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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
Dear Member,
I love ratios, especially when both, the numerator and
the denominator, are not well defined.
According to the International Monetary Fund, bank
nonperforming loans to total gross loans are the value of
nonperforming loans divided by the total value of the
loan portfolio (including nonperforming loans before the deduction of
specific loan-loss provisions).
The loan amount recorded as nonperforming should be the gross value of
the loan as recorded on the balance sheet, not just the amount that is
overdue.
Here is where the Basel Committee on Banking Supervision comes in, with
a paper: “Prudential treatment of problem assets - definitions of
non-performing exposures and forbearance - consultative document”.
According to the paper, at present, banks categorise problem loans in a
variety of ways and there are no consistent international standards for
categorising problem loans.
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International Association of Risk and Compliance Professionals (IARCP)
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The definitions proposed by the Basel Committee aim to foster
harmonisation in the measurement and application of two important
measures of asset quality and thereby promote consistency in supervisory
reporting and disclosures by banks.
(i) The definition of non-performing exposures introduces criteria for
categorising loans and debt securities that are centred around delinquency
status (90 days past due) or the unlikeliness of repayment. It also clarifies
the consideration of collateral in categorising assets as non-performing.
The definition also introduces clear rules regarding the upgrading of an
exposure from "non-performing" to "performing" as well as for the
interaction between non-performing status and forbearance.
(ii) Forbearance refers to concessions, such as a modification or refinancing
of loans and debt securities, that are granted as a result of a counterparty's
financial difficulty. The proposed definition sets out criteria for when a
forborne exposure can cease being identified as such and emphasises the
need to ensure a borrower's soundness before the discontinuation.
The proposed definitions complement the existing accounting and
regulatory framework in relation to asset categorisation. They are intended
to be used, for example, in the supervisory monitoring of a bank's asset
quality as well as by banks in their credit risk management and as part of
their internal credit categorisation systems.
Forbearance occurs when:
• a counterparty is experiencing financial difficulty in meeting its financial
commitments; and
• a bank grants a concession that it would not otherwise consider,
irrespective of whether the concession is at the discretion of the bank
and/or the counterparty.
A concession is at the discretion of the counterparty (debtor) when the
initial contract allows the counterparty (debtor) to change the terms of the
contract in their favour (embedded forbearance clauses) due to financial
difficulty.
Forbearance includes concessions extended to any exposure in the form of a
loan, a debt security or an off-balance sheet item (eg loan commitments or
financial guarantees) due to financial difficulties of the counterparty.
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International Association of Risk and Compliance Professionals (IARCP)
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Forbearance is identified at the individual exposure level to which
concessions are granted due to financial difficulties of the counterparty.
The moral of the story: The more problems we have with ratios, the more
we use them.
Janet Yellen has said that one common way of judging whether housing's
price is in line with its fundamental value is to consider the ratio of housing
prices to rents. This is analogous, she said, to the ratio of prices to dividends
for stocks.
Norman Schwarzkopf believed that any student of military strategy would
tell you that in order to attack a position, you should have a ratio of
approximately 3 to 1 in favor of the attacker. (In my opinion, if you recruit
Sylvester Stallone and his team in the Expendables, you could attack with a
ratio of 3 to 1 in favor of the defender). Anyway, when we rely on ratios, our
decisions look more scientific, so we can call them informed decisions.
I love ratios. I would kill to have more. Read more at Number 8 below.
Welcome to the Top 10 list.
Best Regards,
George Lekatis
President of the IARCP
General Manager, Compliance LLC
1200 G Street NW Suite 800,
Washington DC 20005, USA
Tel: (202) 449-9750
Email: [email protected]
Web: www.risk-compliance-association.com
HQ: 1220 N. Market Street Suite 804,
Wilmington DE 19801, USA
Tel: (302) 342-8828
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Iternational headwinds and the effectiveness of
monetary policy
Vítor Constâncio, Vice-President of the European
Central Bank, at the 25th Annual Hyman P Minsky
Conference on the State of the US and World
Economies at the Levy Economics Institute of Bard
College, Blithewood, Annandale-on-Hudson, New York
“Minsky displayed a keen understanding of the damaging effects of
uncertainty, not just on economic performance but also, ultimately, on the
fabric of civil society and democratic institutions.
These insights have acquired renewed urgency in view of the world-wide
resurgence of "easy-answer populism" whose simple but flawed solutions to
complex problems become more appealing the greater the uncertainty.”
Keynote Address at the SEC-Rock Center on
Corporate Governance Silicon Valley Initiative
Chair Mary Jo White
“This is an important event that brings together
regulators, academics, lawyers and entrepreneurs to
discuss the issues impacting the start-up, venture
capital and private equity worlds rooted here in this
cutting edge center of technological innovation.
It is essential that the Commission fully engage with Silicon Valley, and
participants in this important market across the country, so that we can
better understand the unique features of its investors and financings.
This Valley-SEC dialogue, which I hope becomes a permanent fixture, can
only make the Commission a more effective regulator and better able to
protect all investors.
We all know the significant impact that technology innovation coming from
Silicon Valley continues to have on our lives.”
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International Association of Risk and Compliance Professionals (IARCP)
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Defining the objectives and goals of
supervision
Speech by Mr Andrew Bailey, Deputy Governor
of Prudential Regulation and Chief Executive
Officer of the Prudential Regulation Authority
at the Bank of England, at the New York Fed conference "Defining the
objectives and goals of supervision", Federal Reserve Bank of New York,
New York City
“I want to start with some important definitions. Frequently, and
mistakenly, "supervision" and "regulation" as terms are used
interchangeably. That's wrong.
Regulation is to do with the framework of rules and guidance that put the
structure around the objectives that as authorities we are usually given in
statute.”
PCAOB Proposes to Strengthen Requirements for Auditor
Supervision of Other Auditors
The Public Company Accounting Oversight Board issued a proposal to
strengthen existing requirements and impose a more uniform approach to a
lead auditor's supervision of other auditors
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International Association of Risk and Compliance Professionals (IARCP)
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A year of negative interest rates. Where do we
stand now?
Speech by Ms Cecilia Skingsley, Deputy Governor of the
Sveriges Riksbank, at Danske Bank, Stockholm
“Is it possible to conduct a national monetary policy in a
complicated international environment? How has Swedish monetary policy
been conducted in recent years? What considerations should govern our
choice of future path?”
“So how did we get to where we are now, with such low interest rates? In
the long run, it is structural factors such as the conditions for growth and
the willingness to save that determine the level of the real interest rate. As a
small, open economy, Sweden must in principle accept the international
real interest rate as a given.
Monetary policy is not able to affect the real interest rate to any great extent
in the longer run, but it affects inflation and inflation expectations.
Statement on Proposed Amendments
Relating to the Supervision of Audits
Involving Other Auditors and Proposed
Auditing Standard—Dividing Responsibility
for the Audit with Another Accounting Firm
James R. Doty, Chairman
Open Board Meeting, Washington DC
“Last December, the Board adopted a rule that will provide public
transparency on the significant extent to which such audits involve the
work of other auditors beyond just the lead auditor who signs the audit
opinion.
Under that rule, registered firms will disclose information that will allow
investors to see, for any particular audit, how much of the work was
performed by other auditors.”
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International Association of Risk and Compliance Professionals (IARCP)
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Statement on Proposed Amendments
Relating to the Supervision of Audits
Involving Other Auditors and Proposed
Auditing Standard—Dividing
Responsibility for the Audit with
Another Accounting Firm
Jeanette M. Franzel, Board Member
Open Board Meeting, Washington DC
“I support today's proposal to strengthen the auditing standards for the
lead auditor's performance when other auditors participate in an audit.
When more than one audit firm is involved in an audit, it is important for
investor protection that the lead auditor assures that the audit is performed
in accordance with PCAOB standards and that sufficient appropriate
evidence is obtained to support the audit opinion.
As described in the proposing release before us today, the need for stronger
standards in this area has become evident over the past few years.”
Prudential treatment of problem assets definitions of non-performing exposures and
forbearance - consultative document
The Basel Committee on Banking Supervision has
issued for consultation Prudential treatment of
problem assets - definitions of non-performing
exposures and forbearance.
At present, banks categorise problem loans in a variety of ways and there
are no consistent international standards for categorising problem loans.
The definitions proposed by the Basel Committee aim to foster
harmonisation in the measurement and application of two important
measures of asset quality and thereby promote consistency in supervisory
reporting and disclosures by banks.
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International Association of Risk and Compliance Professionals (IARCP)
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The importance of credit institutions'
capitalisation, financial regulation
development
Speech by Mr Lars Rohde, Governor of the National
Bank of Denmark, at the annual meeting of the
Danish Mortgage Banks' Federation, Copenhagen
“Today I will focus on the importance of credit institutions' capitalisation,
financial regulation developments and a few significant consequences of the
very low interest rates.
My key messages are: It is in everyone's interest that credit institutions are
well-capitalised. The risk-based approach should be retained in financial
regulation.
And we must have a realistic approach to how much special Danish
circumstances will be taken into account in future. I will also observe that
the credit institutions' own targeted returns seem to be rather high, and
that a long period of low interest rates involves considerable inherent risk.”
New NIST Security Standard Can
Protect Credit Cards, Health
Information
For many years, when you swiped your
credit card, your number would be stored on the card reader, making
encryption difficult to implement.
Now, after nearly a decade of collaboration with industry, a new computer
security standard published by the National Institute of Standards and
Technology (NIST) not only will support sound methods that vendors have
introduced to protect your card number, but the method could help keep
your personal health information secure as well.
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International Association of Risk and Compliance Professionals (IARCP)
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Iternational headwinds and the effectiveness of
monetary policy
Vítor Constâncio, Vice-President of the European
Central Bank, at the 25th Annual Hyman P Minsky
Conference on the State of the US and World
Economies at the Levy Economics Institute of Bard
College, Blithewood, Annandale-on-Hudson, New York
Ladies and Gentlemen,
I want to start by thanking the Levy Institute for inviting me again to
address this important conference honouring Hyman Minsky, the
economist that the Great Recession justifiably brought into the limelight.
His work provides crucial insights not only identifying the key mechanisms
by which periods of financial calm sow the seeds for ensuing crises, but also
the specific challenges that economies face in recovering from such crises.
Moreover, Minsky displayed a keen understanding of the damaging effects
of uncertainty, not just on economic performance but also, ultimately, on
the fabric of civil society and democratic institutions.
These insights have acquired renewed urgency in view of the world-wide
resurgence of "easy-answer populism" whose simple but flawed solutions to
complex problems become more appealing the greater the uncertainty.
This year's conference has a very topical title "Will the Global Economic
Environment Constrain U.S. Growth and Employment?" Indeed, the
prospects for the full recovery of the U.S. economy and the normalisation of
its monetary policy are of utmost importance but can only be properly
assessed in an international context.
Conversely, international spillovers from the U.S. to the other economies
must be well understood, to appreciate the most likely scenarios for the
global economy.
Nine years after the inception of the Great Recession, it is no secret that
economists and policy-makers are baffled and disappointed with the
lacklustre nature of the ongoing recovery.
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The perplexities and anxieties generated by the present situation were
summed up in a rather open and pessimist way by the Governor of the Bank
of England in a recent speech, who noted that: "the global economy risks
becoming trapped in a low growth, low inflation, and low interest rate
equilibrium".
But, equilibrium implies a prolonged stable situation, and while that might
be emerging in economic terms, the same is not the case in social terms. Put
differently, the social equilibrium is not stable.
Advanced economies must either radically change their economic prospects
by generating growth and jobs, or they will be forced to adjust their social
systems in uncharted ways.
In the rest of my remarks, I will first discuss some of the hypotheses put
forward in the literature to explain the determinants of this prolonged,
low-growth period, sometimes characterised as a global liquidity trap.
I will then review some of the proposed measures to exit from the liquidity
trap, including fiscal and structural policies.
While each of these measures has specific benefits, they also all have
limitations or are subject to constraints.
Against this background, it is important to emphasise that, while having to
resort to non-standard tools, monetary policies also remain effective in
fighting the global liquidity trap even against international headwinds.
For the euro area, I will conclude that only an encompassing policy mix can
deliver stability and prosperity.
Global liquidity traps
The literature about liquidity traps and their international contagion is vast.
A subset of that literature considers the implications of a liquidity trap in
the open economy and highlights the importance of a global response to the
trap.
For example, Jeanne (2009) demonstrates how a recessionary shock in a
country can lead the world into a global liquidity trap.
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This is particularly the case when monetary policy interest rates reach the
Lower Bound (or LB).
The author argues that increasing the expected inflation rate in both
countries through monetary policy, if feasible, is the more efficient
response to the global liquidity trap, more efficient than an increase in
public expenditures.
Hélène Rey (2013) shows how monetary policy spillovers from major
advanced economies create a global financial cycle that reduces the
efficiency of monetary policy even in a regime of flexible exchange rates.
The trilemma of international economics (free capital movements, and
independent monetary policies being only possible with flexible exchange
rates) is thus reduced to a dilemma that can be resolved with capital
controls and effective macroprudential policies to limit the leverage of the
financial system.
Cook and Devereux (2014) use a two-country, new Keynesian model to
illustrate how the liquidity trap can propagate from one country at the LB to
the world economy, through the interconnected international financial
system.
This international contagion undermines the effectiveness of domestic
monetary policy even in a regime of floating exchange rates. Capital
controls are proposed as a solution to restore the independence of
monetary policies.
This strand of literature is also linked with the "savings glut" explanations
of the Great Recession. Put forward by Ben Bernanke in 2005, it was later
used by him in 2007 and 20106 to justify how capital inflows had depressed
U.S. medium-term interest rates and fuelled the subsequent housing
bubble.
