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Page |1 International Association of Risk and Compliance Professionals (IARCP) 1200 G Street NW Suite 800 Washington, DC 20005-6705 USA Tel: 202-449-9750 www.risk-compliance-association.com Top 10 risk and compliance management related news stories and world events that (for better or for worse) shaped the week's agenda, and what is next Dear Member, You have probably heard that as a result of the increasing use of algorithms in trading, trading banks of the future will simply consist of a computer, a man and a dog. The computer will be there to handle the transactions and the dog to stop the man from interfering with its trading programs. The man’s job will be to feed the dog. But we have a problem! As Commissioner Kara M. Stein told us, Algorithms “don’t quite get jokes”. A recent example that demonstrates some of the potential pitfalls of overreliance on technical and algorithmic trading occurred on April Fools’ Day this year. A Tesla press release jokingly announced a new “W” model for a watch. It was clearly intended as a joke. However, it was taken all too seriously by computers dutifully executing their algorithms in response to the press release. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) Page |2 The algorithms didn’t quite get the joke, trading hundreds of thousands of shares and spiking the stock price within one minute of the issuance of the release. So, a computer, a man and a dog are never going to replace all other employees of a future bank. I love jokes. Commissioner Kara M. Stein is really good at explaining our reliance on algorithms. “For hundreds of years, securities transactions were dominated by human hands. Traders stood face to face and looked each other in the eye. Some of the New Yorkers in the audience may know that the Buttonwood Agreement established the New York Stock Exchange in 1792. Twenty-four brokers signed the agreement to become the NYSE’s first members. The agreement created a closed club whose members agreed to trade only with each other. The location of the exchange was originally under a tree – a buttonwood tree - at 68 Wall Street. Face-to-face trading in securities and in-person communication were everything. It was a clubby exchange where everyone knew each other and deals were done in person and with a handshake. Over 200 years later, today’s securities markets would be unrecognizable to those who signed the Buttonwood Agreement. Forget about conducting business under a tree – the central nexus of securities trading activity for decades, the trading floor, has also rapidly become a relic of the past. The close-knit atmosphere of the Buttonwood days – which persisted to some extent on trading floors – is gone. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) Page |3 Human dealers and specialists have largely been phased out. Today, nearly all trades occur on electronic venues, with more than one third of orders executed off-exchange. The early 1970s brought fundamental change to the actual process of transacting in securities. A confluence of regulatory changes, technological advancements, and changes in communication drove the market to automate securities transactions. As a result, our securities market is, for better or for worse, less human. Gone are the trader’s gestures and shouts. Artificial intelligence is replacing human intelligence. Human considerations are being replaced with mathematical models and algorithms. And, the need for speed is unquenchable. Wires are being replaced with fiber optics, microwaves, and laser beams. The human blink of an eye is too slow for today’s market. Trading volume is scattered among venues with no one exchange having an overall market share of twenty percent. Increasingly, more and more volume is executed off- exchange. Computer “matching engines” match electronic limit orders with electronic market orders. High-speed trading dominates, representing over 55 % of US equity markets and 40% of European markets volume. Liquidity provision has largely shifted from traditional market-makers to computerized systems that trade at light speed and across different exchanges and securities. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) Page |4 In addition, computers, not research analysts, cull through vast quantities of data to pick stocks. Market data, news reports, Twitter feeds, weather reports, and other data sets are scooped up by computers and used to devise trading models and predict prices.” Read more at Number 2 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 _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) Page |5 Should banks be bailed out? Speech by Mr Jon Nicolaisen, Deputy Governor of Norges Bank (Central Bank of Norway), at the Norwegian Academy of Science and Letters, Oslo On Sunday, 29 September 2008, two weeks after the bankruptcy of the US investment bank Lehman Brothers, the Irish government faced a dilemma: On the following morning, Monday, 30 September, the debt of a number of Irish banks was falling due, and many of these banks could not meet their obligations. Unable to issue new debt in the market, they were in danger of failing. The Dominance of Data and the Need for New Tools: Remarks at the SIFMA Operations Conference Commissioner Kara M. Stein “The rate of today’s changes is unprecedented. For hundreds of years, physical paper documents and human beings dominated our securities operations. Today, data dominates. Digital data is part of every aspect of our markets.” Price stability – a sinking will-o’-the-wisp? Intervention by Mr Peter Praet, Member of the Executive Board of the European Central Bank, during a panel on “The elusive pursuit of inflation” at the IMF Spring Meetings Seminar, Washington DC _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) Page |6 IFIAR Projects of Interest to the Academic Community Lewis H. Ferguson, Board Member PCAOB/AAA Annual Meeting Washington, DC “Our economy in the United States is increasingly globalized, and our audit firms are auditing the financial statements of many multinational corporations where components of those audits are performed in foreign countries by a foreign firm that is, most often, part of a larger network of affiliated but independent firms.” ENISA at the service of the EU’s Cyber Security Udo Helmbrecht Executive Director ENISA SEDE speech, European Parliament “Information and communication technologies (ICT) are the backbone of every modern society. An open, safe and secure cyberspace is key to supporting our core values set down in the EU Charter of fundamental rights such as privacy and freedom of expression. This is also essential for the smooth running of our economies within the European single market. However, ICT technologies and business opportunities in cyberspace also present opportunities for crime and misuse. Security of network and information systems is essential to the security of all the critical sectors in society. Disruptions on these infrastructures and services are becoming more frequent and are estimated to cost annually 260-340 billion EUR to corporations and citizens.” _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) Page |7 ESMA updates data on performance of Credit Rating Agencies The European Securities and Markets Authority (ESMA) has published its latest set of semi-annual statistical data on the performance of credit ratings, including transition matrices and default rates. Financial regulation and the global recovery Speech by Mr Vítor Constâncio, Vice-President of the European Central Bank, at the 24th Annual Hyman P. Minsky Conference "Is financial reregulation holding back finance for the global recovery?", Washington DC “This year's theme is quite topical and opens the door to a lively debate about the role of finance and regulation, both in the crisis period and in the moderate recovery underway.” Remarks at the Harvard Law School Symposium on Building the Financial System of the 21st Century: An Agenda for Europe and the United States Commissioner Daniel M. Gallagher Frankfurt, Germany “Back in 2013, I opened a speech to the American Academy in Berlin with a bit of German. While I managed not to call myself a jelly donut, my German was nonetheless so bad that I have been banned from entering the country to speak in a public forum.” _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) Page |8 Issues for the Academic Community to Consider Steven B. Harris, Board Member PCAOB/AAA Annual Meeting Washington, DC “I think it is fair to say that by effectively educating future accountants and auditors, you play an essential role in protecting the integrity of financial statements upon which our capital markets are dependent. Before I continue, let me say that the views I express are my own and do not necessarily reflect the views of the Board or the PCAOB. Today I will touch on three topics: the evolving audit firm business model; recruitment at the firms and the various new skills sought by the firms; and the importance of diversity in the profession. I hope that you will consider examining each of these topics in your future research.” To G20 Finance Ministers and Central Bank Governors Financial Reforms – Progress on the Work Plan for the Antalya Summit In February in Istanbul, we agreed the following priorities for the FSB’s G20 financial regulation agenda: • full, consistent and prompt implementation of agreed reforms; • finalising the design of remaining post-crisis reforms; and • addressing new risks and vulnerabilities. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) Page |9 Should banks be bailed out? Speech by Mr Jon Nicolaisen, Deputy Governor of Norges Bank (Central Bank of Norway), at the Norwegian Academy of Science and Letters, Oslo On Sunday, 29 September 2008, two weeks after the bankruptcy of the US investment bank Lehman Brothers, the Irish government faced a dilemma: On the following morning, Monday, 30 September, the debt of a number of Irish banks was falling due, and many of these banks could not meet their obligations. Unable to issue new debt in the market, they were in danger of failing. If the banks were to close, economic activity in Ireland would be crippled. The authorities had to act. It was not a matter of a trifling amount. At the time, the debt of Irish-owned banks was over two times Ireland's GDP. Over half of the banks' debt had been funded in the market. That evening, the Irish government decided to guarantee most of the debt of Irish-owned banks for two years. The government and the Irish people thereby assumed a considerable risk. Eventually, the losses at Irish banks also proved to be enormous. Since then, the Irish authorities have made capital injections into banks equivalent to around 40 percent of GDP to keep the banks running. This is money the Irish government has had to borrow. Along with the downturn that followed in the wake of the financial crisis, the Irish bank bailout quadrupled Ireland's sovereign debt. The interest on the debt is borne by all, rich and poor alike, regardless of who had benefited from the pre-crisis economic boom. The banking crisis and the government debt led to a deep economic downturn in Ireland. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 10 It is only now that Ireland has returned to its pre-crisis level of prosperity. But the economic and social consequences would probably have been even more serious if the banks had not been kept afloat. The Irish bank bailout illustrates a number of classic questions: Was it right for the government to risk its citizens' money to rescue the banks? Did the Irish authorities actually have a choice? When things went wrong, was it right to protect creditors as the Irish authorities ultimately did? How has this affected the future risk taking of the banks' owners and creditors? The answer to the question of whether banks should be rescued is about economics and incentives. But the problems banks create and how these problems are solved are also a matter of morals and ethics - law and justice. Norway has also been faced with these problems. Why are banks bailed out? In 1923, a little more than 90 years ago, there was a banking crisis in Norway. One of the banks in serious difficulty was Andresens og Bergens Kreditbank, or Foreningsbanken, as it was also known. Losses were considerable, equity had to be written down sharply and the bank needed fresh funds to stay afloat. At that time, Foreningsbanken was indisputably Norway's largest bank, with total assets of more than NOK 600 million, equivalent at the time to 16 percent of GDP. On behalf of the bank's board of directors, the businessman and former Prime Minister Christian Michelsen argued in favour of a rescue package in negotiations with the authorities. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 11 Michelsen warned Norges Bank of the problems that would result from allowing the bank to fail. Michelsen requested a government guarantee for the bank, or at least a NOK 100 million loan. There were drawn-out negotiations between Norges Bank, headed by Governor Nicolai Rygg, and the board of Foreningsbanken. The resumption of pre-war gold parity, fiscal concerns and Norges Bank's financial position were crucial for Norges Bank's choice. But Rygg also emphasised the importance of Norges Bank's not supporting activities that should be wound up, activities that he referred to as "unsound lending and non-viable businesses". The negotiations ended with Norges Bank's refusal to provide support. "We'll survive the bank's closure too," Rygg is reported to have said. "Even if you're skinned alive, you'll still live", Christian Michelsen responded. In any event, there would be pain. Not long afterwards, Foreningsbanken had to petition to be placed under public administration. The bank Centralbanken for Norge followed only a few days later and then Handelsbanken. Michelsen was on to a fundamental problem. Banks have critical functions in a modern economy. First, banks play a key role in the payment system. In one way or another, practically all payments go through banks. Individuals and firms have bank deposits that they depend on for making payments. Banks operate payment systems used by shops and other businesses. They operate interbank and international payment systems and payment systems for securities trading. If payments come to a halt, the economy will seize up. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 12 Second, banks extend credit: Short-term trade credit and operating credit; long-term loans for investing in housing, real estate and businesses. Without this credit, businesses and investments come to a standstill. Banks may be regarded as intermediaries. They channel money from depositors and other investors to borrowers. Banks determine who should be given credit and monitor borrowers and their projects. Moreover, they do so with considerable efficiency. Thus, depositors and investors avoid having to do this job themselves. This function makes banks unique: Banks extend long-term credit and raise short-term debt. We call this banks' maturity transformation. But this transformation also makes banks vulnerable. Banks are dependent on public trust. If any doubt arises as to a bank's ability to service its debt, a run on the bank may ensue. Depositors will then try to withdraw their funds before the bank runs out of cash and other liquid funds. The bank will in turn be forced to sell its long-term assets - its loans. This is a slow and loss-generating process. Normally, a bank will fail long before it gets that far. Until recently, such bank runs were usually associated with the Great Depression of the 1930s. That is, until 2007, when the UK bank Northern Rock failed, with long queues of depositors outside its doors. This was a forceful reminder that banks may also be vulnerable today. The closure of a bank can create fear that also other banks will have to close, and depositors and other investors may begin to withdraw their funding from a large number of banks at the same time. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 13 Problem banks can infect other banks, partly because banks have claims on one another. If a large bank should experience difficulties, the contagion to other banks and the rest of the economy can be very serious. This is called systemic risk. Banks' activities have considerable externalities. Few bank failures illustrate this point better than the bankruptcy of Lehman Brothers on 15 September 2008. In the course of the week following the closure of the bank, interbank lending rates soared. Banks distrusted one another. Short-term funding markets, money markets, dried up worldwide. US money market funds experienced payment problems. The spillovers spread throughout the financial system. One of the world's largest insurance companies, AIG, teetered on the edge of bankruptcy. To prevent the Lehman bankruptcy from ending in the complete collapse of the financial system, the authorities in a large number of countries took measures on an unprecedented scale. Central banks in many countries injected large quantities of liquidity into the banking system to keep the wheels turning. The aim of these measures was to keep the banking system operating so that the rest of the economy would not be impacted. That is why banks are bailed out. The costs associated with closing a bank are largely borne by parties other than the bank itself. We bail out banks to prevent systemic crises. