchange rate
appreciation.

These other countries kept interest rates low or else intervened in the
foreign exchange market and invested the proceeds in the countries with
international currencies, in turn putting further downward pressure on
yields there.

Post-crisis, if anything, the same process has intensified.

_____________________________________________________________

P a g e | 55

This raises tough issues.

Economically, the risk is that monetary conditions for the world as a
whole end up being too loose.

Signs that financial imbalances have been building up, especially in
several emerging market economies, are a source of concern, particularly
when large mature economies have not yet returned to self-sustaining
growth.

The world remains unbalanced.

Politically, one obvious risk is that countries might revert to the
modern-day equivalent of the competitive devaluations of the interwar
years, which proved so divisive.

Worryingly, post-crisis the term “currency wars” has been all too often on
policymakers’ lips.

But the bigger risk is that yet another epoch-defining shift in the global
economy’s tectonic plates might take place.

As historians such as Niall Ferguson and Harold James keep reminding
us, such shifts often occur quite abruptly and when least expected.

So far, institutional setups have proved remarkably resilient to the huge
shock of the Great Financial Crisis and its tumultuous aftermath.

But there are also troubling signs that globalisation may be in retreat, as
states struggle to come to grips with the de facto loss of sovereignty.

This is true both globally and regionally.

It is simply most visible in Europe, where a more ambitious historical
experiment with greater integration has reached a watershed.

Meanwhile, the consensus on the merits of price stability is fraying at the
edges.
_____________________________________________________________

P a g e | 56

As memories of the costs of inflation fade, the temptation to get rid of the
huge debt burdens through a combination of inflation and financial
repression grows.

Taking all these hard-won gains for granted is the surest way of losing
them.

The future is not pre-determined; far from it. But we should not
underestimate the challenges ahead.

Conclusion

A cyclist has made a strong start to the race.

But, as it happens, he has overestimated his strength.

After a while, he has to pedal harder just to avoid falling over.

His energies are flagging and he is on the point of collapsing from
exhaustion.

His mistake was to treat a long-distance race as a series of
ever-shortening sprints.

His horizon was too short; the cumulative effort is finally catching up.

And yet, he struggles on.

The global economy is not so different from this sportsman.

It gained new force from a powerful wave of globalisation and the
suppression of inflation.

But the resurgence of the financial cycle made it feel, for a while, stronger
than it really was.

Market participants and policymakers did not see through this illusion.

_____________________________________________________________

P a g e | 57

And, every time that a financial boom turned to bust, they would simply
try harder, re-applying the same old nostrums.

Their horizons were too short; and the cumulative impact of their efforts
is catching up with them: stocks of private and sovereign debt have been
growing beyond sustainable levels and the policy room for manoeuvre has
been shrinking dramatically.

Maybe it is time to change course.

Maybe it is time to recognise the need to address underlying weaknesses
head-on, to stop postponing adjustments to an ever-elusive better day, to
stop calling for illusory monetary policy fixes for what are deeper balance
sheet and structural problems.

This would mean incurring some costs in the short run, but the
alternative would risk creating much bigger costs further down the road.

As the French say: “reculer pour mieux sauter”.

It would be a mistake, as some have noted, to believe in the confidence
fairy, but it would be an even bigger mistake to believe in the free-lunch
fairy.

Some signs are encouraging, others less so.

Navigating the tricky waters ahead will require a balance between
Gramscian “pessimism of the intellect and optimism of the will”:
pessimism to assess the challenges ruthlessly, never underestimating
them; optimism to overcome them.

And, as the late Tommaso Padoa Schioppa stressed, it will require a
long-term view.

Keynes once famously said: “in the long run, we are all dead”.

But, one would hope, the next generation will be very much alive.

_____________________________________________________________

P a g e | 58

What is at stake is nothing less than the legacy of the current generation
to the next.

This is as true at the global level as it is in Europe.

_____________________________________________________________

Monday November 19 2012 - Top 10 Risk Management News

Monday November 19 2012 - Top 10 Risk Management News

Recomendados

Recomendados

Mais conteúdo relacionado

Mais procurados

Mais procurados (20)

Destaque

Destaque (9)

Semelhante a Monday November 19 2012 - Top 10 Risk Management News

Semelhante a Monday November 19 2012 - Top 10 Risk Management News (19)

Mais de Compliance LLC

Mais de Compliance LLC (20)

Último

Último (20)

Monday November 19 2012 - Top 10 Risk Management News