Despite being contested, this hypothesis has been quite influential and has
been supported since 2008 by the theory which explained global
imbalances by a "shortage of safe assets" in countries with underdeveloped
financial systems.
The ensuing search for those assets, particularly in the U.S., generated
capital flows, decreased medium-term yields and allegedly conditioned U.S.
monetary policy.
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Until 2008, the imbalances resulting from excessive savings in search of
safe assets could be equilibrated by the decrease of interest rates.
After the crisis, the decrease of yields was accentuated by the reduction of
the stock of assets resulting from weaker private issuers and from weaker
European sovereigns. Interest rates were therefore pushed down to the LB
and the phenomenon propagated to other countries through the financial
markets.
The recent paper by Caballero, Farhi and Gourinchas (2015) models what
happened after the LB was reached.
With interest rate variations prevented by the LB, the supply and demand
of safe assets could only be balanced through recessionary variations of
output.
This would explain the weakness of the worldwide recovery and the
temptation felt by all countries to try to use the exchange rate as a way to
stimulate their own economy - hence the expression "currency wars" in the
paper's title.
The authors highlight that the U.S., by adopting a very expansionary
monetary policy earlier, was able to benefit from a depreciating U.S. Dollar
(USD), but this changed after 2014 when both Europe and Japan embarked
also in a more expansionary unconventional monetary policies. Due to a
non-Ricardian treatment of public finances, there is a role for fiscal policy
in dealing with the situation.
The paper also finds that countries with more wage and price flexibility
have a smaller share of the world recessionary trend but "at the global level,
more downward price or wage flexibility exacerbates the global recession".
The idea of a prolonged global liquidity trap is connected with the notion of
secular stagnation, i.e. the possibility of a prolonged situation of low
inflation and low growth at the global level.
The secular stagnation hypothesis in this case refers to the demand-side
version promoted by Larry Summers, where a trend of planned savings
systematically higher than planned investment implies a situation of
persistent lack of demand and a negative output gap, interest rate at the LB
and low inflation or even deflation.
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The real equilibrium rate that ensures the savings investment balance at
full employment may indeed become negative as recent estimates for the
U.S. indicate.
Eggertsson and Mehrotra (2014) and Caballero and Farhi (2015) modelled
secular stagnation in a closed economy and more recently, Eggertsson,
Mehrotra, Singh and Summers (2015) presented a model of secular
stagnation in a multi-country context in which exit policies may include a
global increase of the inflation target (if made credible), fiscal policy
stimulus or capital controls for the countries with a domestic positive real
equilibrium interest rate.
The effectiveness of both monetary and fiscal policy is strongly amplified by
possible international co-ordination of their use.
Some exit solutions
The whole literature on global liquidity traps provides an overall consistent
view of how the world economy works and leads to a bleak outlook on the
feasible exit solutions from the present quagmire.
The first solution is credible forward-guidance about future policy rates
linked to a somewhat higher inflation target in order to influence inflation
expectations. In the type of models used in this literature, forward-guidance
is the only available monetary policy tool.
The measure would be more efficient if applied simultaneously by all major
jurisdictions.
The shortcoming of this approach is the lack of a sufficiently credible
commitment mechanism that would convince markets about the central
bank "committing to be irresponsible", no matter what.
The second solution is to use the exchange rate as a policy target in order to
stimulate growth via net exports. Obviously, this is a zero-sum game if all
countries try to do it.
Recently, the hope in many countries has been to depreciate against the
dollar as a result of U.S. recovery, but the more recent months have proved
that this is not an assured development, or perhaps that the U.S. is not
ready to accept these consequences. I will return to this point later.
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The third exit solution proposed in the literature is the use of capital
controls that would restore independence to national monetary policy, so
that real equilibrium interest rates could differ across countries. For those
with a positive real rate, capital controls would avoid the fall into the LB.
It is indeed the case that the international community and the IMF have
now lightly condoned the use of capital controls as a macroprudential tool
in developing countries. However, the implication of the literature would be
to use capital controls among advanced economies, an option that stands
out as unrealistic for political and ideological reasons.
The fourth exit solution is to use tariffs and protectionism. Jeanne (2009)
illustrates this option in his model, but points out that it would be less
efficient. Going beyond models, a generalised rush towards protectionism
would aggravate, rather than solve, the world economy predicament.
The fifth and final solution is to rely on fiscal policy, the traditional way-out
in situations of liquidity traps. All the models concur with this prescription,
which is particularly efficient at the LB, and amplified if adopted
internationally in an effort of international co-ordination. Fiscal policy,
however, seems to be out of bounds in all major economies. In t
he euro area, fiscal policy is strictly conditioned by the legislation of the
Stability and Growth Pact and in the U.S., it is seemingly blocked by
political partisanship. Apparently, only if the state of the world economy
deteriorated considerably, would governments step up the use of all the
tools at their disposal.
One can therefore understand the dispirited conclusion of Caballero, Farhi
and Gourinchas (2015): "Unfortunately, this state of affairs is not likely to
go away any time soon. In particular, there are no good substitutes in sight
for the role played by US Treasuries in satisfying global safe asset demand.
With mature US growing at rates lower than those of safe asset demander
countries - its debt and currency are likely to remain under upward
pressure, dragging down (safe) interest rates and inflation, and therefore
keeping the world economy (too) near the dangerous ZLB zone."
Nevertheless, as I will argue later, this list of solutions to the global liquidity
crisis dismisses too easily non-standard monetary policy tools. Thanks to
such tools, international headwinds may hamper, but do not annul the
effectiveness of major central banks in influencing economic outcomes.
The structural reforms solution
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Before moving on to monetary policy, let me first recall that another
proposed option to boost the recovery is to increase growth potential in the
medium and long-term through structural reforms. However, structural
reforms entail short-term contractionary effects many times.
Eggertsson, Ferrero and Raffo (2014) highlight that such contractionary
short-term effects are amplified at the LB, because they cannot be off-set by
expansionary monetary policy through a reduction in interest rates.
A recent IMF working paper by Bordon, Ebeke and Shirono (2016)
concludes that "Existing studies have shown that the long-run effects of
structural reforms on growth and employment are positive.
However, the evidence on the short-run effects of structural reforms is
rather mixed and limited."
The recently published April 2016 IMF WEO agrees and writes: "Product
market reforms deliver gains in the short term, while the impact of labor
market reforms varies across types of reforms and depends on overall
economic conditions.
Reductions in labor tax wedges and increases in public spending on active
labor market policies have larger effects during periods of slack, in part
because they usually entail some degree of fiscal stimulus.
In contrast, reforms to employment protection arrangements and
unemployment benefit systems have positive effects in good times, but can
become contractionary in periods of slack.
These results suggest the need for carefully prioritizing and sequencing
reforms."
To summarise, the effects of structural reforms are contingent on the state
of the cycle and the degree of slack in the economy as well as on the
accompanying stance of macroeconomic policies.
That is why the IMF WEO pleads for the use of structural reforms
accompanied by fiscal policy when there is fiscal space, a concept that has
several different interpretations.
In their recent Shanghai meeting, the G20 pleaded for the same approach,
although one can be sceptical about delivery.
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We can recall the embarrassing results of the G20 agreed plan in Brisbane
two years ago to generate an additional 2% in world growth via a long list of
concrete reforms put forward by the IMF and the OECD. Less than half was
implemented and in fact, the world economy now risks not even attaining
what was then considered the baseline scenario.
So, on both the demand and supply sides, there are constraints to effective
policy action. I would like to add two key issues to this discouraging
perspective: one that aggravates the challenges with a different version of
secular stagnation and another that offers some hope related to the role of
monetary policy.
Another version of secular stagnation
The version of the secular stagnation hypothesis promoted by Robert
Gordon in a series of papers and in his recent magisterial book is a
supply-side phenomenon.
The two broad frameworks for secular stagnation are not mutually
exclusive. One emphasises supply-side factors that lower potential growth
while the other points at chronic weakness in demand as the root cause of
secular stagnation.
Demand and supply factors may, in fact, reinforce each other because a
chronic weakness in demand would amplify and exacerbate supply
constraints as, for instance, persistent unemployment may hamper
workers' set of skills, thereby curtailing the productive capacity of the
economy.
Gordon diagnoses a slow-down in the pace of innovation with regard to so
called general-purpose technologies, consisting in inventions that
revolutionize living standards and business practices. As he points out,
many of these technologies, such as electricity, clean running water, cars
and planes, as well as vaccines and antibiotics, were brought to large
sections of the population in the time between 1870 and 1970, which he has
dubbed the "special century".
By contrast, he argues that current innovations, such as the internet,
improve existing technologies in a less spectacular and more marginal way.
The reduction of total productivity growth in the U.S. and other advanced
economies, decade after decade since the 70s, offers a compelling empirical
case for Gordon's views.
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This gloomy assessment has not gone unchallenged. Most prominently,
Joel Mokyr, Erik Brynjolfsson and Andrew McAfee argue that, given recent
advances in robotics, genetic modifications, 3D printing, and further
innovative technologies, we stand at the cusp of a new industrial revolution.
This scenario is certainly desirable. But, as Robert Gordon has also pointed
out: even if innovation is not slowing in absolute terms, global economy is
still facing an uphill battle, given the challenges of population aging, rising
inequality, failing education systems and debt overhang.
The role of demographics is especially dominant here. As Charles Goodhart
and colleagues (2015) have noted, recent decades have benefitted from a
positive global labour supply shock, deriving from the baby-boomer
generation in the 1970s, and from the integration and expansion of
emerging markets as part of the global economy.
These demographic headwinds are fading out, implying that another crucial
source of growth is drying-up, at least until a demographic reversal takes
place in about 25 to 30 years' time.
Beyond these factors, doubts can also be raised about the depth of the
economic traction of the innovations that are in the pipeline. The
technological changes at the turn of the 20th century and after the Second
World War, led to the creation of mass products widely used in association
with the urbanisation explosion that is about to end.
The second wave of income growth was triggered by women's participation
in the labour force and jump in education levels, developments that cannot
now be repeated to the same degree.
So far, the new products or services associated with the digital economy
have not a similar impact on jobs and income. Part of their value is not even
paid for in a market, as is the case with the internet or social media.
To count these and other intangibles which clearly improve our lives and
personal productivity, would only be justified in an indicator of well-being
but not in a GDP concept that aims to measure traded goods and services
that generate monetary income and consequently, jobs.
Robotics is expected to introduce an important new wave of innovation, but
that will only make the question of jobs more complicated, requiring
significant and difficult changes in the income redistribution systems of our
societies.
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This secular stagnation thesis and the related declining real productivity
also provide an explanation for the continuously decreasing real
equilibrium interest rate. Other contributing factors to this phenomenon
are the demographic decline, greater income inequality and lower public
investment.
The declining real equilibrium interest rate cannot be ignored by monetary
policy that grounds its rationale in real variables and tries to achieve a real
rate that ensures macroeconomic stability with low inflation and a zero
output gap.
Facing the Great Recession and this development of the real equilibrium
rate, central banks had no alternative but to reduce rates until the zero
lower bound was attained.
In other words, the low level of nominal interest rates in advanced
economies before and after the crisis cannot be explained only by the
"savings glut" view or by the "shortage of safe assets" theory which is its
mirror image.
These views provide an explanation for what happened to nominal market
rates but not to the evolution of the real equilibrium interest rate over time.
What is more, monetary policy also has a decisive influence on interest
rates that cannot be explained by the loanable funds theory alone.
Short-term market nominal rates are directly influenced by monetary
policy rates and via expectations of future policy rates, and risk premia
policy rates also influence medium and long-term market rates.
This means that monetary policy cannot escape responsibility for the low
level of rates before the crisis. It must however be acknowledged that
central banks were doing so in pursuit of their mandates, which exclude
assets prices or other aspects of financial stability from their primary
objectives.
In the period of the so-called Great Moderation, they ensured low inflation
and reasonable growth while the financial system brewed credit booms and
instability.
The fact remains that central banks cannot pursue several objectives with
the same instrument and that, in order to ensure financial stability, they
need to be given regulatory powers of a macroprudential nature that can
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International Association of Risk and Compliance Professionals (IARCP)
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smoothen the financial cycle by controlling leverage of the credit
institutions.
What happened before the crisis was a failure of financial regulation and
supervision that did not react to excessive leverage, credit booms and
growing debt, believing in the rhetoric of the efficient markets hypothesis
that blessed all market practices and accepting that the risk management
techniques behind securitisation and the "originate and distribute model"
were safe and sound.
In another criticism of the "savings glut" view of the crisis, Claudio Borio
and Piti Disyatat (2011)18 are correct in pointing out that "a focus on
current accounts in the analysis of cross-border capital flows diverts
attention away from the global financing patterns that are at the core of
financial fragility. By construction, current accounts and net capital flows
reveal little about financing.
They capture changes in net claims on a country arising from trade in real
goods and services and hence net resource flows. But they exclude the
underlying changes in gross flows and their contributions to existing stocks,
including all the transactions involving only trade in financial assets, which
make up the bulk of cross-border financial activity."
They also underline the importance of monetary policy in determining
interest rates and other analyses have added to the criticism of the vision
that external influences were behind the low interest rates that led to
various asset price bubbles.
Hélène Rey (2013) also indicates that "A VAR analysis suggests that one of
the determinants of the global financial cycle is monetary policy in the
centre country, which affects leverage of global banks, capital flows and
credit growth in the international financial system."
To sum up, there are some good points against the view that the "savings
glut" or "safe assets shortage" theory, while useful in understanding key
aspects of the present global economy framework, contain all the truth. In
particular, they fail to fully capture the responsibilities of monetary policy
of the major central banks. But they also fail to capture their possibilities.
Possibilities and challenges of monetary policy
Turning to the challenges of monetary policy, perhaps the most salient
issue to refer is that monetary policy has gone beyond the lower bound on
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nominal interest rates and is actually into negative territory even though, as
there is a floor to negative rates, one can say that this has only displaced the
lower level further down.
While this monetary policy move is unprecedented in a historical
perspective, it is entirely standard insofar as it relies on the traditional
interest rate instrument. From a purely monetary policy point of view, it is
entirely consistent to aim at negative rates when the real interest rate has
itself turned negative.
Speaking from the perspective of the ECB, negative rates have only been
applied to the deposit facility which banks use to credit funds to the central
bank at an overnight maturity.
The main objectives of this measure are twofold: first, to further lower
money market rates and the longer end of the yield curve via expectations
effects; and second, to increase the velocity of circulation of excess reserves
in the interbank market towards the banks that need liquidity to sustain or
expand their credit portfolio.
The banks with excess liquidity have an incentive to pass it on to other
institutions or use it to fund new loans. We have had some success on both
scores and the stimulus to demand has benefited the European and global
economies.
Many market commentators link negative deposit facility rates mostly with
exchange rate policy. This interpretation may well be correct in the case of
small countries trying to avert the risk of excessive currency appreciation.
However, recent experience clearly demonstrates that it does not work the
same way for larger economies. In spite of the ECB's and the Bank of
Japan's decision to implement negative deposit facility rates, both the euro
and the yen have been appreciating against the US dollar.
There is no inexorable link between the levels of deposit facility rates and
exchange rates, as even the possibility of some form of carry trades depends
on the general situation of risk aversion. Additionally, recent empirical
evidence points to a relatively limited pass-through of the exchange rate to
the economy.
It is, nevertheless, important to recall that there are clear limits to the use of
negative deposit facility rates as a policy instrument.
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First, there is always the possibility of hitting the limit where the preference
for cash withdrawals would set in, even if the threshold seems to be
significantly distant in view of the costs of cash storage, safety and
insurance.
Second, the instruments should not push banks to pass on their additional
direct costs by turning deposit rates negative or increasing lending rates to
increase margins.
Both developments would be problematic for our monetary policy goals.
Tier systems that simply pass direct costs at the margin can mitigate this
concern but cannot dispel it altogether.
Overall, broadly counting all the effects that negative deposit facility rates
have on banks' profitability, the aggregate result comes up positive for the
euro area as a whole.
Negative money market rates reduce the cost of funding for many banks,
the lowering of yields for several assets produces capital gains and the
support to the recovery reduces impairment costs on non-performing loans.
In more general terms, there has recently been quite some pushback
against monetary policy in certain quarters, in particular questioning its
effectiveness in the present situation.
More sophisticated critiques focus on the alleged exclusive, short-term
effects of monetary policy which can only buy time for other policies,
presumably structural reforms, to do the real job.
The main common idea behind these arguments is the more general view
that monetary policy is merely about the short-term with supply policies
determining the longer term.
This separation between the short and long terms is an analytical device, a
needed abstraction, to build simpler models and theories.
However, such distinctions are artificial when we consider chronological
real time.
Monetary policy can stimulate demand and investment and as this creates
productive capacity, a link is established with the supply-side and the
long-term.
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Also, by speeding up the closing of output or unemployment gaps,
monetary policy influences future potential output and growth.
By avoiding protracted periods of recession, monetary policy helps avoid
hysteresis that affects productive capital efficiency, when equipment is not
timely substituted, or when the quality of human resources deteriorates due
to periods of long unemployment. Both forms of hysteresis influence the
supply-side and the long-term potential of the economy.
As Keynes wrote "Life and history are made up of short runs" which implies
that the long run is just a sum of many different short terms. Monetary
policy cannot be reduced to a short-term gimmick since our economies do
not spontaneously return quickly to zero output gaps and full employment.
U.S. and Euro Area Monetary Policy
After the crisis, monetary policy responded forcefully everywhere,
particularly in the U.S. with the early implementation of QE and credit
easing measures. The U.S. recovery has been stronger than in the euro area
and for 2016 buoyant growth was expected, accompanied by a gradual
normalisation of interest rates.
This would have been a vital development for world economy and at the
same time, an important proof that, even with a restrictive fiscal policy,
monetary policy can play a decisive role in generating a meaningful
recovery and getting firmly away from the LB. This would be a relevant
disproval of the more sombre views about the world economic system and
monetary policy.
Although this possibility is still very much alive, it has apparently been
delayed by some mixed results since the fourth quarter of 2015. Turmoil in
financial markets and the external environment seem to have affected the
economy.
In the blogosphere and some market literature, we could see minority views
about a possible double dip or significant slowdown and market
expectations for further rate increases this year became quite weak.
Importantly Chair Janet Yellen has said recently that while "global financial
developments could produce a slowing in the economy.
I think we want to be careful not to jump to a premature conclusion about
what is in store for the U.S. economy".
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So, we can continue to hope that the centre of the world economy will hold
and will prove its resilience, independently of some external headwinds.
On our side, the ECB has confronted the severe and persistent
disinflationary forces affecting the euro area economy with a broad set of
measures. In particular since mid-2014, we have adopted a range of
monetary policy tools that had been unprecedented in scope and scale for
the euro area.
These tools have followed a three-pronged approach: first, they have
entailed targeted measures to revitalise specific market segments and
strengthen bank lending, which is a particularly relevant conduit of
monetary impulses in the euro area; second, they have effectuated a
broad-based easing of overall financial conditions, most notably through
central bank purchases in the large and liquid sovereign debt market and,
third, they included cuts in the main ECB interest rates, including by taking
the deposit facility rate to negative territory.
Given that monetary policy takes time to transmit to the real economy, the
full effects of these measures on macroeconomic conditions have yet to fully
materialise.
However, the adjustment in financing conditions, via which monetary
policy transmission operates, provides encouraging signals.
For instance, since June 2014, the GDP-weighted average of euro area
10-year sovereign bond yields has fallen by more than 130 basis points and
bank lending rates to euro area companies by about 95 basis points.
The lion's share of these declines can be directly attributed to the monetary
policy measures that the ECB has taken since then.
Our measures have also helped arrest the contraction of loans to
companies, which have, in fact, started to grow again and are granted at
more favourable conditions. As a result, also fewer SMEs report that credit
is a limiting factor for their businesses.
Ultimately, what matters for the assessment of our measures is whether
they contribute to a sustained adjustment in the path of inflation.
Applying a large and diverse set of models to account for the uncertainties
surrounding such analysis, ECB staff estimate a substantial effect of our
measures on growth and inflation.
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In the absence of these measures, inflation would have been negative in
2015 and would be projected to remain in negative territory also this year.
Regarding growth, two thirds of one percent of the registered growth in the
past two years can be attributed to our monetary policy.
We will continue to do whatever is necessary, in accordance with our
mandate, to bring the euro area inflation rate close to our objective.
From a global perspective, monetary policy measures that strengthen the
resilience of the domestic recovery do not amount to a zero-sum game, in
which different jurisdictions merely aim to debase their currencies vis-? -vis
each other.
In fact, monetary policy accommodation, by improving domestic credit
conditions and stimulating nominal spending, creates additional global
demand, rather than just leading to demand-switching from one economy
to the other - as some observers have suggested.
Vice versa, a large literature has reported a decline in the exchange rate
pass-through to inflation, suggesting that the relative role of this channel is
likely to have become less relevant in the quest to reflate the domestic
economies.
Moreover, as evidence by Kristin Forbes and colleagues for the U.K.
economy shows, there are indications that exchange rate fluctuations
originating from monetary policy shocks display a relatively limited
pass-through to consumer prices.
Notwithstanding a forceful response, monetary policy can only be one
element of an encompassing policy mix.
Other policy domains, both at national and European level, have to step up
to their responsibilities to transform the prevailing uncertainty into a
positive scenario.
I refer, naturally, to a full use of any existent fiscal space, especially for
infrastructure expenditures; to the continuation of structural reforms to
improve the business climate, educational levels, judicial system efficiency
and product market competition, especially in services; and finally, to
institutional progress at European level.
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This refers in particular to completing banking union and taking the first
steps of fiscal union, thus proving the willingness of Member States to
create better conditions for the successful functioning of a monetary union
that can deliver stability and prosperity.
Thank you for your attention
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Keynote Address at the SEC-Rock Center on
Corporate Governance Silicon Valley
Initiative
Chair Mary Jo White
Introduction
Thank you Jina [Choi] for that kind introduction and
for your leadership of the San Francisco Regional Office. It is always good
to be back at Stanford, and it is an honor to speak at the SEC’s and Rock
Center’s Silicon Valley Initiative.
This is an important event that brings together regulators, academics,
lawyers and entrepreneurs to discuss the issues impacting the start-up,
venture capital and private equity worlds rooted here in this cutting edge
center of technological innovation.
It is essential that the Commission fully engage with Silicon Valley, and
participants in this important market across the country, so that we can
better understand the unique features of its investors and financings.
This Valley-SEC dialogue, which I hope becomes a permanent fixture, can
only make the Commission a more effective regulator and better able to
protect all investors.
We all know the significant impact that technology innovation coming from
Silicon Valley continues to have on our lives.
We see the effect everywhere –companies that trace their start to
basements, shared office spaces and classrooms are changing how we get
around our cities, how we analyze big data, how we find places to stay when
we travel, how we communicate with each other, and even how we put
satellites in space.
As technology has evolved, so too have the financial markets that support it.
New models for how these companies are funded and how investors unlock
their value are changing the landscape of private start-up financing and the
IPO market. SEC rulemakings have also opened new ways to raise start-up
capital with general solicitation allowed in private offerings,
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securities-based crowdfunding campaigns coming soon, and an updated
and expanded Reg A (known as Regulation A+).
New approaches to secondary market liquidity have sprouted. New types of
investors have entered the mix, including mutual funds. All of these factors
are contributing to the decision made by more and more companies to stay
private longer.
I thought I would spend my time with you tonight discussing some of the
opportunities, challenges, and risks in these rapidly changing markets.
A very important part of the SEC’s mission is to facilitate capital formation,
so it is important that our rules and regulatory actions create an
environment that fosters innovation and growth.
But entrepreneurs and issuers in these new markets should also recognize
that protecting investors is at the core of the SEC’s mission and it should be
something that they too hold at the core of what they do.
Being a private company obviously does not mean that you can disregard
the interests of investors. Indeed, being a private company comes with
serious obligations to investors and the markets.
Whether the source of the obligation is the federal securities laws or the
fiduciary duty that is owed to shareholders, the resulting candor and fair
dealing should be fundamentally the same.
And beyond any specific regulatory requirements, some of the principles
that characterize public companies – transparency with investors, controls
on financial reporting, strong corporate governance – have applicability
and relevance to private companies, especially those pre-IPO companies
that aspire to go public, and should not be overlooked or avoided, whether
or not mandated by federal law or an SEC regulation.
For the new and evolving markets to be successful, all investors need
confidence that they are being treated fairly and that the full range of risks
are transparently disclosed. We must work together to ensure that this
confidence is well-placed, so that investors feel comfortable providing the
capital essential for business development and growth.
Only then can we reap the full rewards of the creativity, genius, and
innovation for which this Valley is famous.
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The Challenges of Pre-IPO Financing
Accuracy of Company Information
Let me first focus on the accuracy of disclosures made by pre-IPO
companies. It is undisputed that venture investing is not for the faint of
heart.
There is certainly nothing novel in this Valley about pre-revenue start-ups
attracting millions of dollars, also often much less, from angels, traditional
VC firms, and more recently, private equity firms, all looking to add to their
portfolios that moon-shot, once-in-a-fund investment opportunity.
The investors are sophisticated and generally understand well the
parameters of the private securities markets – they are aware that most of
their investments will fail.
While the common refrain is that 9 out of 10 start-ups fail, an equally
interesting statistic from one post-mortem analysis is that 70 percent of
failed start-ups die within 20 months after their last financing, having
raised an average of $11 million.
In other words, not only are these investments highly risky, they fail quickly
too.
From a securities law perspective, the theory behind the private markets is
that sophisticated investors do not need the protections offered by the
robust mandatory disclosure provisions of the 1933 Securities Act.
So, if those participants choose – with eyes wide open – to invest in private
companies at valuations that may be ethereal or overinflated, who loses
when the truth behind inflated valuations is revealed?
I think we all do.
Not just the VC and private equity funds, but also smaller retail investors
and the next Stanford student whose great idea needs funding, but
investors are unwilling to take a bet on her because they were burned last
time.
To better understand what I mean, we need to look more closely at how
these deals are done and structured, as well as the downstream effects on
other market participants.
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A current feature of the pre-IPO financing market that puts these questions
in sharp (and local) relief is one that has gathered considerable attention
recently – unicorns.
Of course, this audience knows that I am speaking not of the creatures of
fantasy, but of private start-up firms with valuations that exceed $1 billion.
By one count, there are nearly 150 unicorns worldwide, many based here in
Silicon Valley.
And, they do not appear to be an endangered species. One survey shows
that there were 52 unicorn financings in the last three quarters of 2015
compared to 37 such financings over the 12 months that ended in March
2015.
Beyond the hype and the headlines, our collective challenge is to look past
the eye-popping valuations and carefully examine the implications of this
trend for investors, including employees of these companies, who are
typically paid, in part, in stock and options. These are areas of concern for
the SEC and, I hope, an important focus for entrepreneurs, their advisers,
as well as investors.
At the SEC, the questions we are asking do not fundamentally differ from
the questions we ask about all transactions. They include whether the
information supplied to investors is accurate and complete – that is,
whether it accurately reflects the performance and prospects of the
company.
Making sure that is so becomes more compelling when the transactions are
smaller and the investors are more retail.
And, for those involved in advising, investing and nurturing unicorns, there
is an important related question – how do $1 billion valuations affect all of
the relevant investors – both those investing in the unicorn round, and
those that came before and after, whether in private or public transactions.
It is axiomatic that all private and public securities transactions, no matter
the sophistication of the parties, must be free from fraud.
Exchange Act Section 10(b) and Rule 10b-5 apply to all companies and we
must be vigorous in ferreting out and punishing wrongdoers wherever they
operate. In the unicorn context, there is a worry that the tail may wag the
horn, so to speak, on valuation disclosures.
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The concern is whether the prestige associated with reaching a sky high
valuation fast drives companies to try to appear more valuable than they
actually are.
Nearly all venture valuations are highly subjective. But, one must wonder
whether the publicity and pressure to achieve the unicorn benchmark is
analogous to that felt by public companies to meet projections they make to
the market with the attendant risk of financial reporting problems.
And, yes that remains a problem.
We continue to see instances of public companies and their senior
executives manipulating their accounting to meet various expectations and
projections.
As I will discuss, the risk of distortion and inaccuracy is amplified because
start-up companies, even quite mature ones, often have far less robust
internal controls and governance procedures than most public companies.
Vigilance by private companies about the accuracy of their financial results
and other disclosures is thus especially critical.
The Challenges of New Models of Capital Formation
While we have our eye on unicorns, because of their outsized impact on our
markets and investors, our primary focus is obviously much broader.
One key and current area of focus for us at the SEC is on the three new
methods that have recently been created by our rules for capital raising
under the JOBS Act – Rule 506(c) of Regulation D (permitting general
solicitation), Regulation A+ and Regulation Crowdfunding.
In one way or another, all three are designed to foster new ways for smaller
companies to access the capital markets, and we must ensure that the
investor protections included as part of these new structures work as
intended to foster capital formation in a transparent, safe and efficient way.
In contrast to the institutional investors that have typically been involved in
the capital raising that has created unicorns, these capital formation tools
can be used to, and in certain cases are expected to, raise money from retail
investors.
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So, it should come as no surprise that we are closely looking at not only how
well these tools are working for companies seeking to raise capital, but also
how well they are protecting investors.
As an integral part of the implementation of each one of these new tools, I
have drawn on the expertise of the staff across the agency and engaged
them in a program that actively monitors the volume of such transactions,
developing industry practices, how the implementing rules are working,
and any instances of fraud or other rule violations.
I have discussed before what these staff initiatives have found for general
solicitation and Regulation A+.
Tonight, I will just touch on some of our thinking on the third offering tool
of the JOBS Act – crowdfunding – which we adopted last fall and becomes
effective in May.
Crowdfunding Portals as the New Gatekeepers
Crowdfunding is an evolving method of raising capital that has been used to
raise funds through the Internet for almost any project that can garner
sufficient interest.
Before our regulation, individuals who contributed money to such ventures
were essentially just “contributing” to the project – they were rewarded
with a first of its kind product, a memento, or, in some cases, just the
satisfaction that comes from being part of a worthy venture. But they were
not “investors” – they could not share in the financial returns of the
enterprise.
Regulation Crowdfunding will allow retail investors to acquire small equity
stakes in new companies.
Significant excitement surrounds the use of securities-based crowdfunding,
which we hope will fuel the development of a vibrant market.
It is important, however, for this excitement not to be short-sighted by
failing to keep the interests of investors paramount, which could quickly
deliver a very damaging blow to the success of crowdfunding.
Our regulatory regime is designed to streamline capital formation while still
providing robust investor protection.
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Importantly, the rule requires crowdfunding to be conducted by a
registered broker or a funding portal, a new type of SEC registrant with an
important role as an intermediary between those seeking capital and
investors.
Entrepreneurs here in Silicon Valley have developed many of these funding
portals.
The funding portals were established with the primary purpose to serve as a
classic gatekeeper and it is vital that they strongly function as such. As with
general solicitation and Regulation A+, in addition to the strong regulatory
protections built into the rule, we will closely monitor the funding portals
through rigorous inspections and examinations as well as close
coordination with FINRA.
And to repeat, we are counting on brokers and funding portals to be
bulwarks of investor protection in this space, and we will hold them to that
responsibility.
Secondary Market Trading
Another set of issues that we are focused on in the private markets is the
effect of valuations on secondary market participants. In the last wave of
technology-focused IPOs, a secondary market was created, before the IPOs,
by early stage employees that enabled them to sell their stock to outside
investors. That market unfortunately had some problems – from
unregistered broker-dealer activity to conflicts of interest and undisclosed
compensation, to fraudulent offers of pooled investment vehicles that
purported to hold pre-IPO stock.
These issues stemmed, in part, from the fact that secondary market
investors did not have access to accurate information concerning the value
of the companies in which they were investing, directly or indirectly.
Care should be taken to avoid these issues in the new secondary market that
is emerging, structured largely around derivative contracts and other novel
ways to capture the economic interest in a pre-IPO company without
actually transacting in its stock.
Depending on the structure of these derivative deals, errors or
misconceptions in valuation could be amplified – whether through leverage
or simply contracts built on faulty valuations.
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These secondary markets also raise other issues. A primary concern is
whether they have, or will have, sufficient liquidity to allow investors to
trade out of their positions and that they are transparent as to what that
liquidity actually is.
Recognizing that many participants in the secondary market may be “buy
and hold” investors seeking exposure to late round pre-IPOs so they can
profit from an eventual IPO or acquisition, we still must scrutinize these
emerging platforms to ensure they provide a functioning market that
operates within the parameters disclosed to investors.
We must also look carefully at the role of gatekeepers such as the financial
advisers who recommend these investments to their clients, and the
potential registration regimes that might apply to the operators of these
marketplaces.
Again, we are counting on the advisers to make those markets work fairly
for investors, ensuring that they are well-informed of the significant risks
they are taking.
The Challenges of Financial Controls and Corporate Governance
Another area in which pre-IPO companies, including unicorns, present
risks for investors centers on financial controls and corporate governance.
As many companies are choosing to stay private longer, Silicon Valley has
become home to many private companies with valuations that exceed many
listed ones that in another time would be publicly traded.
So, this is an issue for you.
Theories about the current slow-down in IPOs and why unicorns are
staying private longer, while an important topic, are beyond the scope of my
remarks tonight. Whatever the cause, there are several governance
implications for the longer pre-IPO lifecycle.
The IPO process is not just about raising capital. A public company
commits to shed light on its operations and strengthen its controls and
governance in ways not required of private companies.
The securities laws and relevant listing standards, for example, require a
company to form an audit committee; it must establish disclosure controls
and procedures and create internal controls over financial reporting; the
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CEO and CFO must certify to the adequacy of those controls; and the
company must be audited by a PCAOB registered firm.
This framework serves important investor and market protection functions,
including facilitating a board’s attention to fulfilling its fiduciary duty to
shareholders.
Particularly as a company grows in operations, revenue, and scale, without
adequate preparation and clear-eyed attention to the interests of investors,
including employees, directors unschooled in these areas may find
themselves overlooking critical aspects of their duty and companies will fail
to have the controls necessary to assure accurate financial statements.
While internal controls over financial reporting, and the regulations and
certifications applicable to them, do not apply to private companies, all
companies should consider enhanced structures and controls for
conducting their operations, especially in anticipation of going public.
Rapidly growing enterprises present significant risks if the appropriate
control structure is not in place. Time and again, we have seen companies
go public and grow at a pace that exceeds their control structure.
For example, just last month, the Commission brought charges against a
company and a former executive for inflating financial results to meet
projections that it would double revenues in its first year as a public
company.
Because, in part, of insufficient internal controls, the executive was able to
direct his subordinates to obtain false sales and shipping documents and
intentionally ship the wrong product to book sales.
As the latest batch of start-ups mature, generate revenue, achieve
significant valuations, but stay private, it is important to assess whether
they are likewise maturing their governance structures and internal control
environments to match their size and market impact.
Entrepreneurs and their advisers, venture capital and private equity
investors, and those whose voices are heard and listened to in this market
all have an interest in this issue and should be asking of start-ups: Is your
board expanding from founders and venture seats to include outsiders with
larger, and ideally public, company experience?
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Do you have the right regulatory and financial expertise on your boards to
appropriately make decisions on behalf of all investors?
Do you have the relevant expertise in the particular industry in which your
company functions to bring to bear different viewpoints and spot critical
issues?
Is your company, in short, being run and governed for the benefit of all of
your investors – a requirement whether the company is public or private
and it is the responsibility of all market participants and their advisers to
ensure that this overarching obligation is being fulfilled.
The Challenges of Fintech
Developments of significance in the SEC’s and Silicon Valley’s space extend
well beyond those I have discussed.
Time does not permit me to cover them all, but I would be remiss if I ended
my remarks without mentioning fintech developments. Innovations in
digital finance, many of which originated in Silicon Valley, have the
potential to transform how our markets operate in virtually every
respect—from streamlined market operations to more affordable ways to
raise capital and advise clients.
These innovations compel us to think carefully about how best to protect
investors so they – and we – can have confidence in this growing and
changing landscape.
In my closing minutes, I will just very briefly touch on three digital finance
developments that are impacting the securities industry – blockchain,
automated investment advice, and marketplace lending.
Blockchain and Distributed Ledgers
Blockchain technology has the potential to modernize, simplify, or even
potentially replace, current trading and clearing and settlement operations.
As you know, blockchain or distributed ledger is a database comprised of
unchangeable transaction data in packages called blocks; each block in the
chain is a record of transactions and contains information about the
previous transactions.
We are closely monitoring the proliferation of this technology and already
addressing it in certain contexts. For example, Corporation Finance staff
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recently reviewed the registration statement of a company seeking to offer
and sell digital securities, eliminating the need for intermediaries and
allowing settlement on a nearly instantaneous basis.
One key regulatory issue is whether blockchain applications require
registration under existing Commission regulatory regimes, such as those
for transfer agents or clearing agencies. We are actively exploring these
issues and their implications.
Our Advanced Notice of Proposed Rulemaking and Concept Release on
transfer agent regulations issued last December, for example, asked for
public comment on the use of blockchain technology by transfer agents and
how such systems fit within federal securities regulations.
The insight from the comment process will help us evaluate how to best
regulate these new innovations, and we encourage comment from all
constituents.
Robo-Advisors
Another expanding technological development that has our close attention
is automated investment platforms. These so called “robo-advisors” offer
discretionary asset management services based on algorithms and provide
minimal, if any, interaction between advisory personnel and investors.
Many offer or appear to offer relatively low-cost investment advice, often
with low account minimums, which has the positive potential to give retail
investors broader, and more affordable, access to our markets.
Like all registered investment advisers, robo-advisors managing over $100
million in assets or otherwise registered with the Commission are subject to
the Investment Advisers Act of 1940.
So, in this area, the key questions are focused on whether and how a firm
meets its Advisers Act obligations, as well as its fiduciary duties, when it
provides only or primarily automated advice.
Providing financial advisory services electronically is different than the
traditional adviser model, but in many respects our assessment of
robo-advisors is no different than for a human-based investment adviser.
Just like a conversation with a “real person” about a client’s financial goals,
risk tolerances, and sophistication may be more or less robust, so too there
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is variation in the content and flexibility of information gathered by
robo-advisors before advice is given.
As part of our effort to monitor emerging automated investment models,
staff from our National Exam Program are examining robo-advisors.
Through these inspections, we deepen our knowledge of the range of
services provided, as well as the challenges associated with different
automated models.
It is also an on-the-ground opportunity to proactively convey the need for
these entities to operate within the regulatory framework of the Advisers
Act.
Marketplace Lending
A third area we are closely monitoring is the continued growth of
investments made via online marketplace lending platforms. This activity
broadly refers to using investment capital and data-driven online platforms
to lend either directly or indirectly to small business and consumers.
As a threshold matter, the SEC evaluates these platforms through the lens
of the federal securities laws – that is, are they offering securities and, if
they are, are the offerings registered or made using an exemption.
We are also concerned about the adequacy of the information received by
investors in registered offerings.
We expect that investors will receive disclosures about the loans underlying
their investments, including information about the borrowers as well as the
platform’s proprietary risk and lending models, that will enable them to
make informed investment decisions – both at the time of investment and
on an ongoing basis.
As investors are attracted by potentially higher yielding but riskier
marketplace loans as an investment strategy, information about the
borrower’s ability to repay the loan underlying the investment is critical.
Innovation in finance is welcome, but it must be built upon the disclosure of
material information, which is the bedrock of the federal securities laws.
Marketplace lending has impacts beyond investors and the securities
industry – there are also many consumer and banking considerations. That
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is why we are engaged with our fellow financial and consumer protection
regulators, including the Department of Treasury, the Federal Reserve, the
CFPB, OCC, FTC, and FDIC, to develop a broader understanding of the
online marketplace lending industry, and regulatory initiatives that would
enhance investor, consumer and borrower protections.
Conclusion
There are many other topics of mutual interest that I would like to discuss
that our time together does not allow.
But I hope that I have conveyed tonight how closely the SEC is monitoring
and responding to developments in the private markets, as well as the
relevant fintech phenomena.
We, of course, recognize that the regulatory scaffolding around venture
company advisers and private issuers is considerably scanter than that
which frames registered investment advisers and public companies.
And it only increases the challenge for the SEC that companies are
increasingly choosing private status for longer, no doubt, in part, because
they believe it is the best environment to foster the creativity, rapid cycling
of success and failures, and yes, disruption that is the oxygen of
technological innovation.
We have a keen interest in ensuring that all of the applicable rules and
regulations are followed and that the pressures that shape these markets do
not lead to fraud and harm to investors.
And we will provide the appropriate regulatory oversight to protect
investors so that they can have confidence in continuing to support the
marvelous technologies for which this Valley is famous.
You and your clients share in that responsibility and indeed are closer to the
action in many ways and thus in a position to use a strong investor
protection lens of your own as you go about raising money.
And I challenge you to meet your responsibilities to investors with the same
vigor you search for the next “new unicorn.”
At the SEC, we want the exciting innovations of the Valley and the
expanded ways of funding them to succeed. Working together, we up the
odds of both success for entrepreneurs and issuers and the strong
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protection of investors that is ultimately essential to the success of your
ventures.
Thank you for inviting me to speak to you to tonight and enjoy what I know
will be a lively and irreverent panel.
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Defining the objectives and goals of
supervision
Speech by Mr Andrew Bailey, Deputy Governor
of Prudential Regulation and Chief Executive
Officer of the Prudential Regulation Authority
at the Bank of England, at the New York Fed
conference "Defining the objectives and goals of supervision", Federal
Reserve Bank of New York, New York City
First of all, many thanks to the New York Fed for organising a conference
on supervision of banks. This sounds a strange thing to say in one sense not in another because the gratitude is genuine - but strange in the sense
that surely supervision is such an important part of what we do that we
shouldn't be particularly surprised at the idea of having a conference on it.
But in my experience, it is surprising how little time we spend being more
reflective about supervision.
I want to start with some important definitions. Frequently, and
mistakenly, "supervision" and "regulation" as terms are used
interchangeably.
That's wrong.
Regulation is to do with the framework of rules and guidance that put the
structure around the objectives that as authorities we are usually given in
statute.
In the UK, the PRA has a primary objective in terms of the safety and
soundness of firms we authorise to do business, and safety and soundness
are expressed in terms of the stability of the financial system.
There is then a rulebook that tells us what safety and soundness means.
That's the framework of regulations. Supervision is about how we use it in
practice.
For me, two critical elements of supervision are that it is forward-looking,
and it requires the use of judgement. Sounds obvious, but sadly hasn't been
consistently done well in the past, with bad consequences.
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Supervision is therefore a skill - in fact it's quite a few skills. The essence of
the job is to understand risks in firms, and where necessary to step in and
do a number of things: point out risks, or their significance when the firm
seems to have failed to notice - through either lack of awareness or intent;
or point out that while the firm may have identified the risk, it has failed to
understand or calibrate its significance.
This leads me to a couple of important points.
First, our assessment of risks can differ from firms because our objective
represents the public interest, and there is an externality in the risk in
question which affects the public interest in ways that do not register with a
definition of private interest. The causes of the financial crisis sadly remind
us of this.
It means that we have to be very clear and forthright on what is the public
interest, and thus why we supervise.
Second, risk is our business. This conference is about supervising large,
complex financial institutions. I read too often the criticism of supervision
that we cannot understand the risks of these institutions, and so we should
give up all hope of doing so.
It's an argument which seems to say, we can't value the firm, we can't
supervise it, and we can't resolve it, so therefore let's ensure it has a very
large amount of equity financing, what I call the "Big Equity" argument.
Honestly, it's a nonsense. Large amounts of equity financing will not be
available for such firms, so the best we can say is that this is a route to a
radically different financial system, but in that world the risk goes
somewhere else, and we shall still be worried. But this is not an argument
against having non-risk based tools like the leverage ratio in the
supervisors' toolbox.
They are very important, because to understand risks well, we need more
than one view of the firm.
And the leverage at ratio is an important other view. But I want to
emphasise that understanding risk is at the heart of supervision.
But this, of course, begs a very important question. Why did supervision go
wrong in the period before the financial crisis, and what do we learn from
that bad experience? Let me offer a number of thoughts on that.
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First, supervision was never given sufficient prominence and attention. It's
a very real skill.
In my experience it demands not just high levels of technical skill but also
interpersonal skills - to get very strong egos to change their thinking and
actions - do things that they had not intended - to recognise the public
interest.
Second, I think we saw pre-crisis a tendency for what I, probably too
loosely, call the political-economy to be pro-cyclical and thus approve of
excessive light-touch supervision. This was a problem I think on both sides
of the Atlantic.
The public interest in financial stability was lost amidst an enthusiasm for
the persistence of growth and easy credit. In 1979,the former chairman of
the Federal Reserve Board, Arthur Burns, gave a lecture entitled "The
Anguish of Central Banking".
It was about monetary policy, and how there had been a build-up of ideas
which had accommodated inflation.
Historians have suggested that Burns himself was not innocent in this
respect, but the point is that there was a role for broad ideas which enabled
the accommodation of pernicious inflation. It was dressed up as
enthusiasm for growth and societal change which was ultimately
unsustainable.
We saw similar traits before the financial crisis, with the consequence that
supervision was supressed. The whole thrust of the post-crisis changes in
my view is to make supervision less pro-cyclical - not to aim off in the good
times, but also not over-compensate the other way in the bad times.
A third thought in this respect is that we underestimated the importance of
system-wide risks and macro-prudential policy. Supervision - and
particularly large complex firm supervision - cannot be remote from
macro-prudential policy.
To be honest, while I think we have made some progress breaking down the
barriers, we still have a long way to go to integrate micro and macro
prudential approaches. Douglas Elliott has made the point that we entered
the crisis at a point in the history of economic policymaking where we had
abandoned all macro tools other than the use of interest rates, the price of
money. This was fairly unprecedented.
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We had lost confidence in quantitative tools in monetary policy, and the
role of reserve money had been diminished.
We had very little in the way of bank liquidity policy, of which holdings of
reserve money are an important part. The experience of the crisis tells us
that we have to keep working hard to re-develop these tools and to knit
large firm supervision into the picture. In my experience, it doesn't happen
naturally.
This brings me to the fourth and final thought on supervision. It was
absolutely essential and natural that the immediate reaction to the crisis
was to re-build regulation and supervision in respect of the core prudential
All speeches are available online at building blocks, which are solvency
(capital) and liquidity (funding).
And, we had work to do, and still have, to get these core elements into
better shape.
And the work of interpreting these standards will never stop because the
precise forms of risk taking will evolve.
But, when I have stepped back and looked at the causes of the crisis in
firms, another thing stands out.
In the UK, I don't think we saw a major prudential failure of capital and
liquidity which did not have a governance and management story at is root,
and we had a system which was very poor at creating the right incentives for
good outcomes.
Here I want to put the emphasis on creating the right incentives.
In my experience supervision is in part about creating and overseeing those
incentives.
The critical distinction here is that supervision is not just about doing
things to firms, it is also about creating the conditions for firms to do this
right thing in the first place. Let me give three examples of what we are
doing.
First, we have been much more active in remuneration policy and practice.
I have no interest in regulating the level of pay, but we are interested to
ensure that remuneration is compatible with meeting capital requirements
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(so it can be varied to do so) and that variable remuneration is deferred and
can be withdrawn, and is thus compatible with creating the right incentives
by putting that remuneration at risk if the firm fails to conform with the
objectives of safety, soundness and good conduct of business. I am not in
favour of limiting variable pay in the way European legislation has done
through the so-called bonus cap because it reduces the opportunity to
create the right incentives.
We then supervise firms to ensure those incentives remain in place.
The second example relates to senior individuals in firms. Earlier this
month we introduced the new Senior Managers Regime.
The aim of this regime is to establish clear responsibilities for senior
managers, including chairs of Board Committees.
This is not to create new responsibilities, but rather to be clear on what
those responsibilities are, and then to supervise to hold individuals to those
responsibilities. In the previous regime, we had too many examples of
individuals shirking their responsibilities.
My strong view is that senior figures cannot delegate responsibilities. We
will then direct our supervision to support this new regime operating
effectively.
The third example concerns the supervision of governance, executive and
Board level.
We are in the process of revamping our approach here, recognising that too
many problems of the past have had their roots in ineffective governance.
This is probably the prime area where supervision is distinct from
regulation, because there is very little regulation, rightly so. Supervising
governance is inherently a matter of judgement based on evidence.
So, to conclude, we should devote more time to discussing the skill of
supervision.
It has at its heart the understanding of risk. And, we should devote more
time to developing supervisors and value then for the skill that they need to
do the job well. Thank you
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PCAOB Proposes to Strengthen Requirements for Auditor
Supervision of Other Auditors
The Public Company Accounting Oversight Board issued a proposal to
strengthen existing requirements and impose a more uniform approach to a
lead auditor's supervision of other auditors
For the proposal you may visit:
http://pcaobus.org/Rules/Rulemaking/Docket042/2016-002-other-audit
ors-proposal.pdf
The Board requests public comment on its proposal by July 29, 2016 at:
http://pcaobus.org/Rules/Rulemaking/Pages/Docket042.aspx
In many audits, particularly those of large, multinational companies,
important audit work is performed by accounting firms or individual
accountants outside the audit firm issuing the audit report.
The proposal addresses the lead auditor's responsibilities in overseeing
those other auditors.
"Investors depend on the lead auditor to provide assurance that there are
no material misstatements in audited financial statements or material
weaknesses in internal control, no matter where those misstatements or
weaknesses may reside," said PCAOB Chairman James R. Doty.
"Today's proposal is intended to improve the consistency in the quality of
engagement partner oversight of other firms engaged to assist in the audit."
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The proposal spells out a lead auditor's responsibilities for planning,
supervising, and evaluating the work of other auditors.
The proposal is intended to increase the lead auditor's supervision of the
work of other auditors and to enhance the lead auditor's ability to prevent
or detect deficiencies in the other auditors' work.
"We know from PCAOB oversight activities that the supervision of other
auditors is an issue at some firms," said Martin F. Baumann, PCAOB Chief
Auditor and Director of Professional Standards. "
That, and the fact that a majority of the audits of Fortune 500 companies
use other auditors, underscores the importance of this proposal."
PCAOB inspections have found that many engagement partners do a good
job of overseeing and coordinating the work of affiliates and other audit
firms that participate in the audit.
But PCAOB inspectors also encounter engagements that are not well
managed, as well as work performed by other auditors that does not meet
the objectives of the auditor's role in the audit.
The proposal includes amendments to current standards and a new
standard.
These changes include:
-
Directing the lead auditor's supervisory responsibilities to the areas of
greatest risk, consistent with PCAOB risk-assessment standards.
-
Making clear that, to act as lead auditor, an audit firm must itself audit a
meaningful portion of the financial statements.
-
Requiring more explicit procedures to prompt the lead auditor to
bolster its involvement in the work of other auditors (through enhanced
communication and more robust evaluation of other auditors'
qualifications and work).
A fact sheet on the proposal is also available at:
http://pcaobus.org/News/Releases/Pages/PCAOB-proposal-other-auditor
s-fact-sheet.aspx
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Comments can be submitted through the proposal's rulemaking docket
page at:
http://pcaobus.org/Rules/Rulemaking/Pages/Docket042.aspx
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A year of negative interest rates. Where do we
stand now?
Speech by Ms Cecilia Skingsley, Deputy Governor of the
Sveriges Riksbank, at Danske Bank, Stockholm
Thank you to Christina Nyman, Ulf Söderström,
Charlotta Edler, Marianne Sterner, Emil Brodin and
Anders Vredin for useful comments and assistance.
Thank you for inviting me here today. I intend to talk about three issues:
Is it possible to conduct a national monetary policy in a complicated
international environment? How has Swedish monetary policy been
conducted in recent years? What considerations should govern our choice
of future path?
Is it possible to conduct a national monetary policy in a
complicated international environment?
I believe that most people will recognise the description of growth and the
recovery following the global financial crisis as being a disappointment in
most countries. In many cases the setbacks have been severe and
prolonged, for instance, in southern Europe, while in other cases growth
has been positive but low.
Many central banks, wishing to live up to their price stability commitments,
have implemented more far-reaching and long-term measures to stimulate
monetary policy than have previously been imagined as possible.
So how did we get to where we are now, with such low interest rates?
In the long run, it is structural factors such as the conditions for growth and
the willingness to save that determine the level of the real interest rate. As a
small, open economy, Sweden must in principle accept the international
real interest rate as a given.
Monetary policy is not able to affect the real interest rate to any great extent
in the longer run, but it affects inflation and inflation expectations.
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In recent years, the IMF and other forecasters have revised down their
forecasts for GDP on several occasions. If one looks at real interest rates,
these began to fall even before the financial crisis and real interest rates
have also fallen during periods of higher growth.
Opinions differ with regard to the causes of this slowdown.
The more pessimistic line talk about secular stagnation, where savings have
increased and willingness to invest has declined as a result, for instance, of
the composition of the population, of growing income gaps and weak
technological innovations.
This has in turn pushed down the interest rate level compatible with normal
resource utilisation.
The other more optimistic line say that remaining effects from the global
financial crisis, such as deleveraging and increased political uncertainty,
explain the slowdown but that these effects are transitory.1
Lower real interest rates and inflation
But it is not merely real interest rates that have fallen. In recent years,
inflation has also shown a downward trend.
This trend began later than the decline in real interest rates, but Swedish
inflation began to fall slightly before that in other western countries such as
the United States and the euro area.
The most recent downturn in inflation in the euro area can to some extent
be explained by the fall in energy prices.
However, underlying inflation has also fallen in the wake of both the
banking crisis and the euro crisis.
It is necessary to take into account the decline in both real interest rates and
inflation in the monetary policy deliberations.
The fundamental reasoning regarding the stabilisation ability of monetary
policy with a floating exchange rate is based on the assessment of a normal
nominal interest rate, simply described as an interval for a nominal interest
rate that neither speeds up nor slows down the economy.
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To estimate how high the normal nominal interest rate should be, we look
at the real interest rate and add to this the inflation target. If the real
interest rate is 2 per cent and the inflation target is 2 per cent, then the
nominal interest rate should be around 4 per cent.
If the real interest rate rises to 3 per cent, and the inflation target remains
unchanged at 2 per cent, the nominal interest rate will be 5 per cent, and so
on.
But as I have just shown, developments are instead showing a downward
trend. Lower real interest rates and lower inflation and inflation
expectations are pushing the nominal interest rate downwards.
This means that the central bank has to take stronger action for monetary
policy to have a stimulating effect.
Some important questions are raised here: What are the fall in real interest
rates and the downturn in inflation due to? Are these temporary or
permanent changes?
Are the central banks over interpreting their price stability task or have they
not done sufficient to cure the low inflation? Some say that all things bad
are mostly the fault of the central banks.
I believe that part of the intensive debate on monetary policy conducted
both here in Sweden and abroad is due to us economists tending to have
different answers to these questions.
These answers in turn affect the opinions on what is the best policy in both
the long and the short term.
How has Swedish monetary policy been conducted in recent
years?
Swedish monetary policy strategy entails stabilising inflation around the
target and striving to stabilise production and employment around paths
that are sustainable in the long term.
If we look back two years, to the period before the April 2014 meeting, CPIF
inflation had been around 1 per cent for some time, which is too low given
that the Riksbank wishes to uphold confidence in the inflation target of 2
per cent as an anchor for price-setting and wage-formation.
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Another observation from April 2014 was that the more long-run inflation
expectations had fallen below the 2 per cent level. It became increasingly
clear over the course of the year that further monetary policy stimulation
was needed.
Six months later, in autumn 2014, after rate cuts totalling 75 basis points,
the situation became critical as a result of the halving of the oil price in
USD. This further dampened the already low inflation, although lower
energy prices also benefit demand.
On top of this, there were clear signals that the ECB was preparing a
powerful stimulation package that would come into operation in spring
2015.
Measures taken to improve the prospects for our trading partners are of
course also positive for the Swedish economy, but if the negative interest
rate differential between Sweden and the rest of the world were to increase,
it could contribute to a strengthening of the krona. This would make it even
more difficult for us to attain the inflation target.
At the beginning of 2015, the initial situation for the Riksbank was
problematic.
The risks of waiting to see what happened were assessed as greater than
those connected to being proactive, as inflation had been low for a long time
and inflation expectations were moving in the wrong direction.
If monetary policy had not been made more expansionary, there was a risk
that inflation expectations in the corporate and household sectors would
fall further and I did not see this is a path to higher and more normal
interest rates.
The Executive Board was agreed that further stimulation was necessary.
Starting from the February meeting, the repo rate was cut below zero and
the first of a series of asset purchase programmes was begun.
Furthermore, we signalled that there was a possibility of foreign exchange
interventions if the krona appreciation already forecast were so strong and
rapid that it jeopardised the upturn in inflation.
We deliberately increased our focus on the development of short-run
inflation, as we had a low tolerance of poor outcomes.
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What considerations should govern our choice of future path?
We are now in April 2016 and I judge that we have largely succeeded in our
efforts. Growth has become much higher than expected, although this is not
merely due to monetary policy.
The trend towards declining confidence in the inflation target has turned
around in that inflation expectations have begun to rise again.
The monetary policy conducted is far from uncomplicated. In a world of
minus rates it is more difficult to assess what impact the interest rate
decisions will have on different channels, that is, how the transmission
mechanism will work. It is also difficult to assess the stimulation effects of
the bond purchases.
Moreover, the Riksbank has been clear that low interest rates increase
indebtedness among households in a way that increases vulnerability in the
Swedish economy. But most of all, I feel that our monetary policy is
successful and better than the alternative.
The inflation target would have risked losing its role as anchor for
price-setting and wage-formation if we had not cut the repo rate in 2014
and 2015.
With regard to my thoughts on going forward, I would like to begin with the
monetary policy meeting on 10 February.
The report presented then stated that resource utilisation in Sweden was
assessed to be at a normal level. The members of the Board agreed that the
important thing for monetary policy is for the trend in inflation to come
closer to the target and to avoid weakening confidence in the target.
The upturn in inflation is expected to continue to be fitful and there may be
surprises along the way. Whether, and if so how, monetary policy will react
depends on the causes of such surprises and how they are deemed to
influence the outlook for inflation.
We were also agreed that we shall maintain a high level of preparedness for
action, even between the ordinary meetings, in case further measures are
needed to safeguard confidence in the inflation target.
Exactly how tolerant we are with regard to different outcomes may vary
somewhat on an individual basis, which is natural on a committee. In my
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contribution to the debate at the meeting I wanted to say that I now have a
greater tolerance for setbacks, in that we now have a more favourable
situation in Sweden.
I do not see this as advocating a new monetary policy strategy for the
Riksbank.
Instead I would describe it as a natural consequence of the change in the
economic situation and inflation prospects.
When the analyses of data point to resource utilisation normalising and
inflation showing a trend towards the target, it is reasonable not to make
monetary policy more expansionary, but instead to see developments in the
slightly longer run.
Or, as I have previously put it "it is time to take a longer view".
Some people probably think that central banks should always take a longer
view, and normally I would agree with this.
But I consider that the Riksbank was in a situation at the end of
2014/beginning of 2015 that required greater focus on the present, in words
and deeds, to show that the Riksbank does not just talk, but also takes
action to uphold confidence in the inflation target.
As I said in other contexts, further monetary policy stimulation must entail
advantages that are greater than the disadvantages.
But I am not ruling out the possibility of further stimulation.
I have already referred to the reason why this may be needed in my
introduction today.
The big questions, such as growth conditions, real interest rates and the
behaviour of inflation in the short and long run, have in no way been
answered.
My point is that the global conditions for growth will gradually improve and
that the course of inflation will normalise. But this depends on decisions
made abroad, which govern the real interest rate that we in Sweden have to
relate to.
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Growth conditions in Sweden also depend on the Swedish economy's ability
to constantly transform in an orderly manner.
Monetary policy can function as a bridge over to a new normal situation.
But the new normal will be determined by decisions that are beyond the
central bank's control.
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Statement on Proposed Amendments
Relating to the Supervision of Audits
Involving Other Auditors and Proposed
Auditing Standard—Dividing Responsibility
for the Audit with Another Accounting Firm
James R. Doty, Chairman
Open Board Meeting, Washington DC
The Board meets today to consider a proposal to amend the auditing
standards governing an audit firm's use of other audit firms. This comes up
regularly in multi-national audits by firms of all sizes.
Last December, the Board adopted a rule that will provide public
transparency on the significant extent to which such audits involve the
work of other auditors beyond just the lead auditor who signs the audit
opinion. Under that rule, registered firms will disclose information that will
allow investors to see, for any particular audit, how much of the work was
performed by other auditors.
The proposal before us today comes at the matter of other auditors from a
different perspective – not one of ensuring transparency but one of
ensuring appropriate involvement in that work by the lead auditor.
PCAOB-registered firms around the globe contribute audit work to each
other's audits, and our existing auditing standards prescribe
responsibilities for the lead auditor with respect to the work of other
auditors.
Investors depend on the lead auditor to provide assurance that there are no
material misstatements in audited financial statements or material
weaknesses in internal control, no matter where those misstatements or
weaknesses may reside.
In our inspections, we review audits in which the inspected firm served as
the lead auditor and used other auditors. We often also review the inspected
firm's work in audits in which it was not the lead auditor but played a role.
That role can range from a full scope audit of a significant subsidiary, to
certain selected procedures that the lead auditor specifies relating to a less
significant component.
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Our inspections have found that many engagement partners do a good job
of overseeing and coordinating the work of the affiliate and other audit
firms that participate in the audit. But our inspections also encounter
engagements that are not well managed, as well as work performed by the
other auditor that does not meet the objectives of that auditor's role in the
audit.
Today's proposal is intended to require conduct by lead auditors that
should result in a consistent level of quality assurance regarding other
auditors' participation in in the audit. The proposal would direct the lead
auditor's supervisory responsibilities to the areas of greatest risk, consistent
with our risk assessment standards.
It would also require procedures that would cause the lead auditor to be
more involved in the work of other auditors, through more communication,
access to the other auditor's work papers, as well as more robust evaluation
of the other auditor's qualifications and work.
I look forward to public comment on the proposal, including comment on
the economic analysis that underpins the proposal.
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Statement on Proposed Amendments Relating to the Supervision
of Audits Involving Other Auditors and Proposed Auditing
Standard—Dividing Responsibility for the Audit with Another
Accounting Firm
Lewis H. Ferguson, Board Member
PCAOB Open Board Meeting, Washington DC
I support this proposed standard because I believe it is important that there
be clarity about the role of the lead auditor in engagements where a number
of other auditors are involved.
It is important that the lead auditor's engagement partner and engagement
team in PCAOB audits understand what is required of them by our
standards when they assign work on an audit to another auditor, and then
review and rely on that work in forming their opinion.
This proposed standard will strengthen those requirements by more clearly
defining the lead auditor's responsibilities when using the work of other
auditors, including by defining "engagement team" to extend the range of
supervision to cover other auditors for whose work the lead auditor
currently assumes responsibility under AS 1205.
A growing number of audits, particularly audits of global enterprises, are
being conducted by more than one firm, legally distinct from one another,
but commonly affiliated in a global network.
The use by the lead auditor of such other auditors in an audit, often located
in a different country, and at times in several different countries, can
provide a number of benefits, including competitive and efficiency benefits,
by allowing lead auditors to leverage the use of locally-licensed auditors.
The locally licensed auditors may have language skills and knowledge of
local culture and business practices that can be a great benefit to the lead
auditor if properly used and supervised. The use of other auditors in a
multinational environment, however, also introduces a number of
challenges that can lead to inadequate audit performance.
As discussed in this proposal, the PCAOB's inspection reports show a
significant number of findings in the conduct of multinational audits,
including in the work performed by other auditors. Such findings are not,
however, confined to the United States.
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The International Forum of Independent Audit Regulators' annual survey
of inspection findings, including findings from more than thirty audit
regulators around the world, has identified, for a number of years,
supervision of group audits as a frequent area of inspection findings in the
audits of public interest entities.
In the four years that the survey has been conducted, there has not been a
meaningful reduction in the number of those findings, which, to me,
strongly suggests the need for closer examination and possibly
amendments of the standards governing supervision of other auditors.
To this end, the Global Audit Quality Working Group of IFIAR, which I
Chair, is undertaking an effort, working with the six largest global network
firms, to take a closer look at group audit issues with a goal of deepening
our understanding about the root causes leading to these issues. We will
also focus on how the auditing firms are remediating these issues and
assuring audit quality across their networks.
At the same time, the Global Audit Quality Working Group is also
undertaking a coordinated multi-jurisdictional inspection of a single
multinational audit performed across several countries in order to enhance
the regulators' insight into the communications and understanding among
and between the group auditors.
It is my understanding that some firms today have guidance and policies for
the conduct of audits involving other auditors that exceed what is required
by our current standards, but that is not true for all firms.
It is important that the standards demand a level of performance in the
supervision of other auditors that is consistent and that will assure a high
and uniform level of audit quality whether an audit is conducted by a single
firm or by many firms.
Our current inspections show that some lead auditors, even where they
themselves meet the requirements of the current standards, fail to detect
inadequate work by other auditors that they engage.
The proposed standard will be beneficial both to elevating the performance
expectations in the standards, and also to prospective enforcement of the
audit firms' obligations to supervise other auditors in accordance with the
standards.
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I would like to thank the staff of the PCAOB for their hard work in
developing this proposal. In particular, Dima Andriyenko, Marty Baumann,
Lillian Ceynowa, Matt Goldin, Stephanie Hunter, Hunter Jones, Joon-Suk
Lee, Denise Muschette Wray, John Powers, Robert Ravas, Greg Scates,
Andres Vinelli, and Keith Wilson.
We are also indebted to the staff of the Securities and Exchange
Commission for their thorough and thoughtful review of this proposal as it
was developed. I support today's proposal and I look forward to reviewing
the comments we receive in response.
In particular, I hope that we will receive helpful input on our economic
analysis and thoughts on the benefits and costs of the proposed standard.
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Statement on Proposed Amendments
Relating to the Supervision of Audits
Involving Other Auditors and Proposed
Auditing Standard—Dividing
Responsibility for the Audit with
Another Accounting Firm
Jeanette M. Franzel, Board Member
Open Board Meeting, Washington DC
I support today's proposal to strengthen the auditing standards for the lead
auditor's performance when other auditors participate in an audit.
When more than one audit firm is involved in an audit, it is important for
investor protection that the lead auditor assures that the audit is performed
in accordance with PCAOB standards and that sufficient appropriate
evidence is obtained to support the audit opinion.
As described in the proposing release before us today, the need for stronger
standards in this area has become evident over the past few years.
In my view, the proposed requirements will help to enhance audit quality in
this area of increasing audit risk and significance to the capital markets. As
the proposing release describes, this has been an evolving and challenging
area for audit regulators and auditors around the world.
Increasing numbers of audits, primarily multinational audits, involve the
use of accounting firms and accountants (other auditors) outside the
accounting firm that issues an audit report. In addition, the complexity and
globalization of financial reporting and auditing has evolved over several
decades.
When a lead auditor engages other auditors in (sometimes many) different
countries, new challenges are injected into the audit.
These challenges can be associated with different languages, business
practices, cultural norms, and market conditions in different countries, as
well as different quality control systems and professional training of staff in
different audit firms.
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Meanwhile, the evolution of auditing standards and auditing practices that
address the auditor's performance requirements and expectations under
such circumstances has varied, increasing the risk of variability in audit
quality.
Indeed, as the proposing release points out, PCAOB's oversight activities
too frequently identify audit deficiencies in the work of other auditors that
the lead auditor failed to prevent or detect in supervising the work and in
preparing the resulting audit report.
Such deficiencies can cause the lead auditor to lack sufficient appropriate
evidence to support the audit opinion.
The proposed amendments related to the supervision of audits involving
other auditors would address these risks by strengthening and making
more uniform and risk-based the responsibilities of the lead auditor.
In particular, the requirements for a lead auditor when assuming
responsibility for the work of other auditors would be stronger in the areas
of supervision, planning, review, and documentation.
Also, the lead auditor would be required to follow stronger requirements
when assessing the sufficiency of its participation in order to serve as the
lead auditor.
The proposed standard on dividing responsibility for the audit with another
accounting firm retains many of the existing requirements with
modifications designed to improve communication between the lead
auditor and referred-to auditors, and improve compliance with ethics,
independence, and PCAOB registration requirements.
The amendments and new standard should reduce variability in audit
performance, causing auditors to focus more consistently on the risks of
material misstatement in the financial statements, thereby benefiting
investors.
As described in the proposing release, the benefits and costs of the
proposed amendments and new standard may depend upon a number of
factors associated with each firms' current practices and the facts and
circumstances of a particular audit.
In addition, the release identifies several potential unintended
consequences that we factored into our deliberations. I look forward to
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receiving comments on both the operational and likely economic impacts of
the proposal.
Strong auditing performance or procedural requirements, when
appropriately designed, are a key element of audit quality.
When auditors comply with and properly implement strong auditing
standards in their work, investors benefit in that they should be able to
form expectations about the audit.
I welcome input from commenters on key elements of this proposal,
including suggestions for further refinement of the lead auditor
requirements to achieve high quality audits that benefit investors.
I want to thank the staff of the Office of the Chief Auditor, the Center for
Economic Analysis, and the Office of the General Counsel for the hard work
put into this proposal.
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Statement on Proposed Amendments Relating to the Supervision
of Audits Involving Other Auditors and Proposed Auditing
Standard—Dividing Responsibility for the Audit with Another
Accounting Firm
Jay D. Hanson, Board Member
PCAOB Open Board Meeting, Washington DC
We are here today to issue a proposal intended to enhance the planning and
supervision of audit work conducted by so-called "other auditors"
participating in audits of the financial statements of U.S. public companies,
brokers or dealers. In addition, we are proposing a new standard – though
incorporating many of the current requirements – for situations in which
an auditor divides responsibility for the audit with another accounting firm.
The "other auditors" addressed in the proposed amendments include other
firms or individuals who participate in the audit but who are not part of the
audit firm issuing the audit report. Under standards currently in effect,
auditors may apply a variety of approaches to the oversight of other
auditors involving varying degrees of oversight by the lead auditor over the
work of the other auditor.
While certain approaches taken by firms work well and result in high
quality audits, some of the approaches that are permissible under current
standards do not involve enough oversight by the lead auditor to ensure
that sufficient appropriate evidence is obtained to support the lead
auditor's opinion in the audit report.
As described in the release, many of the larger audit firms, particularly
those that are part of international networks, have adopted methodologies
that combine existing PCAOB standards and International Standards on
Auditing.
In some cases, firms have further supplemented these requirements by
incorporating additional procedures, including procedures developed in
response to inspection findings identified by the PCAOB or similar
regulators in other parts of the world.
These firms require frequent, comprehensive communications with other
auditors and review of other auditors' work papers in areas of significant
risk, steps which go beyond those currently required by PCAOB standards.
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Other firms, including those who don't follow international standards,
continue to base their supervision of other auditors largely on existing
PCAOB standards. As a result, the PCAOB has observed inconsistencies in
practice among firms with regard to the supervision of other auditors. The
proposed amendments are intended to enhance supervision over other
auditors generally and bring consistency to the approaches used by firms.
As the release discusses in more detail, our overall approach incorporates
many of the concepts currently included in International Standard of
Auditing 600, Special Considerations—Audits of Group Financial
Statements (Including the Work of Component Auditors), but also imposes
certain additional or more specific requirements.
-
For example, ISA 600 generally requires the "group engagement
partner" to evaluate whether the group engagement team will be
involved in the work of the "component auditors" to the extent
necessary to obtain sufficient appropriate audit evidence. Our proposed
amendments, on the other hand, more specifically require the lead
auditor to determine its "sufficiency of participation" based on its
relative responsibility for the areas of highest risk of material
misstatement.
-
In addition, our proposal includes more specific requirements than the
ISAs regarding the information that must be provided by the lead
auditor to the other auditor and the documentation to be created and
provided by the other auditor.
-
Our proposed approach is designed to be scalable for audits of different
size and complexity based on risk.
-
The proposed requirements address certain aspects of working with
other auditors that are not addressed by the ISAs, including
multi-tiered audits involving multiple levels of other auditors,
engagement quality review in connection with the lead auditor's
sufficiency determination, and dividing responsibility with a
"referred-to auditor."
Overall, I believe that the proposed amendments mirror what would be a
common sense approach in any situation in which one party decides to rely
on another in connection with important tasks. Similar steps would apply
in many situations outside of auditing, such as hiring a new employee, for
example. Important considerations include:
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-
The basis for believing reliance is appropriate – in this case, the other
auditor's qualification and experience;
-
The extent of reliance – such as the lead auditor's decision about the
scope of the other auditor's work and the risk-based determination of
the sufficiency of the lead auditor's own involvement;
-
Communication to avoid misunderstandings and agreement on what
needs to be done – including, for example, directions regarding the
work the lead auditor wants the other auditor to perform;
-
Monitoring, supervising and reviewing the work performed – including
requiring the other auditor to document its work, frequent two-way
communications to ensure that nothing is missed, and reviewing the
other auditor's work product; and
-
Doing a final check – including through the issuance by the other
auditor of a report and the involvement by the lead auditor of an
engagement quality reviewer.
I look forward to receiving comments about whether we have struck the
right balance with the proposed approach. In particular, I am interested in
comments in the following areas:
Sufficiency determination – Is it clear how the lead auditor determines
whether its own involvement in the audit is sufficient? Is this a significant
change in practice compared to current approaches? Do firms currently
take a different approach to the sufficiency determination if the "other
auditor" is a firm in their own network? Should a different approach be
permitted in that circumstance, contrary to the requirements in the
proposal?
Independence determination – The proposal states that the lead auditor
must take certain steps to determine whether the other auditor is
independent.
These include gaining an understanding of the other auditor's knowledge of
and experience with the SEC and PCAOB independence and ethics, and
obtaining a written representation from the other auditor that it is in
compliance with SEC and PCAOB independence and ethics requirements.
Are these proposed requirements clear? Are there any obstacles firms face
in meeting the proposed requirements?
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Supervision and review – Are the proposed amendments to AS 1201,
requiring specific steps to supervise and review the work of other auditors,
sufficiently clear and reasonable in scope?
Scalability – Are the requirements sufficiently risk-based and scalable,
allowing for their application in a variety of different types of audits, and by
firms of various sizes, without imposing any unreasonable burdens?
As always, I encourage comments not only from auditors, but also from
preparers, audit committees, investors and others. I encourage audit
committees and preparers, in particular, to discuss the proposals with their
auditors in order to fully understand the degree to which the proposal will
change existing practice and to consider any possible unintended
consequences.
Finally, I would like to thank the staff who work long and hard on this
project in order to help us achieve what I believe is a good balance between
the potential benefits and costs of the proposal. Our Office of the Chief
Auditor did much of the heavy lifting, especially Dima Andriyenko, Keith
Wilson, Lillian Ceynowa, Stephanie Hunter, Robert Ravas, Denise
Muschette Wray, and Hunter Jones. They were ably assisted by economists
Andres Vinelli, John Powers, Joon-Suk "Joon" Lee, as well as Matt Goldin
from the Office of General Counsel.
A special thanks also to Greg Scates in the Division of Registration and
Inspections who has worked on this project from its inception, as well as
Santina Rocca and Elizabeth Echternach whose command of the relevant
inspection findings helped immensely. And, of course, as always, we
appreciate the thoughtful input of the staff of the Securities and Exchange
Commission.
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Statement on Proposed Amendments Relating to the Supervision
of Audits Involving Other Auditors and Proposed Auditing
Standard—Dividing Responsibility for the Audit with Another
Accounting Firm
Steven B. Harris, Board Member
EVENT PCAOB Open Board Meeting LOCATION Washington DC
Mr. Chairman, I support the proposal before us today regarding audits
involving other auditors. I view the proposal as an important step forward
in addressing the audit quality concerns noted through our inspection and
enforcement activities.
The audits implicated here are those where portions of the audit are
performed by auditors other than the firm signing the audit report. The
other auditors are often located in different jurisdictions and may be
affiliates of the signing firm. If the signing firm takes responsibility for the
work performed by the other auditors involved, it does not identify the
participation of the other firms or individuals in its report.
However, if the signing firm does not take responsibility, it identifies the
portion of the work performed by the other auditor and that auditor
provides a separate audit report for its work.
Most investors in today's capital markets own shares in companies with
foreign operations. As noted in the release, approximately 40 percent of
total assets and revenues of publicly listed companies are outside of the
country of the signing auditor.
The increasing globalization by public companies has led to the expanded
use of other auditors in the audits for those companies. Based on PCAOB
staff analysis of inspections data as of March 31, 2013, about 80 percent of
Fortune 500 issuer audits performed by the top six U.S. firms involved
other auditors.
In addition, other auditors are now playing a more significant role in such
audits.
The signing auditor may enlist assistance from another auditor to, among
other things, manage costs or use personnel who are familiar with local
practices and culture. Engaging other auditors may also enable a firm to
accept engagements that it may have had to otherwise decline due to
jurisdictional hindrances.
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Audits that involve other auditors, though, face certain challenges.
Differences between auditors' business practices, languages, cultural
norms, market conditions, and professional training, just to name a few,
may adversely affect the quality of the audit.
It is important that the signing auditor ensures that the work done by the
other auditors is of high caliber. Our inspections have noted a generally
higher rate of deficiencies for foreign-affiliated firms than for U.S.-affiliated
firms between 2011 and 2013.
This indicates that there are real differences in the quality of work
performed by firms in the U.S. and their affiliates abroad.
The nature of the deficiencies that our inspectors have observed cover a
wide range, from the other auditor not performing procedures requested by
the lead auditor or required under our standards to failing to communicate
significant accounting and auditing issues to the lead auditor.
Inspectors have also noted issues with the lead auditor's work as it relates
to the other auditor. These include the lead auditor failing to (i) assess the
qualifications of other auditors participating in the audit, (ii) review the
results of the other auditor's procedures relating to fraud risk factors, and
(iii) provide specific instructions to the other auditors.
Today's proposal, which calls for increased lead auditor involvement in, and
evaluation of, the work of other auditors, is a positive step in addressing
these deficiencies and increasing investor protection. This is especially
important as inadequate lead auditor supervision has led to deficient
audits. It is also consistent with what our Investor Advisory Group
recommended in 2011.
The amendments proposed appropriately direct the lead auditor's attention
to the areas of greatest risk and include specific lead auditor supervisory
responsibilities.
For example, the proposal includes a requirement for the lead auditor to
(i) provide the other auditor with specific information in writing, (ii) have
discussions about potential risks of material misstatements with the other
auditor, and (iii) obtain and review the other auditor's description of audit
procedures it plans to perform. The signing firm will also need to maintain
a list of work papers of the other auditor that were reviewed but not
retained.
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Today's proposal requires the lead auditor to be better informed about the
qualifications and performance of the other auditor as well. For example,
we are proposing that the lead auditor assess the other auditor's
qualifications and compliance with pertinent independence, ethics and
registration requirements.
The proposal also includes a separate standard for those situations in which
two or more firms divide responsibility for an audit.
We are not alone in taking action in this area. The International Auditing
and Assurance Standards Board (IAASB) is currently assessing the need for
change following persistent deficiencies in group audits reported by the
International Forum of Independent Audit Regulators.
Certain aspects of this proposal are also consistent with what a number of
the largest firms already require under their methodologies. As noted in the
release, some firms now require the lead auditor to have frequent,
comprehensive communications with other auditors and review the other
auditors' work papers in areas of significant risk.
The Board recognizes that imposing new requirements may result in some
additional costs. Such costs, however, will not be significant for those firms
that already require heightened supervision by the lead auditor and are
justified for those that have not adopted such methodologies for the
protection of investors. In my opinion, alternatives to rulemaking, such as
issuing interpretive guidance, would not address the audit quality issues
noted.
I believe improving the relevant performance requirements in this area is
consistent with the Board's investor protection mission by promoting high
quality audits. There are indications that firms with enhanced supervision
methodologies have already experienced a reduction in audit deficiencies.
For these reasons, I support the amendments being proposed today.
Finally, Mr. Chairman, today's proposal deals with the supervision of other
auditors. However, I believe that appropriate supervision of firm personnel
at all levels within a firm is an essential ingredient for an audit practice to
perform high quality audits. Such a supervision standard regarding all such
firm personnel was contemplated by Section 105(c)(6), the Failure to
Supervise section, of the Sarbanes-Oxley Act. The Board previously issued a
concept release in this area in August 2010 noting "[t]he quality of a firm's
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audit practice is directly affected by the quality of supervision within the
firm", and I would hope that we might revisit and move ahead soon on that
proposal as well.
In conclusion, I would like to thank Marty Baumann, Keith Wilson, Dima
Andriyenko, Lillian Ceynowa, Stephanie Hunter, Denise Muschett Wray,
Robert Ravas, and Hunter Jones, from our Chief Auditor's office, Andres
Vinelli, John Powers and Joon-Suk Lee from our Center of Economic
Analysis, and Gordon Seymour and Matt Goldin from our Office of General
Counsel. I would also like to thank Greg Scates who worked on this project
prior to joining our Division of Registration and Inspections.
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Prudential treatment of problem assets definitions of non-performing exposures and
forbearance - consultative document
The Basel Committee on Banking Supervision has
issued for consultation Prudential treatment of
problem assets - definitions of non-performing
exposures and forbearance.
At present, banks categorise problem loans in a variety of ways and there
are no consistent international standards for categorising problem loans.
The definitions proposed by the Basel Committee aim to foster
harmonisation in the measurement and application of two important
measures of asset quality and thereby promote consistency in supervisory
reporting and disclosures by banks.
(i) The definition of non-performing exposures introduces criteria for
categorising loans and debt securities that are centred around delinquency
status (90 days past due) or the unlikeliness of repayment. It also clarifies
the consideration of collateral in categorising assets as non-performing.
The definition also introduces clear rules regarding the upgrading of an
exposure from "non-performing" to "performing" as well as for the
interaction between non-performing status and forbearance.
(ii) Forbearance refers to concessions, such as a modification or refinancing
of loans and debt securities, that are granted as a result of a counterparty's
financial difficulty. The proposed definition sets out criteria for when a
forborne exposure can cease being identified as such and emphasises the
need to ensure a borrower's soundness before the discontinuation.
The proposed definitions complement the existing accounting and
regulatory framework in relation to asset categorisation. They are intended
to be used, for example, in the supervisory monitoring of a bank's asset
quality as well as by banks in their credit risk management and as part of
their internal credit categorisation systems.
The Committee welcomes comments from the public on all aspects of the
proposals described in this document.
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Comments on the proposals should be uploaded by Friday 15 July 2016 at
http://www.bis.org/bcbs/commentupload.htm
All comments will be published on the Bank for International Settlements
website unless a respondent specifically requests confidential treatment.
To learn more:
http://www.bis.org/bcbs/publ/d367.pdf
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The importance of credit institutions'
capitalisation, financial regulation
development
Speech by Mr Lars Rohde, Governor of the National
Bank of Denmark, at the annual meeting of the
Danish Mortgage Banks' Federation, Copenhagen
Thank you for inviting me to speak at your annual meeting.
Today I will focus on the importance of credit institutions' capitalisation,
financial regulation developments and a few significant consequences of the
very low interest rates.
My key messages are: It is in everyone's interest that credit institutions are
well-capitalised. The risk-based approach should be retained in financial
regulation.
And we must have a realistic approach to how much special Danish
circumstances will be taken into account in future. I will also observe that
the credit institutions' own targeted returns seem to be rather high, and
that a long period of low interest rates involves considerable inherent risk.
***
My first topic is equity capital and financial regulation.
Robust equity is of paramount importance if people are to have confidence
in a financial enterprise. The financial crisis showed that many financial
institutions were insufficiently capitalised.
As a result, some of them were not resilient to the losses incurred in the
wake of the overheating. This inability to absorb losses exacerbated the
economic downturn. Since then, much has been done to increase the
resilience of the financial system, both internationally and in Denmark.
For example, capital requirements have been enhanced. The financial
system has become more robust than it was before the financial crisis.
The improved capitalisation of Danish credit institutions is without
question an advantage, whether or not it is a result of financial regulation.
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There is nothing to indicate that the increased capital requirements have
led to a lack of lending capacity or led to lower growth in Denmark.
It is also in the interest of the credit institutions themselves to be
well-capitalised - and even more so after the introduction of the new EU
bail-in regime.
It is now the owners and creditors who must bear the losses of a distressed
institution. And it is at least as important to be well-capitalised in the eyes
of the market as in the eyes of the supervisory authorities.
Important work is underway in relation to resolution planning for credit
institutions. As regards the mortgage banks, it is chiefly a question of
ensuring that the authorities can handle a distressed mortgage bank.
Without the use of taxpayers' funds. And in such a way that the lending
capacity of the institution is retained and there is no knock-on effect on the
rest of the system.
***
The capital adequacy rules are based on the principle that a financial
institution's capitalisation should reflect the actual risk on the institution's
balance sheet.
This is why e.g. the risk-based capital requirements apply. They are aimed
at ensuring that the institutions' capitalisation is adequate so that they can
resist shocks. At the same time, the risk-based capital requirements
contribute to improving the institutions' risk management.
The internal models used by most large institutions to calculate their
risk-weighted assets have been criticised internationally. It has given cause
for concern that the risk weights calculated can differ substantially across
institutions, even if the exposures are similar. For many institutions, the
risk weights have also declined notably over the years.
The Basel Committee, which proposes standards for financial regulation of
banks at the global level, has recently published a consultative document
proposing certain limitations on the use of internal models for calculating
risk-weighted assets.
It is yet too early to assess the full consequences of the Basel Committee's
proposal. Nor is it possible to say whether it will be possible to take special
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national circumstances into account when the proposal is incorporated into
EU regulation.
Danmarks Nationalbank finds that the risk-based approach should be
retained. That is in line with the position of the Danish government and
with your view.
Therefore, we support the continued use of internal models for calculating
risk-weighted assets. At least to the extent that the credit institutions have
sufficient data for the use of such models to make sense. In other words,
there should not be any floor requirements if the documented risk of losses
is very low.
It is also important that both credit institutions and authorities take a
thorough and critical view of whether the internal models reflect the
institutions' risks.
***
Regulation of the financial sector is mostly determined at the international
level. There may be elements that we in Denmark find inexpedient. And it is
possible that EU regulation is gradually doing away with national
discretions.
There can be no doubt that it is in the interest of Denmark to have a level
playing field for credit institutions. If everyone wants special rules, the
playing field is no longer level.
The Danish mortgage credit system is based on our special statutory
requirements. Furthermore, it relies heavily on a well-functioning land
registration system and a creditor-friendly system of enforced sales.
We have seen that the Danish mortgage credit model does not always fit
into the framework of new international financial regulation.
In recent years, we have also seen a clear tendency for mortgage banks to
resemble other banks more and more.
Our expectations must be realistic. And we must face the fact that there are
limits to the number of special arrangements that the Danish mortgage
credit sector can obtain when new international regulation is introduced.
Instead, our ambition should be to fit Danish mortgage credit into the
framework laid down by the international standards and rules.
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We can do so by seeking to influence this framework. But we should choose
our battles carefully.
A challenge in relation to Denmark's efforts to influence developments in
international regulation is that much of this regulation is initially conceived
by the Basel Committee, where we do not have a seat. We only have a say
from the stage where the rules are transposed into EU regulation. So the
main channel of influence goes via the EU cooperation.
By the way, the European Commission should be given credit for generally
listening to the Danish views. At least if our argumentation is convincing
and supported by empirical data. On the other hand, we must accept that
non-membership of the banking union closes another possible channel of
influence on international financial regulation - the ECB.
***
More changes to financial regulation are likely to be introduced in the
coming years in the form of new initiatives from the Basel Committee as
well as changes to EU regulation resulting from the banking union.
According to the Basel Committee, the forthcoming changes are not aimed
at increasing the total capital requirements for the financial sector.
But for the individual institution the new requirements could mean that it
should prepare for increased capital adequacy requirements. Therefore, it
would be wise to ensure robust capitalisation. This can be done by raising
capital in the market or by retaining a larger share of profits.
In this connection I would like to make it clear that an increased share of
own funding relative to debt funding does not entail any substantial extra
costs for a credit institution.
More equity capital makes the institution more robust and reduces the
returns demanded by both bond owners and shareholders. And the return
on and risks related to the assets are the same irrespective of the method of
funding. Moreover, right now might be a good time to boost the capital
buffers as equity investors' expected returns are currently low.
***
Given the very low level of interest rates, the targets set by credit
institutions for return on equity seem to be rather high. According to these
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targets, an investment in a Danish bank or mortgage bank should yield a
considerably higher return than an investment in Danish government
bonds. The reason for this high risk premium is not obvious to me. And
certainly not if we take into account that the institutions have increased
their capitalisation in recent years and are now seen as safer investments.
The high targeted returns give cause for concern as they may trigger a need
to increase the risks taken by credit institutions. This can be done on the
assets side, e.g. via more risky lending. Or on the liabilities side via higher
leverage ratios. I hope that the high targets are not based on this type of
strategic considerations. The credit institutions should carefully consider
whether the current targeted returns are consistent with a prudent level of
risk.
***
The long period of low interest rates may have had an impact on the
expectations and behaviour of firms and households. The risk that interest
rates may rise is disregarded. Most people have clearly become accustomed
to low interest rates.
In relation to financial stability, this requires enhanced vigilance. If interest
rates rise, this may lead to losses on the credit institutions' assets and the
collateral behind their lending.
For households, the costs of borrowing to purchase a home are historically
low at present, even if the announced increases in administration margins
are taken into account. How the administration margins are determined is
no concern of ours.
However, I would like to emphasise that there is a link between the very low
level of interest rates, which also leads to a modest return on a credit
institution's equity, and the need for a certain level of earnings from other
sources so that capital can be accumulated with a view to increasing
lending.
It should also be noted that improved earnings and better capitalisation of a
mortgage bank benefit its customers by way of lower funding costs. This is
reflected in the yield payable by the customers on the underlying bonds.
Combined with migration to the cities, the very low interest rates have led
to a period of strong growth in house prices in some parts of Denmark.
Adjusted for seasonal fluctuations, house prices continued to rise at a
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International Association of Risk and Compliance Professionals (IARCP)
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robust rate in the 2nd half of 2015 and at the beginning of this year. But
there are signs of a slowdown compared with one year ago. Trading activity
has generally declined over the last year. This could indicate that price
pressures will ease in the future.
Although substantial interest rate hikes are not on the cards for the time
being, it is important that borrowers are resilient to higher loan costs if
interest rates do rise.
Households can achieve this by: increasing the fixed interest period,
keeping their loan-to-income and loan-to-value ratios at a prudent level,
and amortising their loans. All these measures protect them against higher
interest rates.
I have also noted that the mortgage banks comply with the Danish
Financial Supervisory Authority's new lending guidelines in many respects.
These are sound principles that would have boosted the robustness of the
financial sector, had they been observed in the mid-2000s.
Even though the guidelines are observed, the leverage ratio may still be
high for first-time buyers who borrow right up to the LTV limits. A high
leverage ratio makes borrowers vulnerable to even small price falls in the
housing market.
Let me conclude by summarising my key messages:
Well-capitalised credit institutions are in everyone's interest.
The risk-based approach should be retained in financial regulation.
A level playing field is in Denmark's interest, and we should have a realistic
approach to how much the Danish mortgage credit system will be taken
into account in future international financial regulation.
The credit institutions' own targeted returns seem to be rather high. And
finally: A long period of low interest rates involves considerable inherent
risk. Thank you for your attention.
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New NIST Security Standard Can
Protect Credit Cards, Health
Information
For many years, when you swiped your
credit card, your number would be stored on the card reader, making
encryption difficult to implement.
Now, after nearly a decade of collaboration with industry, a new computer
security standard published by the National Institute of Standards and
Technology (NIST) not only will support sound methods that vendors have
introduced to protect your card number, but the method could help keep
your personal health information secure as well.
NIST Special Publication (SP) 800-38G, Recommendation for Block Cipher
Modes of Operation: Methods for Format-Preserving Encryption, (at
http://nvlpubs.nist.gov/nistpubs/SpecialPublications/NIST.SP.800-38G.p
df specifies two techniques for “format-preserving encryption,” or FPE.
The publication addresses a longstanding issue in many software packages
that handle financial data and other forms of sensitive information: How do
you transform a string of digits such as a credit card number so that it is
indecipherable to hackers, but still has the same length and look—in other
words, preserves the format—of the original number, as the software
expects?
According to author Morris Dworkin, the new techniques are more suitable
for this purpose than NIST’s previously approved encryption methods,
which were designed only for binary data – the frequently lengthy strings of
1s and 0s used by computers.
But because financial software – used in card readers and billing, for
example – often expects a credit card number to be the typical 16 digits
long, encountering a lengthier encrypted number might cause problems in
the software.
The new FPE method works on both binary and conventional (decimal)
numbers—in fact, sequences created from any “alphabet” of symbols—and
it produces a result with the same length as the original.
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“An FPE-encrypted credit card number looks like a credit card number,”
Dworkin says. “This allows FPE to be retrofitted to the existing, installed
base of devices.”
The two FPE techniques, called FF1 and FF3 in the new publication, were
vetted during public comment periods on the standard in 2009 and 2013.
While the main commercial impetus for developing these techniques is
credit card number encryption, another potential application is the
“anonymizing” of personally identifiable information from databases,
particularly those containing sensitive medical information.
Databases of this sort are invaluable for researching the effects of different
treatment methods on diseases, for example, but they often use social
security numbers to identify individual patients and can contain other
personal information.
FPE encryption could handle this problem as well, though Dworkin stresses
that in this case the approach would not necessarily be foolproof.
“FPE can facilitate statistical research while maintaining individual privacy,
but patient re-identification is sometimes possible through other means,”
he says. “You might figure out who someone is if you look at their other
characteristics, especially if the patient sample is small enough. So it’s still
important to be careful who you entrust the data with in the first place.”
NIST SP 800-38G is available online at:
http://nvlpubs.nist.gov/nistpubs/SpecialPublications/NIST.SP.800-38G.p
df
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P a g e | 83
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International Association of Risk and Compliance Professionals (IARCP)