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 14 We bail out banks to limit the substantial damage a deep banking crisis can inflict on the economy. Why should banks not be bailed out? But it is not that simple. There are also compelling arguments against bank bailouts. Most of the government measures in 2008 were targeted at viable banks and were intended to prevent the crisis from spreading. Supporting otherwise viable banks in times of financial turbulence may be necessary and profitable for society. An interesting feature of the Irish crisis is that this was exactly what the authorities believed they were doing when the first guarantees were issued. But eventually it transpired that Irish banks were sitting on huge losses. Government support for insolvent banks violates a fundamental principle of economics: We should avoid supporting unprofitable activities. We do not rescue a business that is bankrupt. Instead, we should allow businesses that are profitable to take over. Over time, this improves the conditions for a healthy economy. Apportioning losses following a crisis may also be viewed as a matter of morality and fairness. When the authorities bail out banks, some parties are spared the consequences of their own choices. Bailing out investors and owners using public funds conflicts with people's ordinary sense of fairness. Moreover, government support for insolvent banks undermines the stability of the financial system. When the authorities bail out banks, the banks can transfer their losses to others, while reaping the gains in good times. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 15 When the government assumes a substantial portion of bank risk in this way, a problem arises that we economists refer to as moral hazard: If there is a widespread perception that the authorities in reality stand behind banks, banks may take insufficient account of the risk of losses when making decisions. In particular, the risk that things can go horribly wrong may be underestimated, because banks do not have to bear the consequences of a crisis. By bailing out banks, we in turn reduce the motivation of banks' owners and creditors to take full account of the risk associated with their activities. The pricing of risk is easily set too low. Banks may therefore end up taking excessive risk. Now, the authorities that bail out banks will often require that the former owners forfeit their equity. This means that bank owners should, at the outset, have incentives to hedge against the risk of large losses. But owners' risk is limited. It does not cover losses beyond paid-in capital. Owners' motivation to avoid risk may therefore be weakened at a bank with little equity. The lower the equity capital is, the more serious the problem of moral hazard becomes. An interesting feature of the financial crisis was precisely banks' low pre-crisis equity ratios. Many large international banks operated with equity of around three percent of their total portfolios. This means that for every dollar or euro the banks owned they invested thirty. It is obvious that the risk inherent in such activity may easily become too high. And the solution is in itself simple enough: The authorities should require higher equity ratios for banks, so that owners must absorb a larger share of the losses if things go wrong. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 16 Another solution to this might be the one Governor Rygg chose in his day: Close insolvent banks and place the losses where they belong. If the authorities intervene and bail out one bank, expectations are created that they will also bail out others. We may then end up with a system in which banks take excessive risk, potentially increasing the likelihood of new and greater banking crises in the future. Therefore, banks should not be bailed out. We are facing a dilemma. Bailing out banks increases the risk of instability in the long term. Yet the cost of refraining is even greater instability in the short term. Once the crisis has arisen, there is no escaping it. If banks are facing sizeable losses, then someone must bear those losses. If we do not allow the Treasury to bear the losses through support for the banks, the populace will still be affected, especially if the consequence is a systemic crisis and economic downturn. This dilemma is what is called a time-inconsistency problem. In principle, it may be desirable to allow insolvent banks to fail, but there will be valid reasons to depart from this principle when actually faced with the decision. This means that even if it is the stated intention of the authorities to refrain from bailing out banks, this intention will not be particularly credible. In other words, and put succinctly: Banks should not be bailed out, but they must be bailed out nevertheless. Who should be bailed out? If we must bail out banks to avoid an economic breakdown, the next question is: Is there anything we can do to reduce the damage arising from setting aside normal bankruptcy rules? _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 17 The question becomes how, rather than whether, banks should be bailed out. Or more directly: Who should be bailed out? It is a critical function for a bank to accept and provide access to deposits. Depositors must have confidence that their deposits are safe. Arrangements that guarantee deposits and the ability of solid banks to meet their obligations stabilise banks and support a socially beneficial activity. Such measures are intended to reduce banks' susceptibility to panicky withdrawals. Moreover, ordinary considerations of fairness dictate that small depositors should be protected. Some form of deposit guarantee for limited amounts has therefore become common in most western countries. At the other end of the scale, we find bank owners - the shareholders. It seems reasonable, and in keeping with general perceptions of fairness, to allow shareholders to lose the equity they have paid into the bank when an insolvent bank must be taken over by the authorities. Moreover, allowing shareholders to bear losses will not result in the closure of the bank, since shareholders are not able to withdraw their capital. The current debate is focused on how creditors other than small depositors should be treated - the extent to which funding obtained in the market is to be guaranteed if banks fail. In this area, headway has been made in the years following the financial crisis, especially in Europe. However, how creditors can be made to pay when banks suffer losses - and exactly which creditors can be made to pay without triggering crises are not simple questions. To elucidate this, let me begin with Norwegian legislation as it currently stands. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 18 Guarantee Schemes Act It is barely 24 years since the largest banks in Norway were on their knees. On 17 October 1991, Finance Minister Sigbjørn Johnsen addressed the Storting (Norwegian Parliament) on the Government's extraordinary measures aimed at the banking industry. By then the second largest bank, Kreditkassen, had lost more than its equity capital, and it quickly transpired that the other two large commercial banks were not in much better shape. Johnsen underscored the seriousness of the potential consequences for the Norwegian economy if the Government did not intervene resolutely in the crisis: "The gravity of the situation is simply this: A collapse of the banks will also break the backbone of the Norwegian economy. If we do not implement extensive measures now, a good many ordinary people may lose their savings." But the Minister of Finance made an important reservation. In the same account, he also stated that the banks' owners could not expect to escape unscathed: "At the same time, the instruments are designed so that banks themselves will have a principal responsibility for solving their financial problems. They will not simply be able to send the bill for their misjudgements to the government." That was also the case in practice. The shares in banks that lost all their equity capital were written down to zero, in line with the principles pertaining to the bankruptcy of other enterprises. The capital injections banks received were made on the condition that they restored order to their organisations while cutting unnecessary costs. In other words: we bailed out the financial system, but not the banks' owners. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 19 On the other hand, practically no creditors lost their assets, even in the banks that had lost more than their equity. Creditors were bailed out through the government's recapitalisation of the failed banks. In the aftermath of the crisis, the Banking Law Commission was tasked with drafting a new law on crisis resolution. In 1996, the Bank Guarantee Schemes Act was passed, which continues to be current Norwegian law. The act makes it possible to write down equity capital and force banks to issue new shares to the government, enabling them to be nationalised. Subordinated debt - debt instruments with characteristics similar to equity capital - is to be written down in proportion to banks' losses. In this way, banks can continue operating under government ownership. Should a bank nevertheless be closed, deposits of up to NOK 2 million per depositor are guaranteed by the Norwegian Banks' Guarantee Fund. For a long time, this was one of the world's most modern bank resolution laws and Norway weathered the crisis in 2008 better than most countries. Moreover, Norwegian banks have probably also drawn lessons from the banking crisis of the 1990s. Norwegian banks had via that crisis gained greater insight into crisis risk than banks in many other countries had before the global financial crisis erupted in 2007. Managements and boards of Norwegian banks were probably also more conscious of their social responsibility than those in many so called leading financial centres elsewhere in the world. But the Bank Guarantee Schemes Act does not provide for the imposition of losses on creditors who have made ordinary loans to banks, without, in practice, closing the bank. EU Bank Recovery and Resolution Directive _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 20 Just as the banking crisis led to Norway's Bank Guarantee Schemes Act, the financial crisis gave rise to a new EU framework for crisis resolution. In January 2015, the Bank Recovery and Resolution Directive entered into force. The aim of the directive is to enable insolvent banks to be resolved in a manner that ensures continuity of their critical functions, but without banks necessarily receiving public funds. The authorities are empowered to take control of a bank that is insolvent, or is at risk of becoming insolvent, and ensure that critical functions continue without bailing out shareholders and creditors. A new tool will make this possible. Beginning in 2016, national authorities in Europe will be able to write down and convert liabilities to equity while a troubled bank is kept open. The value of the bank's assets is to be calculated and losses apportioned in accordance with the order of priority of claims. If the bank does not have sufficient equity, liabilities will be converted to share capital. This tool is called bail-in. Bail-in requires that creditors, and not the authorities, initially cover losses in excess of equity. Creditor claims are converted into equity to ensure continued operation. Short-term liabilities and secured deposits are exempted. It is primarily long-term liabilities not backed by certain assets or guarantee arrangements that will be eligible for bail-in. Long-term creditors will then have to take account in advance of the real risk inherent in the bank they fund. This should also result in risk being priced into these loans to banks. Creditors have been written down while a bank was kept open. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 21 On 5 February 2011, the Danish resolution authority Finansiel Stabilitet A/S took control of Amagerbanken, a mid-sized Danish bank. All equity was written down to zero, and non-guaranteed deposits and wholesale funding were initially written down by nearly half of their original value. This was done over a weekend. On Monday morning, the online banking service was open and all depositors obtained access to their remaining deposits. The bank was kept open as a subsidiary of Finansiel Stabilitet A/S. The bank's critical functions were kept running. Shareholders and unsecured creditors were not bailed out. Over time, the creditors who were not covered by the deposit guarantee were paid back around 85 percent of the value of their original claims. The value of the bank's assets was preserved to a larger extent than if the bank had been wound up. Danish banks' funding costs rose following the resolution of Amagerbanken. However, it did not trigger a systemic crisis in the Danish banking sector, despite its occurrence in the middle of the European debt crisis. What the Danes got was a pricing of the true risk in their banks. Over time, this provides a basis for a less risky financial system. Bail-in may nevertheless be difficult to implement. Bail-in of a large bank, that is a bank with substantial liabilities, will inflict losses on a large number of creditors. That is the intention. But if these liabilities are owned by institutions that are critical to the functioning of the financial system, the problems in one bank can spread quickly. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 22 If the losses are substantial, the authorities run the risk of triggering a systemic crisis. Moreover, bail-in of creditors may make funding more expensive for other banks, particularly in turbulent times. For large, systemically important banks, the time-inconsistency problem remains. This weakens the credibility of the bail-in regime. Therefore, the Bank Recovery and Resolution Directive also provides for measures intended to bolster credibility. An important measure is that national authorities are to prepare resolution plans for individual banks. The authorities are to devise a strategy in advance for managing the bank if it is danger of failing. If the bank is large and important, there is to be a plan to ensure continued operation. If the bank is so large and complex that it probably cannot be resolved without the use of public funds, it can be restructured. The resolution authority can demand that complex parts of the institution be transferred to separate subsidiaries. As a last resort, the authorities can demand that large banks be broken up into several smaller ones. There should also be a plan for how continued operations can be funded. All systemically important banks in Europe shall hold a minimum amount of liabilities that can quickly be bailed-in. This entails a limit on the share of short-term and secured debt banks may issue. The authorities must also ensure that large banks and systemically important investors do not invest too much in other banks' risky debt. This is a new perspective on banks' funding structure. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 23 In the future, banks will have to ensure that portions of their liabilities can quickly be written down and converted to equity. Bail-in as an instrument will be implemented in the EU on 1 January 2016, a year after the rest of the Directive. The Directive must be followed up in Norway under the EEA Agreement. Norway's own bank resolution legislation must be updated. As regards the Norwegian framework, the new elements are in particular the requirements for resolution plans and bail-in. Otherwise, a large part of the framework is already in place. We will probably never entirely solve time inconsistency. There may still be creditors who count on being bailed out. Owners with little at stake may take on excessive risk. One of the most important things we do, therefore, is to ensure that banks are solid. This has two important effects. First, the obvious one: Higher capital ratios reduce the probability that banks will experience a crisis. Banks will be able to absorb larger losses before encountering problems. But as I touched on earlier, higher capital ratios also have long-term effects on owners and bank behaviour: The more equity a bank has, the more capital owners stand to lose. They will have a stronger motivation to ensure that the bank operates prudently. Capital ratios at Norwegian banks are generally somewhat higher than at banks in other European countries, which is a good thing. The plan to gradually increase Norwegian banks' capital requirements as laid down in 2013 will continue until July 2016. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 24 The minimum risk-weighted equity ratio for systemically important banks in Norway will then be 13 percent. What should be done? So what are the lessons we have drawn? Banks should not be bailed out, but banks' functions must be bailed out. If not, all economic activity will be affected. We will bail out the small depositors - that is both profitable and fair. We should not bail out all creditors. If the equity capital in bank is lost, long-term lenders should also bear losses. The new tools that have now been introduced in Europe will ensure that this happens. Norwegian legislation must be updated in line with the new directive. This will improve the pricing of risk in the banking system. We will not bail out the shareholders. Ultimately, bank owners and management must ensure that banks are run prudently. It is crucial that they are aware of their responsibilities. We cannot regulate banks to death. I am confident that owners and managers of Norwegian banks will act responsibly. At the same time, banks must be regulated. Capital requirements must be high and we must ensure that banks are solid and well-run. This will reduce the risk of a systemic crisis. This will also give banks' owners a stronger motive to take account of long-term risk. Banks themselves and Finanstilsynet (Financial Supervisory Authority of Norway) have done a good job to ensure a solid Norwegian banking sector, so that the authorities avoid having to bail out banks. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 25 The Dominance of Data and the Need for New Tools: Remarks at the SIFMA Operations Conference Commissioner Kara M. Stein Good morning and thank you, Lisa Dolly, for that kind introduction. It is a privilege to be with you today. Whether it’s processing trades fairly, ensuring systems are protected from cyber threats, or making operational risk management a firm priority, you, the operations professionals, have a vitally important role and enormous responsibility. And it’s not just your firm that is counting on you. Other market participants are counting on you, and investors are counting on you. Each of you contributes to a network that both enables and protects our markets. And you are doing this against a backdrop of dramatic changes in our securities markets. Our markets have always been influenced by change in technology. But the rate of today’s changes is unprecedented. For hundreds of years, physical paper documents and human beings dominated our securities operations. Today, data dominates. Digital data is part of every aspect of our markets. And this new reality is challenging all of us. The proliferation and reliance on data has disrupted our markets – oversight and regulation need to evolve to keep pace. In this new world, we need new tools. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 26 Today, I want to speak about some of the new tools that this explosion in data now demands. Before diving in, though, I want to provide a bit of historical context to underscore how dramatically our markets have changed. Second, I will outline some of the new opportunities and risks presented by the data revolution. Finally, I will discuss some new tools that the Commission is employing – or should be employing – to keep pace with the new data-dominated world. Before I go any further, I need to remind you that the views I’m expressing today are my own, and do not necessarily reflect the views of my fellow Commissioners or the staff of the Commission. From the Buttonwood Agreement to High Speed, Electronic Trading For hundreds of years, securities transactions were dominated by human hands. Traders stood face to face and looked each other in the eye. Some of the New Yorkers in the audience may know that the Buttonwood Agreement established the New York Stock Exchange in 1792. Twenty-four brokers signed the agreement to become the NYSE’s first members. The agreement created a closed club whose members agreed to trade only with each other. The location of the exchange was originally under a tree – a buttonwood tree - at 68 Wall Street. Face-to-face trading in securities and in-person communication were everything. It was a clubby exchange where everyone knew each other and deals were done in person and with a handshake. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 27 Over 200 years later, today’s securities markets would be unrecognizable to those who signed the Buttonwood Agreement. Forget about conducting business under a tree – the central nexus of securities trading activity for decades, the trading floor, has also rapidly become a relic of the past. The close-knit atmosphere of the Buttonwood days – which persisted to some extent on trading floors – is gone. Human dealers and specialists have largely been phased out. Today, nearly all trades occur on electronic venues, with more than one third of orders executed off-exchange. The early 1970s brought fundamental change to the actual process of transacting in securities. A confluence of regulatory changes, technological advancements, and changes in communication drove the market to automate securities transactions. As a result, our securities market is, for better or for worse, less human. Gone are the trader’s gestures and shouts. Artificial intelligence is replacing human intelligence. Human considerations are being replaced with mathematical models and algorithms. And, the need for speed is unquenchable. Wires are being replaced with fiber optics, microwaves, and laser beams. The human blink of an eye is too slow for today’s market. Trading volume is scattered among venues with no one exchange having an overall market share of twenty percent. Increasingly, more and more volume is executed off- exchange. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 28 Computer “matching engines” match electronic limit orders with electronic market orders. High-speed trading dominates, representing over 55 % of US equity markets and 40% of European markets volume. Liquidity provision has largely shifted from traditional market-makers to computerized systems that trade at light speed and across different exchanges and securities. In addition, computers, not research analysts, cull through vast quantities of data to pick stocks. Market data, news reports, Twitter feeds, weather reports, and other data sets are scooped up by computers and used to devise trading models and predict prices. The New Market Structure Brings Advantages and New Concerns Not only would the new market be unrecognizable to the signers of the Buttonwood Agreement – it barely resembles the market from just a few decades ago. Buyers and sellers still come together, but in new ways. The volume and complexity of today’s securities markets is unprecedented. Today, orders bounce from one place to another in a seemingly endless search for potential counterparties. For example, between 2005 and 2015, the average number of daily order audit trail system (OATS) reports for Nasdaq-listed and OTC quoted securities increased over 700 percent from approximately 107 million in 2005 to 868 million in 2015. In addition, the average daily number of all OATS reports (all NMS Stocks and OTC securities) more than doubled over the last four years, increasing from 1.487 billion in the fourth quarter of 2011 to 3.151 billion in the first quarter of 2015. As many of you know, the OATS figures are a pretty good proxy for the increasing complexity of order routing behavior over time. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 29 Today, so much more routing happens before it ever gets to an exchange. This rapid transformation has outpaced nearly all of us. The infrastructure of our market is now mainly behind the scenes – computer terminals, software, routers, and server farms. Traders provide the same service as before – but in a new way. Our markets are faster, more efficient, less expensive, and provide more choice to investors. Execution, bid-ask spreads, and the cost of transactions have improved. However, new concerns and issues have arisen as technology and communications have converged to form a new market structure driven by data. In 2010, with spectacular effect, the markets demonstrated to the world how interconnected, complex, fragile, and fast they could be. On May 6, 2010, people were already jittery about the debt crisis affecting Europe. Then, an order from one market participant automatically pumped sell orders of E-mini futures into the market. This seemingly simple and isolated action set off a cascade of events that shook the markets. Computers dutifully executed their code. This “Flash Crash” should have been a wake-up call to all of us. It demonstrated that our markets had, in some ways, outpaced their keepers. This was the largest, but not the last flash crash. Other mini flash crashes continue to occur in our markets. A recent example that demonstrates some of the potential pitfalls of overreliance on technical and algorithmic trading occurred on April Fools’ Day this year. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 30 A Tesla press release jokingly announced a new “W” model for a watch. It was clearly intended as a joke. However, it was taken all too seriously by computers dutifully executing their algorithms in response to the press release. The algorithms didn’t quite get the joke, trading hundreds of thousands of shares and spiking the stock price within one minute of the issuance of the release. The New Dominance, Importance, and Impact of Data Flash crashes, disruptions, outages, and artificial intelligence failures continue to underscore the complex and interconnected nature of our new marketplace. Data and technology present tremendous opportunities and benefits – but they have also opened the door to new and exceedingly complicated risks. In today’s market, how do we ensure the market is fair, efficient, and promotes capital formation? How do we promote innovation and the use of technology and data analytics while understanding that there are limitations and risks? These are some of the most important questions that the Commission – and the securities markets – face in the coming years. We need new tools to make sense of this new environment that is so tied to computers and digital data. I would like to spend the remainder of my talk describing how the Commission is reacting to this new environment and make a few suggestions on how to proceed. Legal Entity Identifiers First, I would like to talk about Legal Entity Identifiers or LEIs. The 2008 financial crisis demonstrated the opacity and lack of understanding about the linkages between market participants. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 31 Parties to financial transactions were unable to appropriately assess risks, particularly as events unfolded. That opacity led to nearly catastrophic results that cascaded throughout our financial system. We saw with the collapse of Lehman Brothers in 2008 that both regulators and private sector managers were unable to quickly assess exposure to Lehman. They were also unable to determine the degree of interconnectedness between global financial market players. If participants are going to be interconnected through risky, complex transactions and products that cross jurisdictions, regulators and firms need tools to monitor and understand what is going on. Both need a window into the highly complex linkages that tie firms together. As many of you know, I am a strong supporter of the global system of Legal Entity Identifiers – or LEIs. This system has been developed to assist both regulators and market participants in obtaining reliable information in an increasingly connected financial ecosystem. I want to thank SIFMA for its leadership on developing and advocating for the Global LEI System. SIFMA and others have been working for some time on a method to identify and develop a private-public solution. The LEI is a unique, 20-digit alpha-numeric code, much like a grocery product code, that will make it possible to identify all the legal entities involved in financial transactions. I’m pleased with the progress that we are making. We are on the way to a system that will provide great benefits to both regulators and market participants at relatively minimal cost. Over 350,000 LEIs have been issued so far, and many, many more are on the way. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 32 This new system is a basic building block in understanding the risks and interconnections both within and between financial firms. A global LEI standard means that financial market data will be more consistent and usable. Relationships and connections will become more transparent. Data about entity relationships will ultimately show networks of control, ownership, liability, and risks. The LEI will help counterparties to financial transactions use the data for better risk management. It also assists companies with their internal management of operational risks. The LEI may reduce costs in collecting, cleaning, and aggregating data, and in reporting data to regulators. The LEI also will aid regulators seeking to better monitor and analyze threats to financial stability. Recently, the Commission released rules that mandate the use of LEI when associated with security-based swap transactions. As some companies may have hundreds or thousands of subsidiaries or affiliates operating around the world, more benefits lie ahead as the LEI becomes increasingly used. Greater usage will allow more transparency regarding hierarchies and relationship mapping. This will support better analysis of risks as they aggregate and potentially become systemic. I hope the Commission will undertake additional areas for deploying the LEI. For example, I think that including LEI on the table of subsidiaries filed as an exhibit to a company’s annual report may provide additional transparency about hierarchies and relationships to the marketplace. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 33 Data Needs To Be Protected While computers have helped markets become faster and more efficient, they also have allowed for a myriad of new interconnections and potential vulnerabilities. In the fall, we learned that the failure to upgrade one server at a large US financial firm resulted in the exposure of personal information from 76 million households and seven million small business accounts. Luckily, there was no theft of money or highly confidential information. We all should learn from this and other breaches. Attackers don’t follow a playbook and that means that a security checklist won’t work either. Data is an asset, and the linkages in our information systems architecture provide avenues for people to access it. More importantly, breaches can affect investor confidence. It is vital that everyone works together to develop best practices in detecting and dealing with data breaches. Boards, senior management, and line employees should constantly be asking questions about how to prevent and detect such breaches. I also believe that knowledge sharing is critical to creating resiliency. And this is an area where everyone needs to participate and contribute. This past November, the Commission adopted Regulation Systems Compliance and Integrity (Reg SCI). Reg SCI requires some market participants to establish written policies and procedures to ensure that their systems have the capacity, integrity, resiliency, availability, and security to maintain their operational capability. However, the rule only addressed certain market centers. There is no question that I would have gone further in this rule. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 34 Shouldn’t everyone with direct access to the trading centers have to implement basic policies and procedures to ensure that their computer systems are stable, secure, and contribute to resiliency in our market? Just as we license drivers and register and inspect vehicles for the safety and soundness on our nation’s roadways, shouldn’t there be minimum requirements or standards for anyone with direct electronic access to the equity markets? Market integrity is everyone’s responsibility – not just the responsibility of the largest and most sophisticated. Everyone has a role in ensuring that our US securities market is resilient. We are all responsible. All participants should have some basic controls in place. Despite our complex market structure, we cannot have a fragmented regulatory approach to our diverse and complex marketplace. A Deeper Understanding of Market Data and the Consolidated Audit Trail (CAT) As I mentioned earlier, the speed and interconnectedness in our markets provides a number of benefits. However, we also know that when software or computers fail, they can cause significant disruptions. The Flash Crash gave us many lessons. Heavily traded securities are not immune to crashes driven by algorithms and computers. The interconnections between the equities market and the futures market are such that safety features need to be coordinated. In my mind, though, perhaps the most important lesson learned is the need for a consolidated audit trail or CAT. I was pleased to see that you will have a panel discussing the CAT tomorrow. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 35 With a CAT, market oversight will improve as transparency of transactions across their entire lifecycle improves, including linkages to beneficial owners. Market data will increasingly serve as the source of rulemaking. It can also be used to better understand potential trends or abuses. CAT is one of the largest data projects that has ever been undertaken and it represents a paradigm shift in how we oversee the U.S. securities markets. CAT will be the world’s largest repository of data from securities transactions. It is estimated that CAT will receive over 58 billion records each day, covering all market participants across numerous asset classes. I have consistently advocated for the CAT to be implemented as soon as possible. It is hard to think of an initiative more important to the Commission and our markets. Unfortunately, development of the CAT has been bogged down by administrative hurdles. Development has yet to begin and implementation is still years away. We need the CAT as soon as possible. The Flash Crash and other events in our markets demonstrate the need for CAT. Only through a consolidated audit trail can we truly know what is happening in our marketplace, with trading activity cascading across multiple trading venues and asset classes. The linkages, complexity, and fragmentation of our markets outstrip the current ability to monitor, analyze, and interpret market events. Only through CAT can we develop regulations that are truly driven by facts. Only through CAT can regulators appropriately survey our high-speed and high volume marketplace. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 36 The importance of CAT to our nation’s securities marketplace cannot be overemphasized. This vital initiative is our main tool to be more proactive and informed in our approach to regulation. Office of Data Strategy As you can imagine, in addition to the CAT, the Commission is taking on more and more data projects, such as the Swap Data Repositories. The Commission also now has access to new, rich data sets through filings on Form PF and Form N-MFP that need to be analyzed. Over the last five to ten years, data management and analysis has become more complex and require a strategic approach. I believe that the Commission should form an Office of Data Strategy overseen by a Chief Data Officer. This new office would ensure a comprehensive approach to data collection, business analysis, data governance, and data standards. Other regulators have proactively moved forward on forming similar offices. I believe that the Commission needs to act now to develop a group solely focused on data, including building an infrastructure to facilitate the use of data throughout the agency. One of the most important focuses of this new office would be promoting data standards and taxonomies. Data standards and taxonomies play a vital role in both the quality and utility of data. It is critical that we approach data standards as a community and not in isolation – an Office of Data Strategy should lead this effort. A key role of this office should be identifying data gaps and refining existing data collections. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 37 This should be an evergreen process whereby the Commission – through the Office of Data Strategy – is constantly seeking to improve upon its data quality and filling gaps. We should be testing our forms and data sets continuously and searching for better ways to obtain clear, usable data. As we analyze data and receive feedback from market participants, we can tweak and refine how we collect and ask for data to produce better, more reliable results. It is also important for the Commission to think globally about standards and data. For example, the International Organization of Securities Commissions (IOSCO) in conjunction with the Committee on Payments and Settlement Systems (CPSS) has been working to develop a framework for derivatives data reporting and aggregation requirements. Again, as I’ve stressed throughout my remarks, it is critical that we work together as a community, rather than independently. The Commission has limited resources and needs to optimize its use of data. This includes collaborating with other regulators and market participants whenever possible. Everyone benefits from regulators making informed policy choices driven by the best data possible. Conclusion So, to wrap up my remarks today, our securities market has obviously evolved and changed from the face-to-face trading of the Buttonwood era to lightning fast automated systems and algorithms. Given this new reality, we all must work together as a community to improve risk management, regulation, and market resiliency. We need new tools, and we need to think about whether our regulatory framework is constructed in a way that can handle the new and evolving structure of our markets. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 38 But, the new tools cannot replace the responsibility of all market participants to contribute to a resilient market structure. We all need to do more to ensure that our markets continue to be fair, orderly, and promote capital formation while protecting investors. As part of this collaboration, I hope that you will all consider commenting and providing feedback on Commission rulemaking initiatives, especially in areas relating to market structure and data. Your input is much appreciated and can help inform our policy decisions. Thank you for the opportunity to be with you today. I hope that you enjoy the remainder of your conference. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 39 Price stability – a sinking will-o’-the-wisp? Intervention by Mr Peter Praet, Member of the Executive Board of the European Central Bank, during a panel on “The elusive pursuit of inflation” at the IMF Spring Meetings Seminar, Washington DC I would like to thank John Hutchinson and Elena Bobeica for their contributions to this speech. Ladies and Gentlemen, I would like to thank the IMF for inviting me to this excellent workshop and to be part of such a distinguished panel. I. Introduction Almost 50 years ago Milton Friedman famously described the Phillips curve as a “will-o-the- wisp”. When he first used this metaphor, he was isolated in the macroeconomist community. But in a matter of few years – and after a few bad inflation surprises that were hard to square with the solid and steady Phillips curve formalism that was embedded in many models of the time – his vision became less alien. Many of his colleagues started to admit that the Phillips curve was an extraordinarily frail platform for central banks to base monetary reflation experiments on. Indeed, at that point, Friedman had been joined by the so-called Neo-Classicals to demonstrate that what might appear as a steady association between price pressures and economic slack could in fact represent a collection of disequilibrium points which could only be maintained by monetary policy perpetuating the disequilibrium through ever-more aggressive expansion. Arthur Okun, one of the founding fathers of post-war stabilisation theories, was more cutting in his assessment. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 40 On observing a scatterplot of Phillips curve observations over the stagflation decade of 1970–1980 – which defied theory as it showed a positive (not a negative) correlation between inflation and unemployment – he remarked that the curve resembled “an unidentified flying object.” I think it is safe to say that few economists at that time, at either end of the macro-theory spectrum, could have imagined that a destabilisation of the Phillips curve could occur, symmetrically, in both directions – that is, on a sustained decelerating as well as accelerating path. That today a no less influential observer and global policy actor than the IMF itself entertains this possibility makes it sufficiently important for us central bankers to consider. Therefore, I am grateful for this opportunity to clarify my own thinking on this topic, particularly in the context of the euro area. Is sustained disinflation indeed a realistic possibility? I believe it is not – that is, unless at least one of the following three conditions holds: 1. the structural connection between inflation and unemployment vanishes, with the Phillips curve interpreted as the aggregate supply condition in the spirit of the New Keynesians. This would imply that inflation becomes unreactive to economic slack; 2. the financial transmission channel remains blocked, and at the zero lower bound monetary policy cannot maintain sufficient traction on real activity. In the context of the Phillips curve, the measure of economic slack becomes uncontrollable; 3. macroeconomic policymakers lose their commitment to their stabilisation mandates and renounce control over demand conditions. Consequently, inflation is left to move freely in the Phillips curve space, being driven only by pure sunspots. To bring forward my conclusions, I do not see evidence to support the first two conditions in the euro area. In terms of (1), the inflation/unemployment connection remains intact – in fact, it has probably strengthened precisely in those economies where _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 41 labour market slack has exerted a disproportionate influence on the weak euro area-wide inflation trends. As for (2), the financial transmission channel has largely been restored. In the wake of the sovereign crisis, frictions in financial intermediation had increased on account of heightened risk aversion and driven a large wedge between the risk-free interest rate and the cost at which private borrowers could borrow. Credit standards tightened despite the ECB’s policy orientation to loosen its stance. Over the last year, however, these wedges have largely disappeared and financing conditions have fallen in line with our policy intentions. Turning to (3), there is certainly no lack of commitment on the part of the ECB. I believe that the ECB has demonstrated the necessary awareness when confronted with a downward shift in realised and anticipated inflation. Furthermore, it acted with the requisite force to address those concerns and to leave no doubt about its commitment to delivering price stability. Other economic policy makers, however, now need to meet the challenge with the same degree of determination. In particular, they should view the current loose credit conditions as a historical opportunity to launch policy initiatives that would be far more difficult to enact in a less supportive environment. Let me elaborate on these thoughts in some more detail. II. A flat Phillips curve A key enabling condition for sustained disinflation is the presence of a totally flat Phillips curve. On first reading, this concept may sound somewhat counterintuitive. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 42 After all, a vast literature has adduced that a flat Phillips curve is proof that central banks have been, and will continue to be, successful at both macroeconomic and inflation stabilisation. Indeed, John Roberts has argued this point particularly forcefully and cites the influence of the Federal Reserve’s stabilisation policies on US inflation dynamics. But a negatively sloped Phillips curve – in the inflation/unemployment space – is a precondition for central banks to exercise monetary control in the first place. When the slope of the Phillips curve approaches zero, the inflation process becomes impervious to monetary policy interventions. The NAIRU which divides regimes of accelerating inflation from decelerating inflation loses significance. In other words, any level of unused capacity becomes consistent with any rate of inflation and the inflation target ceases to exert its gravitational pull on inflation expectations. Indeed, why should expectations gravitate around the central bank’s target if the central bank itself cannot correct an inflation deviation by steering the level of economic slack to the appropriate level and, thereby, bring inflation back to target? As inflation expectations set the intercept that determines the height of the Philips curve in the inflation/unemployment space, in this hypothetical case, nothing can prevent the curve from sinking in an uncontrolled way. While it is a matter of dispute whether and where that sinking process would end, it would certainly pull inflation away from levels that are consistent with central banks’ mandates and with macroeconomic stability. Let me make an incidental remark here. The major historical episode of unanchored inflation expectations, at the start of the 1970s, which ultimately opened the door to a decade characterised by bouts of double-digit inflation, occurred precisely at a time when the Phillips curve was thought to have become flat and policymakers saw wage and price-setting as having become insensitive to economic slack. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 43 This perspective, which contrasted sharply with Milton Friedman’s famous dictum that “inflation is always and everywhere a monetary phenomenon”, led the Fed and other central banks to lend their support to measures such as wage and price controls rather than monetary solutions to address inflation. My own view is that I do not see signs of a disconnection between inflation and unemployment in the data for the euro area. There are three observations that lead me to this position. First, various estimates of the euro area Phillips curve slope show that while the slope has varied over time, in recent years it has steepened (see Chart 1). There is no agreed upon functional form of the Phillips curve, and our confidence that estimates using clouds of points in an inflation/economic slack space can capture the structural elasticity attached to slack in the conceptual Phillips curve, is indeed quite limited. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 44 Nonetheless, using different measures of unused capacity to at least hedge against mis-specification risks, we obtain estimates which all indicate that there has been an increased responsiveness of inflation to economic slack in recent years. If I interpret this evidence in a deep parametric way, I tentatively conclude that the slope of the Phillips curve is currently around 0.2. This implies that a 1 percentage point increase in economic slack would, on average, lower inflation excluding food and energy by about 0.2 of a percentage point. And in fact, this relationship measurably increases if one adjusts the headline rate of unemployment for those who have become detached from the labour market for a long time, and who are likely to exert only a mild amount of downward pressure on wage and price formation. Robert Gordon documents a similar result for the US. As I mentioned above, there is some evidence that the Phillips curve has steepened in particular in some of the so-called euro area periphery _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 45 countries, where lawmakers have actively reformed local labour market institutions and deficient demand has promoted a protracted period of wage moderation. There are of course many caveats to interpreting this data: lining up a time sequence of dots in the inflation/unemployment or wage growth /unemployment space and using the slope of that line to draw conclusions for the Phillips curve elasticity is hazardous (see Chart 2). Through time, an economy could be moving along a steady Phillips curve, or Phillips curve could be shifting in the space. And the shift could be due to a host of factors: a revision in inflation expectations for example, or a permanent or temporary change in wage and inflation mark-ups. Incidentally, this latter factor – a temporary reallocation of wage negotiating power between employers and job-seekers – appears to be particularly relevant once the recovery has moved beyond its initial phase. Evidence suggests that the relationship between inflation and labour market slack can be weakened not only during a recession but also in the early phase of a recovery. While the decline in euro area wage growth during the recession was limited due to downward nominal wage rigidities, in the early phase of the recovery wage growth may remain subdued as a result of “pent-up wage restraint”. In other words, the wage adjustment which did not occur during the recession may cause employers to initially curtail wage increases as they do not see a need to attract suitably qualified employees by wage incentives. However, once this pent-up wage restraint has been absorbed, wages should begin to rise at a more rapid pace. Discriminating across such null hypotheses is hard. But with these caveats in mind, a study by Banca d’Italia finds, for example, that the Phillips curve has undergone a structural break in both Spain and Italy, and for two reasons. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 46 First, nominal price rigidities have declined, possibly on account of the impact of structural reforms. Again, this result can be interpreted in a variety of ways, including the idea that a temporary destabilisation of inflation expectations at some point started to influence wage contracts and produced a parallel drift in the curve. The second factor is a higher elasticity of consumer prices to the output gap. The underlying reason mentioned in the study is changes in the price setting behaviour of firms. This reflects the lower number of firms in the market in the aftermath of the deep recession and the reduction in strategic complementarities in price setting that this leaner retail sector brings about. This latter factor indeed comes very close to a New Keynesian type interpretation of the higher sensitivity of inflation to the underlying economic conditions, where different degrees of strategic complementarities in price setting can indeed be viewed as influencing the coefficient attached to slack (or, rather, the marginal cost of production) in the Phillips curve condition. This evidence could tentatively support the contention that what is observed in the data is indeed a structural shift. It is important to remember that a steep(er) Phillips curve is a curse for inflation stability on the way down, when cyclical unemployment is on the rise. But it is a blessing when unemployment is being re-absorbed, as the revival in business activity places more intense upward pressures on prices and thus helps nudge inflation back toward its target level more rapidly. The second reason why I do not see signs of a disconnection between inflation and unemployment in the euro area is that – echoing a point also raised by Robert Gordon – the inflation process is occasionally subject to short-term spells of inertial drift, when supply side shocks hit repeatedly and cause serial downward inflation surprises. Five years ago this phenomenon was invoked to explain the “missing deflation” in the post-Lehman world of mass worker dismissals, when _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 47 realised inflation turned out consistently higher and stickier than forward looking macro models were predicting on the basis of the observed levels of unused capacity. Today, the delayed adjustment of the same inertial process is probably producing a symmetric case of “missing reflation”. In other words, a sequence of negative commodity price surprises may be dampening the reflationary effect of the economic recovery. Still, the possibility that inflation may occasionally be driven by spells of backward-looking dynamics does not mean that downward drifts – in both observed and expected inflation – should necessarily be looked through by the monetary authorities, as self-correcting and hence policy irrelevant. In fact, I will advocate the opposite view later when I turn to the role of monetary policy. What I want to say here is the following: provided the appropriate policy response has been put in place to ward off serious risks of nominal de-anchoring, any outbreak of adaptive expectations will be transient. When the adaptive expectation rule of both households and firms starts to perform badly in the face of strengthening business conditions, they will switch back to expecting price stability in line with central banks’ numerical mandates. The third factor behind my assertion is that the flow of incoming survey data indicates a turnaround in inflationary pressures in line with the cyclical upturn, as evidenced for example by the latest PMI data. Both output and input prices as well as European Commission survey data on selling prices have rebounded since the turn of the year. Looking ahead, the weaker euro exchange rate as well as the continued closing of the output gap will be key drivers in supporting the upward inflationary trajectory for euro area inflation back towards our aim of below but close to 2%. III. Re-integration of financial transmission _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 48 Another possible condition for a situation of sustained disinflation is that monetary policy losses traction over the economy in the presence of disrupted transmission mechanisms. In the euro area our monetary policy response has indeed focused on two tracks: engineering an appropriately expansionary stance, while simultaneously repairing the monetary policy transmission mechanism so that this stance reaches euro area firms and households. The first track has seen us progressively cut rates, resulting in the ECB being one of only a handful of central banks whose short-term rates have gone into negative territory. The power that negative rates have had in propagating our policy stimulus has been striking, for two reasons. First, because a negative interest rate policy can to a certain extent be seen as a substitute for quantitative interventions. Bringing the overnight interest rate to a negative level already in June last year de facto meant that we started generating effects – again to a certain extent – that one expects to see under quantitative policies, eight months before we expanded our purchase programmes on a large scale. And second, because a negative interest rate policy is indeed a complement to a quantitative programme. Let me explain both points in some more detail. When the short-term interest rate falls to zero, the yield curve tends to steepen. This phenomenon is a mechanical consequence of agents revising their interest rate expectations at the zero lower bound. Long-term interest rates are to a large extent driven by expectations of the future evolution of the short-term interest rate. If agents – looking forward – can only expect the short-term interest rate to rise in the future from a zero level, because they think zero is the lower bound, then the long-term interest rate will be determined on the basis of a probability distribution that is skewed toward positive numbers. This is what causes the term structure to steepen. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 49 Now, if agents can be convinced that the lower bound for the short-term interest rate is not zero but can be made negative, then this problem is likely to become less severe. In fact, over the summer and the autumn we have seen our long-term interest rates starting to react to our negative interest rate policy in much the same direction as long-term interest rates have reacted to QE in other countries and, subsequently, in the euro area. We also expect the negative rate to complement – and in fact empower – the expanded asset purchase programme that we decided in January. A negative rate on bank reserves is an inducement for banks selling securities to the Eurosystem, or receiving an inflow of reserves and deposits as a consequence of central bank purchases, to lend these money balances on and avoid the tax that is paid on them otherwise. In other words, we expect an increase in the velocity of circulation of cash reserves – another way to describe an acceleration in the portfolio rebalancing effect that is a key component in the transmission of asset purchases to the real economy. Turning to the second track of our policy – the repair of the monetary policy transmission mechanism – the flow of data indicates that our credit easing measures taken last summer are improving the pass-through of our accommodative stance to the real economy. The nominal cost of bank borrowing for euro area NFCs has declined sharply, with some convergence across countries (see Chart 3). The March 2015 Bank Lending Survey also shows that euro area banks have continued with their net easing of loans to NFCs with a further decline in the disparity across countries. These improvements in net easing were mainly driven by the improved cost of funding – across all main market instruments – and balance sheet conditions. In contrast with the past, the last six months have shown that banks are now passing along their cheaper funding conditions to their customers. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 50 Our credit easing measures have supported this process by generating competitive pressures, which in turn makes banks’ lending behaviour more responsive to their funding situation. As lending rates have declined in tandem with market rates, the demand for loans has also continued to pick-up. Improvements in the net demand for loans to NFCs persisted into the first quarter of this year across almost all euro area countries. This indicates that, by reducing the interest rate charged on the marginal loan, a bank makes the investment project of a firm which requires the marginal loan profitable. It follows from this that the more lending rates are reduced, the greater the number of investments that will break even and consequently, the more investors will ask for loans. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 51 Looking ahead, the indications bode well for future economic activity, as euro area banks expect both a further easing of credit standards and a continued increase of net NFC loan demand. In sum, the monetary impulse is being passed along the entire credit pipeline, including via banks. IV. Policy reaction functions When all the structural preconditions are in place for central banks to influence short-term real activity and limit excessive fluctuations in the rate of inflation from targets – namely a negative Phillips curve coefficient and a viable transmission mechanism – a sustained period of disinflation, if this is possible at all, can only emerge if monetary policy facilitates it. However, present day central banks have little scope to show forbearance when price stability is at risk. Tolerating inflation destabilisation is not an option for them. Modern central banks have two strong antidotes at their disposal to avoid this. First, their robust monetary policy frameworks prescribe the delivery of price stability within a policy-relevant horizon. I stress this qualification as it is a key element. To be sure, the time horizon for central banks to normalise inflation cannot be preset, by statute, unconditionally. Indeed, in a vast part of the world where central banks are assigned numerical objectives for price stability the stabilisation horizon is not defined in rigid calendar-time form, but is left rather flexible for central banks to determine according to the nature of shocks that cause inflation to deviate from target. At the same time, a central bank which allows itself too much discretion over the time horizon when inflation should return to its target would de facto be claiming authority over redefining its monetary policy objective. This would be manifestly inappropriate, probably illegitimate. Central banks know that if they lack a verifiable commitment to control inflation over a horizon for which the public retains some visibility, this can result in inflation expectations becoming “unanchored”. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 52 To go back to a point I made earlier, it is in this spirit that a central bank may choose to react vigorously to supply-side shocks so that it can restore the public’s faith in the effectiveness of monetary policy. Second, and as a corollary, present day central banks do not indulge in the self-absolving notion that monetary policy has reached its limits and that further actions would be fruitless. Historically this sort of pessimism about the potency of monetary policy has led to policy paralysis. To make matters worse, this idea was often combined in central banking circles with the conviction that those authorities with control over income, structural and fiscal policies should be principally responsible for reviving the economy and countering deflation risks. In both the 1930s and 1970s as well as in the early 2000s in Japan, these counterproductive beliefs led to policy inaction which ultimately resulted in enormous harm being inflicted on their economies. Today’s central banks have learned the lesson from these episodes and do not wait for others to move first. The ECB’s actions reflect this learning. Many observers expected that the EU environment of diffuse macroeconomic authority would lead to strategic paralysis. Instead, the ECB has risen to its responsibility of ensuring control over inflation in the medium term, and has responded vigorously to any risks of inflation expectations becoming unanchored. As a result, our expanded asset purchase programme has had three tangible effects. It has prompted a reassessment of inflation prospects as priced in inflation protection contracts: the steady decline of breakeven and inflation swap forwards which occurred in the recent past have not only halted, but have reversed at all horizons. The implemented measures have also flattened the nominal term structure for safe as well as riskier fixed income securities at the longest maturities. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 53 And as a consequence of this, they have led to a drop in real rates across the entire spectrum of term contracts. V. The importance of other stakeholders Nonetheless, it is clear that all stakeholders must also play their part in ensuring a swift and sustained recovery. The current environment where the real interest rate is below the real GDP growth rate is one that is, as I already intimated, very supportive and ripe for undertaking investment. But it is also not without risks. Chart 4 contrasts estimates of the long-term real GDP growth rate with long-term real forward rates for the euro area. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 54 We see that since May last year the real forward curve has been declining consistently. It is now below a range of estimates for real potential growth rates and, in fact, below the zero line throughout the maturities. This chart admits two stylised interpretations. In the first interpretation, the movements of the forward real curve are just a mirror image of the compression in term premia achieved via our expanded asset purchase programme. The fact that the forward real curve has continued its descent observed since 2014 may be the result of the term premium compression, given the anticipation (first) and actual execution (then) of central bank purchases of securities held in price-inelastic portfolios. Indeed, the term premium is part of the real remuneration that investors demand in order to hold on to their investments. In the second interpretation, long-term forward real rates are a measure of an equilibrium “norm”, rather than a reflection of a monetary-policy induced compression of term premia. Another way to look at the outer maturities along the real forward curve is to interpret these rates as a market measure of the equilibrium real rate. That is, they reflect the markets’ view of the real cost of borrowing that can be sustained by an economy that is neither overheating nor decelerating. Indeed, barring preferred habitat and extreme price inelasticities on the side of potential sellers, at those maturities all shocks should have dissipated, and the economy should be expected to have returned to a sustainable path. This interpretation is less benign than the first one I advanced. If one interprets long-term real forward rates as a measure of the equilibrium rate, the comparison of these persistently negative rates with the growth rate of potential suggests that the economy may be dynamically inefficient and expected to remain so for a very long time. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 55 What conclusions can one draw for policies (and I intentionally use the plural)? If the first interpretation is correct and one interprets long-term real rates as influenced by term premia and monetary policy, then – by bringing the real cost of long-term borrowing below potential growth – monetary policy can lower the “return bar” at which investment projects break-even and become profitable. Provided investment reacts to this very strong price incentive, the imbalance will be rectified at some point, and real rates will catch up with (a higher) potential rate over time. If the second interpretation is correct, we are in the fortunate position that the policy conclusions are not so different. The necessary policies that are required to capitalise on the low interest rate environment are the same policies that can repair dynamic inefficiency. In essence, no matter how you read the Chart 4 – or if indeed a combination of interpretations is correct – the safest template for policy action involves largely the same combination of policy strategies. While monetary policy is attempting to shadow the equilibrium real rate, which has been reduced in the aftermath of the financial crisis, the counterpart economic policy authorities should concentrate on lifting potential. What is needed is to boost growth via increased investment, as investment not only creates current demand but future supply. Public investment on infrastructure, if sufficient fiscal space exists, as well as on education and training can promote a new wave of innovations and put more of the labour force to work. At the same time, removing barriers that restrict the reallocation of workers across firms while enhancing the effectiveness of national competition authorities to drive out rent seeking behaviour would reduce market functioning impediments and, thereby, increase the profitability of investment. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 56 The European capital union would greatly facilitate firms wishing to undertake cross-border investment opportunities. Ultimately, a higher potential will create the conditions for a rising equilibrium rate and will pave the way for monetary policy normalisation. Conclusion Let me conclude. Euro area inflation declined substantially over the past year, but as I have just outlined, all the indications are there to support the view that inflation will gradually return to our definition of price stability of below but close to 2%. While the debate over the Phillips curve is likely continue for decades and beyond, there can be no doubt that monetary policy is playing a key role in helping to make this return of inflation to our objective possible. However, it is now up to governments to seize on this opportunity to ensure that the cyclical recovery becomes permanent. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 57 IFIAR Projects of Interest to the Academic Community Lewis H. Ferguson, Board Member PCAOB/AAA Annual Meeting Washington, DC Welcome to our conference for Academics. Many of you will have previously heard me speak about my role as Chair of the International Forum of Independent Audit Regulators, or IFIAR. I began in 2011 as Vice-Chair, and have now been Chair since 2013. My term will expire this month at our plenary meeting in Taipei. As I reach the end of my tenure, I wanted to take the opportunity to talk a little bit about what IFIAR has accomplished and the role that I think it has and will play in improving audit quality. Before I begin, let me say that the views I express are my own and do not necessarily reflect those of the Board or the PCAOB. Our economy in the United States is increasingly globalized, and our audit firms are auditing the financial statements of many multinational corporations where components of those audits are performed in foreign countries by a foreign firm that is, most often, part of a larger network of affiliated but independent firms. The PCAOB has jurisdiction over those foreign firms to the extent that they either file audit reports in the United States or play a substantial role in the audit of a United States public issuer. But each national regulator can benefit in its oversight efforts by having a global view of how the firms operate. IFIAR is an excellent forum for its 50 members to gain perspective and collaborate on international oversight. IFIAR Working Groups _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 58 IFIAR conducts its primary work through six working groups: the Enforcement Working Group, the Investors and Other Stakeholders Working Group, the Global Public Policy Committee Working Group, the International Coordination Working Group, and the Standards Working Group. I'd like to focus on the work of a few of these groups. Standards Coordination First, the Standards group has made great strides in the past two years. We as regulators feel strongly that it is important for the standard setters, both the IAASB and the IASB, to heed the views of the community of national regulators when considering what standards should look like. Through our inspection regimes and other forms of outreach, regulators have extensive experience with problems in existing standards and with instances where standards are working well. Therefore, during my term as Chair, IFIAR put in place a new process for the IFIAR members to approve communications from the Standards group to the standard-setting bodies. Since IFIAR developed this new process, five comment letters have been submitted and those letters have the approval of the full IFIAR membership. I am pleased to see that going forward, international standard setters will have to consider the views of the regulators who see how these standards are put into practice. GPPC Discussions The Global Public Policy Committee working group is one of IFIAR's most active groups. It has nine members from Singapore, Germany, France, Japan, the US, Australia, the Netherlands, the UK and Canada. The group meets twice a year with the heads of the audit practices of the largest six global networks. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 59 At one of those meetings, we discuss with the firms' their efforts and progress in performing root cause analysis. The GPPC working group pushes the firms to dig deeper in identifying and remedying the underlying causes of the recurrent audit deficiencies that are identified by regulators and by the firms themselves, and to try to take a global view so that issues are identified and remedies are implemented throughout the firm's network. We are learning in the course of these conversations that current structure of the audit firms' global networks limits significantly the leverage that the global leaders at these firms can bring to bear to implement firm-wide change. It is my hope that the insights gained by the working group, and the growing awareness of the IFIAR members to this problem, will both provide positive pressure and help the leaders of the global networks to make the structural and institutional changes that over time, will raise the bar of audit quality in all of their member firms. In the second annual meeting of the Global Public Policy Committee, we have a conversation with the same global firm leaders about a topic of particular interest to the working group members. Last year, we dedicated time to topics including the impact of audit rotation on their European affiliates and aspects of their business model. We plan to continue this discussion in IFIAR's plenary meeting in Taipei as the regulators around the table at the GPPC meeting consider it beneficial for all of the regulators to understand the business model of the firms they regulate. The discussion about the economic model of the firm in Taipei centers around a paper that IFIAR will publish on trends in the audit profession, and summaries of the discussion will also be made public. I am pleased that IFIAR will be able to contribute to such an important topic in a more public way. Group Audit Inspection The GPPC working group undertook another significant project in the past year. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 60 A sub-group of four regulators conducted a coordinated inspection of the component audits of a single global issuer by a single global audit firm in four jurisdictions. The inspection included reviews of the work of the principal auditor and three component auditors. Those participating then exchanged views and findings with each other and a summary will be provided to IFIAR members. While the effort is in its first stages, I think we stand to learn a lot about the way group audits are conducted by the largest firms, and to grow in our national inspections through enhanced collaboration and cross-fertilization. Multilateral Memorandum of Understanding IFIAR's International Coordination Working Group has led a project for the past two years to develop a Multilateral Memorandum of Understanding, or MMOU, which will facilitate an exchange of information among signatory members. I hope this document will be approved by the members in April, and that soon thereafter members will sign on and begin sharing information in the course of inspections and enforcement matters across borders to a greater extent than is currently possible in the absence of bi-lateral agreements. This MMOU will be most useful to smaller regulators which lack the resources to develop and negotiate their own protocols for exchange on a bilateral basis with every IFIAR member. We in the United States find there is often occasion to collaborate with our fellow regulators on inspections and enforcement matters, and our Office of International Affairs has been working for years to put in place a network of similar bi-lateral agreements. It is my belief that audit quality will be greatly enhanced if regulators can work together to facilitate one another's efforts given our common goals. Annual Survey of Inspection Findings In March, IFIAR released a report summarizing the findings from its third annual survey on member's inspection findings. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 61 This report has confirmed that audit regulators around the world are facing similar issues, and gives a clear indication of areas where improvement is needed. Because of the variations in timing and selection of issuers across jurisdictions, the survey is not a good measure of year-over-year audit quality improvement or decline. Nonetheless, it has been a useful tool to survey the reactions of regulators to the audits they are seeing and to identify the most common areas where we are finding audit failures. Going forward, we hope to continue to improve the information collected and the conclusions we can draw from it. Enforcement Survey and Outreach The newly formed Enforcement Working Group conducted a survey of its members' enforcement regimes and has now organized a workshop to facilitate the sharing of practices and ideas. IFIAR has also placed a great deal of focus on outreach. The goal is to grow IFIAR's membership, and thereby its influence. IFIAR wants to encourage more jurisdictions to establish regulators independent from the profession. IFIAR has partnered with the World Bank to offer technical assistance and to drive improvements in regulation in jurisdictions where established regulators are not yet operating. Conclusion In conclusion, I'm pleased with what IFIAR has accomplished over the past two years. I hope some of these projects are of interest to the academic community and I encourage you to follow the developments of IFIAR as it matures. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 62 ENISA at the service of the EU’s Cyber Security Udo Helmbrecht Executive Director ENISA SEDE speech, European Parliament Dear Ms Fotyga, members of the SEDE committee and representatives of other authorities present. Thank you for the opportunity to address you here today, and provide you with an overview on securing the EU’s cyber space, while at the same time demonstrate the contribution ENISA is making for Network and Information Security (NIS). Information and communication technologies (ICT) are the backbone of every modern society. An open, safe and secure cyberspace is key to supporting our core values set down in the EU Charter of fundamental rights such as privacy and freedom of expression. This is also essential for the smooth running of our economies within the European single market. However, ICT technologies and business opportunities in cyberspace also present opportunities for crime and misuse. Security of network and information systems is essential to the security of all the critical sectors in society. Disruptions on these infrastructures and services are becoming more frequent and are estimated to cost annually 260-340 billion EUR to corporations and citizens. The World Economic Forum’s 2014 report on Global Risks, lists “failure to adequately invest in, upgrade and secure infrastructure networks” as a top threat to the global economy. Various recent studies, including those of ENISA2, demonstrate that the threat landscape will get worse, unless we take firm action. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 63 It is expected there will be a significant evolution in the top threats, with new, more sophisticated malicious attacks on critical services and infrastructures, with a dramatic increase in data and security breaches (25% increase over the same period last year). Today I will present elements and activities in the global cyber security context and talk firstly about the taxonomy. Today we are still living in a tailorised world of the sailos of law enforcement, military, intelligence service, public institutions, private companies etc. The attackers do not care about this separation and use the same tools and infrastructure to achieve their objectives. Therefore we have to distinguish between: Cyber security means protection of information, information systems and infrastructure from those threats that are associated with using ICT systems in a globally connected environment. By deploying security technologies and security management procedures, a high level of protection of personal data and privacy can be achieved. A typical example, is ensuring the integrity and security of public communications networks against unauthorised access. Cyber Crime Crime on the internet has a new dimension. The technology allows organized crime to scale their “business”, especially outside the legal boundaries of states. Cyber Espionage We had military espionage for thousands of years. The only difference between traditional espionage and cyber espionage is the use of technology and as long as we have civil intelligence agencies it will not stop. Another aspect is espionage because of philosophical disagreement. Cyber Warfare We are facing a new type of asymmetric warfare with a new paradigm and no taxonomy. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 64 Assessing the Threat Landscape Environment (ETL) In 2014, major changes were observed in top threats: an increased complexity of attacks, successful attacks on vital security functions of the internet, but also successful internationally coordinated operations of law enforcement and security vendors. Many of the changes in cyber threats can be attributed exactly to this coordination and the mobilisation of the cyber community. However, the evidence indicates that the future cyber threat landscapes will maintain high dynamics. I often say, identifying and understanding cyber threat dynamics can be the basis of a very important cyber security tool. The dynamics of the cyber threat landscape set the parameters for flexible, yet effective security protection regimes that are adapted to the real exposure. Understanding the dependencies among all components of the threat landscape is an important piece of knowledge and an enabler towards active and agile security management practices. With ETL 2014, ENISA continues its contribution to publicly available cyber threat knowledge. CERTs and first response CERTs - the EU’s Computer Emergency Response Teams - respond to emergencies, new incidents and cyber threats that could affect vital computer networks or information systems. These teams assist public and private sector organizations to provide an adequate response to incidents and threats accross an EU wide network. They exchange experience and expertise while developing ‘baseline capabilities’. Furthermore, it raises the bar for non- Governmental teams to offer similar response to incidents across the EU. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 65 As part of ENISA’s cooperation with CERTs, the Agency has updated and extended its training material in the area of Network Forensics, and has published a good practice guide on Actionable Information for Security Incident Response. The study is complemented by an inventory that can be applied to information-sharing activities and an accompanying new hands-on exercise scenario. Pan-European Cyber Exercises Over the past five years ENISA has supported the implementation of the Commission’s policy initiatives, the CIIP Communication and the Digital Agenda, by developing cyber exercises and cooperation and by defining and testing operational procedures (EU-SOPs) for all cybersecurity authorities in the EU. In 2010, there was only a table top exercise and no crisis management procedures at the EU level for dealing with cyber-events. Now Standard Operating Procedures are in place for handling cyber events. New policy initiatives such as the Cybersecurity Strategy and the NIS Directive have highlighted the importance of these successful activities. Both activities will continue to contribute to the long-lasting impact of the EU Cybersecurity Strategy and the NIS Directive on the level of security in the EU. In this light, ENISA will need to streamline its activities in this area and further develop them to support effectively the implementation of this demanding policy context. National Cyber Security Strategies (NCSS) Around twenty (20) MS have now developed a National Cyber Security Strategy (NCSS). The remaining eight (8) Member States are also developing strategies. ENISA has established an expert group with representatives from the Member States to exchange good practices and to analyse specific topics of interest to the group. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 66 Last year the Agency developed a good practice guide for the evaluation of National Cyber Security Strategies. This year ENISA co- operates with Member States on PPPs (Public Private Partnerships) and how they can be used in the context of a National Cyber Security Strategy, while in May a workshop is planned on National Cyber Security Strategy development. Criticial Information Infrastructure Protection (CIIP) The Agency has worked for many years in the Criticial Information Infrastructure Protection (CIIP) area and has assisted the Member States in implementing the EU’s CIIP action plan. Currently our focus is only on a few areas namely the Telecom Sector, Energy sector and Finance sector. In the future we plan to extend our efforts in the area of health, transport and cover more aspects within the energy sector. In the Telecoms and Smart Grids area we have developed minimum security measures. In Telecoms, we have also developed a harmonised incident reporting framework (due to article 13a). This work could provide a strong basis for assisting in implementing similar requirements in the NIS Directive once it is adopted. Incident Reporting All EU National Regulatory Authorities now use ENISA’s guidelines and recommendations for incident reporting. The last four (4) years we have issued four (4) annual incident reports covering the area of Telecom operators. In the context of Article 4, which covers Data Breach Notification, ENISA brings together National Regulatory Authorities and Data Protection Authorities to develop a common approach to incident reporting in Europe. Additionally the Agency has been called in the eIDAS (Electronic identification and trust services) Directive to assist National Regulatory Authorities to implement the incident reporting scheme for trust providers. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 67 The work has just started and is expected to finish in June 2016. Cryptography research and tools and ‘security by design’ Cryptographic tools are widely used to protect our information infrastructure from malicious users. Today cryptography is mainly used to protect the access to services and to protect communication of individuals and groups (e.g. virtual private networks and message encryption, end-to-end encryption). A good approach to secure our personal data is to “reduce, protect, detect”. However, as with any quality measure, it poses a burden for implementers. Hence, EU legislation needs to support privacy by requiring systems’ developers and service providers to build in data protection measures from the design phase on, what is also known as ‘security by design’. Digital sovereignty For the EU to become the single market of choice for governments and industry, it is necessary to have trusted core NIS technologies and services for industry and citizens (i.e. Trust in EU products and services). Furthermore, there is a need for an innovative business model for EU companies producing cybersecurity products and services. Currently there is no properly coordinated EU industry policy in place specifically for the IT security sector. In addition, it is critical to ensure that the cost of implementing NIS legislation and policy does not penalise EU companies in a global market. There are a number of solutions in this direction, for example in the area of standardisation, certification, public procurement and research. Challenges for the future There are different aspects to cyber security and cyber attacks. But all current security approaches tend to make use of the same technology, making it difficult to judge who is attacking what and why. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 68 We are facing a new type of asymmetric warfare with a new paradigm and no taxonomy. This brings cyber security to a new level, making its scope more critical for the EU’s security. The protection of information, information systems and infrastructure from those threats associated with the use of ICT systems in a globally connected environment, is inevitably linked with effective security policies and robust and resilient cyber defence capabilities within a common (= taxonomy) EU policy. To enable the EU to address this, cooperation among Member States, EU Institutions and other relevant bodies, is a top priority. Within this scope, collaboration or so-called ‘Service Centres’ for special tasks can be created between agencies, e.g. ENISA and Europol including Member States’ National agencies. We need European Prevention, Detection and Response capabilities. This includes harmonization of European and international legislative frameworks and procedures as well as collaboration models to ensure adequate policy implementation. Citizens need to be able to trust the EU to create a legal framework and to prosecute those who break the law. Furthermore, we need to implement early warning systems to support detection. Some of the current decisions will have an impact on the EU’s future over the next few decades. ENISA is strategically well positioned to address the technical and organisational elemements of these challenges and threats, provide solutions and the knowledge that will support investment and deployment of electronic services in the EU internal market. ENISA is here to actively contribute to a high level of network and information security within the Union, and use its expertise to stimulate broad cooperation between actors from the public and private sectors, and deliver its agenda on cyber security for the European Union and its citizens. Thank you for your attention. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 69 ESMA updates data on performance of Credit Rating Agencies The European Securities and Markets Authority (ESMA) has published its latest set of semi-annual statistical data on the performance of credit ratings, including transition matrices and default rates. This latest dataset covers the period from 1 July to 31 December 2014 and is available in the Central Rating Repository (CEREP). CEREP provides information on credit ratings issued by the Credit Rating Agencies (CRAs) which are either registered or certified in the European Union. The current publication does not include the rating information of two certified credit rating agencies: HR Ratings de México, S.A. de C.V. that will be made available in May 2015 and Egan-Jones Ratings Co. (EJR) that will be made available at the next bi-annual publication (October 2015). CEREP allows investors to assess, on a single platform, the performance and reliability of credit ratings on different types of ratings, asset classes and geographical regions over a given time period. CEREP is updated on a twice-yearly basis with statistics covering the preceding 6-month period, the reporting periods are January to June and July to December. To learn more: http://cerep.esma.europa.eu/cerep-web/statistics/ratingActivity.xhtml _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 70 Financial regulation and the global recovery Speech by Mr Vítor Constâncio, Vice-President of the European Central Bank, at the 24th Annual Hyman P. Minsky Conference "Is financial reregulation holding back finance for the global recovery?", Washington DC Ladies and gentlemen, Let me begin by thanking the Levy Institute and specially its President, Dimitri Papadimitriou, for inviting me to speak again at the Annual Conference honouring Hyman Minsky. This year's theme is quite topical and opens the door to a lively debate about the role of finance and regulation, both in the crisis period and in the moderate recovery underway. The recovery is however still to achieve the closing of negative output gaps on both sides of the Atlantic. It could then be expected that different views emerge about the regulatory reform efforts that are not yet concluded. Let me mention four. According to one view, the crisis and its recessionary effects result from the excesses of finance and insufficient regulation. This implies that the main effort should be to tame finance in order to avoid future crises of the same type. In this vein, it could be expected that deep reforms of the international financial regulation would follow the acknowledged failure of the legal framework in place before the crisis. Two well-known specialists in the field, Barry Eichengreen and Eric Helleiner have very recently published two books explaining why a transformative reform of the international system has indeed not occurred. Eichengreen explains it the following way: "-depression and financial collapse were avoided, if barely. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 71 This fostered the belief that the flaws of the prevailing system were less. It weakened the argument for radical action [-]. Success thus became the mother of failure." This sounds perhaps too harsh because good work has been done in adopting measures in the domains of capital, liquidity and resolution of banks in order to increase the resilience of the banking sector, within the financial system. Much less has been achieved beyond banks, notably in what regards OTC derivatives or non-bank entities, including activities of the so-called shadow banking. However, as remarked by Helleiner, financial reform saw the emergence of a promising innovation in the form of macro-prudential policy: a policy that uses regulatory measures to deal with system-wide financial risk and the smoothing of the financial cycle, i.e. the fluctuations of credit financing, leverage and asset prices. This goal is essential. Nevertheless, some economists and policy makers continue to view this with scepticism. Monetary policy cannot simultaneously cope with two different objectives and the need for macro-prudential policy has become more acute with the realisation that advanced economies are very likely to face a prolonged period of low real and nominal growth. In such an environment, monetary policy has to remain accommodative, with low interest rates which foster search for yield and froth in asset markets, making the use of macro-prudential policy - to strengthen institutions, to smooth the financial cycle and to pre-empt asset bubbles more necessary. Without an effective macro-prudential policy, advanced economies will not be able to avoid financial instability. This means that regulatory reform has to continue until appropriate instruments are put in place to deal with the non-bank financial sector, which is increasingly taking the role of credit intermediation previously performed by banks. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 72 The concentration of reform measures on the banking sector has led to an expansion of shadow banking or the market-based financing sector. The investment fund industry doubled in size in the last five years in Europe. The financial system is expanding in new dimensions and new risks are emerging in terms of maturity transformation and leverage, especially synthetic leverage. Another view on the regulatory reform is rooted on a sceptical perspective about the possibility of taming finance, accepting that booms and busts are simply unavoidable. After adopting some measures to increase the resilience of financial institutions in terms of capital and liquidity, the policy concern is about how macroeconomic policy should be used to mitigate the effects on the real economy stemming from endogenous financial crises. Monetary policy would "mop-up the mess" via liquidity provision after the bust and would help the recovery. For the more Keynesian-inclined minds, this should extend to the use of fiscal policy, especially in an environment of low interest rates near the zero lower bound. It is true that monetary policy is nowadays considered the most powerful of the macro policies to stabilise the economy, but it is important to be aware of its limitations, especially near the zero lower bound. It is sometimes said that the world avoided the worst in 2008 only because central banks made bold use of their tools, notably by cutting rates and providing abundant liquidity. But the truth is that without the significant use of fiscal policy in 2008 and 2009, stimulating our economies and supporting the banking sector, the meltdown of the financial system would perhaps not have been avoided. At the meeting in Toronto in 2010, the G20 decided to reverse this policy and embarked in fiscal consolidation, to different degrees, leaving monetary policy alone to deal with macroeconomic stabilisation. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 73 In this context, the double dip suffered by the euro area economy after 2011 is easier to explain by fiscal policy short-term effects, than by the behaviour of monetary policy. In a European Commission (EC) working paper 2 using the EC Quest model, Jan Veld finds that the cumulative impact from simultaneous fiscal consolidation in 2011 to 2013 (taking into account spillover effects among seven euro area countries), ranged from 8.1 % in Germany or 9.7% in Spain to 18% in Greece, in terms of GDP losses in relation to baseline. In the same vein, Rannenberg, Schoderand and Strasky (2014) 3 find a cumulative negative effect of consolidation for the euro area in 2011-2013 of 14%, using a variant of the Quest model, and of 15% using a variant of the ECB's New Area-Wide Model (NAWM). Despite the fact that several European countries had to implement deficit reductions, these model-based calculations, with all their caveats, illustrate the importance of macroeconomic policy in determining the outcome of financial crises for the real economy. Coming back to the conference theme, a third view about the regulatory reform, supports a positive answer to the question: "Is financial reregulation holding back finance for the global recovery?". It concludes that regulatory reform has gone too far and that by constraining finance it is hampering the recovery. However, it would first have to be proven that investment and growth are being significantly affected by financing supply constraints in order to validate this view. This does not seem to be the case. Evidence points more in the direction of a general lack of demand and weak growth prospects to explain low investment and the modest recovery. The desperate search for growth and jobs by governments and policy makers, following seven years of gradual reforms, could give some credence to this view amidst feelings of reform fatigue. However, I argue that it would be wrong to listen to these opinions. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 74 The pace of the recovery is not being affected by lack of finance. Finance would be abundant if there were investment projects with prospects of good return. A fourth possible answer to the conference's question relates to a "liquidationist" view that amazingly surfaced again, in spite of the lessons from the 1930's. Its defenders claim that macroeconomic policies, aimed at mitigating the recessionary consequences of the crisis, do more harm than good in the medium-term. However, some accept that reforms to strengthen capital and liquidity buffers in credit institutions were necessary. According to this view, the crisis stemmed from excessive credit, debt and bad investments and thus, deleveraging and liquidation of bad capital must happen. Applying a very accommodative monetary policy to fight recession would risk inflation or, in the more modern guise of the doctrine, would lead to asset price bubbles and future crises. Consequently, monetary policy, in view of the alleged ineffectiveness of macro-prudential policy, should have become restrictive since 2011 or 2012. According to this reasoning, precedence should be given to the financial cycle over the stabilisation of the business cycle or, in more telling terms, precedence should be given to the risk of asset price bubbles over the risks of deflation and unemployment. Acknowledging that my description of these four different opinions has hardly been neutral, in my view, a combination of the first and second approaches is the appropriate response to the question setting the conference theme. Nevertheless, I want to clearly state that the financial regulatory reform has to be completed and extended through further efforts to contain risks in the so called shadow banking sector and to strengthen macro-prudential policies. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 75 Believing that advanced economies face a protracted period of low growth that requires accommodative monetary policy, I see no alternative to regulatory macro-prudential instruments to mitigate financial instability and crises by smoothening the financial cycle. Naturally, we should be aware that taming finance is a challenging, if ever achievable task. As Minsky put it in the last sentence of his book "Stabilizing an unstable economy": "There is no possibility that we can ever set things right once and for all; instability, put to rest by a set of reforms will, after time, emerge in a new guise". Nevertheless, our countries have experienced long tranquil periods, without financial crises in the past, and we should now aim to return to that. I already stated that re-regulating finance is, in my view, not an obstacle to the ongoing recovery. In last year's conference, I argued that "fixing finance" was not enough to ensure higher economic growth. This does not mean that I do not consider finance vital for a healthy economy. A well-functioning financial system is essential to foster long-term economic growth. In this respect, last autumn was characterised by two milestones in Europe: the completion of the asset quality review and stress tests and the start of the Single Supervisory Mechanism, which went live on 4 November. Repairing banks' balance-sheets, together with the advancements in the design of the new resolution framework, the regulatory reforms improving capital and liquidity standards, as well as those concerning the shadow banking system (like securitisation and OTC reforms), constitute clear evidence of the commitment of the ECB and other EU policy makers to restore a well-functioning financial sector and create the conditions for an adequate flow of credit to the real economy. These successes took place against the background of slow growth and subdued inflation. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 76 Despite recent encouraging signs, the recovery in Europe remains gradual and moderate. In the European context, the subject of this conference is therefore very pertinent. I already gave my general answer in favour of completing the regulatory reform. In what follows, I will further substantiate my arguments in favour of that position and will express my concern with the insufficient attention paid so far to the growing risks in the shadow banking sector. A defence of regulatory reform The beneficial impact of regulation on growth Financial institutions support and foster economic growth by intermediating savings and allocating them to productive activities. These functions are also their inherent sources of financial fragility. Regulation plays a key role in reducing the scope of financial fragility and limiting the costs of financial instability. There is vast academic literature that tries to empirically identify the impact of financial deepening (measured by the ratio of credit to GDP) on long-term economic growth. The pre-crisis evidence largely pointed to a positive relationship between financial deepening and long-term economic growth. However, recent evidence has cast doubt on such a simple monotone relationship. Several studies have shown that at high level of financial development, the effect of finance on growth becomes negative or insignificant. Cecchetti and Kharroubi (2012) put the peak of the effect of credit on GDP growth per worker at a 100% ratio of private credit to GDP. In other words, letting the financial system grow too much may harm the economy's growth prospects. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 77 Correspondingly, regulating finance may stimulate rather than retard economic development. Regulation, like any form of public intervention, is justified by the existence of market failures. Financial regulation is not an exception to this, even though it is somewhat "unique" given the special role that banks perform in the economy and the high (social) costs associated to the failure of a financial institution. Financial regulation is meant to correct financial institutions' incentives toward risk, to induce them to internalise the costs and the externalities associated to their failures, thus reducing both the occurrence of crises and the associated costs. Limiting the occurrence of crises has a positive effect on growth for several reasons. Crises affect growth asymmetrically: activity falls much more sharply during a crisis than it increases during credit booms. Their negative effect on growth is very long-lasting. An empirical investigation focusing on a large cross section of countries shows that output losses associated with financial crises are highly persistent and may range from 4% to 16%. When the financial sector is in distress, entrepreneurs' access to credit is impaired with negative effects on the investment of existing firms as well on new business creation. Recoveries from financial crises tend to be slow, 'creditless' and 'jobless'. Even if regulation reduces economic growth in normal times, its impact on average economic growth can still be positive over time. But there is a further argument as to why regulation may have a positive effect on growth: without regulation, the financial sector may become excessively large and displace other, more productive activities. Recent growth in the financial system has not necessarily led to more credit availability for innovative businesses. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 78 In the last two decades, banks in developed economies have channelled an increasing amount of funds to households rather than firms. More and more savings have flowed into low productivity growth sectors like real estate rather than into growth enhancing activities such as technology. In addition, the growth of the financial sector and the high remuneration it offers may have drawn talented individuals away from other productive sectors in the economy since financial and non-financial sectors compete for the same scarce supply of human capital. The need to limit its excessive growth applies not only to the financial system as a whole but also to individual institutions. I am referring here to the well-known too-big-to-fail problem. The recent crisis highlighted the risk of letting individual institutions grow excessively. Some of the recent regulatory changes (Total Loss Absorption Capacity, extra capital charges) can play a crucial role in solving such a problem, as I will discuss in detail below. In short, the long-term relationship between finance and growth is complex and non-linear. But the theory and evidence suggests that effective regulation is likely to be beneficial in the long run. What about the short-term impact of regulation? There are good theoretical reasons to believe that capital ratios' effect on growth should not be overly large. The famous Modigliani-Miller (MM) 'irrelevance' result states that firms' (and banks) business decisions are independent of their capital structure. Of course, the MM insight is developed in a highly idealised setting. For example, the tax advantages of debt and the liquidity services performed by short-term bank liabilities do drive a wedge between the cost of debt and equity for banks. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 79 But the empirical papers that have estimated this wedge have found it to be small. Regulators have gone to considerable length to assess the impact of the various regulatory initiatives. The regular quantitative impact assessments undertaken by the Basel Committee show that most reporting banks have made significant progress to meet the new regulatory requirements for capital and liquidity. The European Commission has published a comprehensive study that aims to estimate the joint economic impact of many regulatory initiatives. This study comes to the conclusion that the expected costs of the reforms will be compensated by the wider economic and societal benefits. Moreover, specific assessments have been made with regard to the macroeconomic impact of stronger capital, liquidity requirements and OTC derivative reforms. In the European context, the European Banking Authority and the Commission have assessed the macroeconomic impact of the regulatory reform for insurance companies and broadened the assessment with regard to the Liquidity Coverage Ratio and currently with regard to the Net Stable Funding Ratio. Overall, the evidence available from these studies demonstrates a positive or neutral impact on GDP growth. Slow growth in Europe has many structural causes So what is the cause of slow economic growth if not regulation? GDP growth comes from three main sources: greater productive efficiency (otherwise known as Total Factor Productivity or TFP), labour force increases and capital deepening (the increase in the amount of capital per worker). The contribution of all three factors has been declining over time and across countries as part of what has been termed 'secular stagnation'. The main reason why labour force growth has declined is population ageing. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 80 As the number of older retired people grows, the labour force is expected to decline at a rate of around 0.6% per annum by 2030. TFP growth has remained subdued at a rate of expansion of around 1% per annum. The determinants of TFP growth are not fully understood but among others, Robert Gordon has argued that TFP growth occurs in waves, driven by major innovations. So far, despite its great promise, the ICT revolution of the 1990s has not led to a pronounced and sustained pick-up in productivity growth in any of the major industrialised countries. Finally, the rate of capital deepening (the increase in the amount of capital per worker) has been weak in recent years reflecting low aggregate demand, financing constraints and weak business confidence. The contribution of this growth driver is expected to return to more normal levels as the economic recovery proceeds. Compared to these structural reasons for the slowdown in growth, the impact of financial regulation has been modest, at best. Another related consequence of secular stagnation may be that the natural real interest rate (the real interest rate consistent with full employment and stable inflation) has fallen. Population ageing has shifted the balance between older households who are likely to save and younger households who are likely to borrow. As a result, real interest rates have declined substantially in the last two decades. Nominal interest rates have also fallen in line with the real, leaving the 'normal' central bank policy rate much closer to the zero bound, thus increasing the likelihood of hitting it during deep recessions. Without getting into a discussion about the merits and risks of unconventional monetary policy, it is probably fair to say that the zero lower bound on nominal interest rates complicates the task of monetary policy in trying to stabilise large shocks. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 81 Financial crises are some of the largest peace-time negative shocks to hit market economies and our ability to use monetary policy in order to deal with them 'ex-post' would be impaired in a secular stagnation world. This makes the role of regulation in avoiding financial crises more important than ever. When it comes to dealing with financial crises, prevention is always better than cure but especially so when 'mopping-up after the crash' is complicated by the inability to cut short-term interest rates sufficiently far below zero. What has been achieved and what is in the pipeline? We have seen that, far from damaging growth, a strong regulatory framework is essential in ensuring strong long-term economic performance. Let me now briefly touch upon the key achievements of the efforts to reform the financial system. We have increased capital requirements well above the levels in force before the financial crisis. This will make banks more resilient to shocks and reduce their incentives to take excessive risks. We have identified the most systemically important institutions and require them to have additional capital buffers reflecting the significant externalities their failure would impose on the financial system and the economy as a whole. The introduction of the two liquidity ratios will make banks more resilient against sudden liquidity and funding shocks. These reforms were changes necessary to the regulatory framework but are, in my view, not yet sufficient for a stable financial system. In view of the current rhetoric of reform fatigue, it is important stress that we still need to finalise several important initiatives that are currently under way. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 82 They are all needed in order to effectively correct market failures and with the minimum of cost to the real economy. TLAC, the leverage ratio and the review of risk weights would help underpin the effectiveness of capital regulation in avoiding excessive risk-taking and protecting the real economy from the consequences of bank failure. The attempts to broaden non-bank funding sources in Europe via improved and safer securitisation practices, as well as capital markets union, should reduce the negative consequences of bank deleveraging now as well as in the future. Total Loss Absorption Capacity Let me begin with the TLAC initiative targeting the most systemically important banks. Too-big-to-fail is a very important source of market failures and I consider TLAC as an important element in effectively tackling this distortion. Allow me to highlight three elements of the proposal. First of all, the Financial Stability Board (FSB) is right in proposing a global Pillar 1 requirement with the possibility to apply additional Pillar 2 requirements. A pillar 1 requirement delivers a robust international standard for globally systemic important banks and ensures, at the same time, a global level playing field. Second, I agree with a Total Loss Absorbency approach with the capital buffers on top. Having the buffers sit on top of TLAC ensures that they can function as intended, regardless of the TLAC calibration. Additionally, it allows for a very strict intervention mechanism for TLAC non-compliance as for the duration of the breach of the buffer requirement, the automatic distribution restrictions specified in Basel III would apply. Third, I agree with benchmarking TLAC eligible liabilities against a non-risked weighted measure (the leverage ratio exposure) in addition to risk-weighted assets. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 83 Under the assumption that TLAC is appropriately calibrated, this ensures that for a failing bank, when risks have materialised and risk-weights do not matter anymore, the actual loss can be compensated and the bank successfully recapitalised. Nevertheless, I acknowledge that industry has raised several important issues to the TLAC proposal, in particular relating to the size of the required TLAC market, the impact on bank funding costs, the calibration and the link with the leverage ratio. Let me assure you that we take these issues seriously. This is why the FSB is performing a thorough impact assessment in close collaboration with the ECB and other members of the Basel Committee (BCBS). This assessment includes a shortfall analysis, a market survey to obtain estimates on investor base and pricing/spread of eligible liabilities, a microand macro-economic impact analysis and a verification of historical losses and recapitalisation - to analyse the proposed calibration. Having said this, all regulatory reform, and TLAC in particular, have an impact on the cost of doing business for banks. And insofar as the increase in funding costs is the result of the effective removal of the implicit state guarantee this is, in principle, welcome. The benefits of the removal of the implicit guarantee outweigh the individual increase in costs for society as a whole. Tax payers and their elected representatives have no appetite for another bail-out. TLAC will significantly reduce the externalities of a failure of systemically important institutions that are imposed on the real economy and will therefore have an overall positive effect on growth. The Leverage Ratio The finalisation of the Leverage Ratio (LR) framework should also be a key priority on the global regulatory reform agenda. Leverage was undoubtedly one of the root causes of the financial crisis. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 84 The 20 largest banks in Europe had built-up significant leverage before the financial crisis, as their ratios of Book Equity to Total Assets (a reasonable proxy for the new definition of the Basel Leverage Ratio) had fallen from 6% in the late 1990s to around 3% in 2008. Hence, a comprehensive and well-calibrated leverage ratio is an important tool for addressing such risks that might be circumvented or not captured by the risk-based framework. I therefore strongly support the migration of the LR to a Pillar 1 requirement, as foreseen by the Basel Committee. I also see a need to complement the micro-prudential minimum LR requirement by a macro-prudential LR framework. In particular, further work should be undertaken on the pros and cons of adding a buffer for systemically important banks to the LR framework. Large banks contribute most to excessive leverage with their greater costs of failure and their greater reliance on internal models. Further work looking at the relationship between the LR and the risk-based framework should be undertaken. For example, policy makers could consider adding a time-varying buffer. Such a buffer could help maintain the relative role of the LR in the capital framework once the countercyclical buffer is activated in the risk-based framework. There are some concerns about a negative impact of a binding LR requirement on lending to the real economy. Critics of the LR often argue that it would trigger significant additional capital requirements and, as a consequence, may make it more costly for banks to finance the real economy. However, I believe that these concerns are overstated for three reasons. First, as already mentioned, there are many reasons to believe that the impact of the higher capital requirements on growth in normal times should not be overly large. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 85 In any case, the latest Basel QIS study shows that the large majority of banks already satisfy the currently envisaged 3% minimum requirement. Any additional impact would be modest. Second, even if the LR leads to some contraction in lending, it may still be good for long-run growth if it helps to avoid costly crises. Finally, there is a more subtle effect by which the LR may actually help improve lending to the real economy. Recent evidence on risk-weights for SME lending in Europe 26 shows that the average capital cost for this activity in the risk-based framework is higher than under the LR. This would imply that in a situation where the LR becomes the binding measure for a subset of banks, banks may potentially increase SME lending at the expense of other activities, which have a preferential treatment in the risk-based framework relative to the LR framework. I would encourage further work on this matter that would present evidence on the significance of this effect. Risk weights Let me now turn to another key lesson we learnt in the aftermath of the financial crisis. The BCBS has shown that significant differences exist in the way banks estimate PDs and LGDs resulting in the reported capital ratios varying by as much as 2 percentage points for banks with similar exposures. We must address this variability of risks-weights, and bank's overreliance on internal models that produce them. Variability of risk-weights may arise because of data scarcity and complexity of models, but may also be a consequence of banks gaming the risk-weights. Behn et al (2014) provide an example of recent empirical work that clearly reveals this gaming behaviour within banks' use of internal models. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 86 By exploiting the staggered introduction of the model-based approach in Germany, Behn et al. show that (1) internal risk estimates employed for regulatory purposes systematically underpredict actual default rates by 0.5 to 1 percentage points; (2) both default rates and loss rates are higher for loans that were originated under the model-based approach, while corresponding risk-weights are significantly lower; and (3) interest rates are higher for loans originated under the model-based approach, suggesting that banks were aware of the higher risk associated with these loans and priced them accordingly. Fortunately, the BCBS has stepped up its efforts in this area. First, it has recently published a consultation paper on its new capital floor framework based on standardised approaches. These floors will limit the extent to which internal models can lower capital requirements relative to the standardised approach and therefore ensure that the level of capital across the banking system does not fall below a certain level. Second, the BCBS has recently established the high-level Task Force on Simplicity and Comparability mandated to undertake a strategic review of the capital framework in order to reduce reliance on models for some risks and portfolios. I expect both strands of work not only to improve the resilience of financial institutions but also to have a positive impact on lending to the real economy. Empirical evidence on the behaviour of German banks during the crisis suggests that loans subject to internal model capital charges were reduced significantly more than loans under the standardised approach to capital regulation, supporting the view that internal models are relatively more pro-cyclical than the standardised approach. The cited paper shows that, for the German banking system, loans subject to model-based, time-varying capital charges were reduced by 3.5 percent more than loans under the traditional approach to capital regulation, during the financial crisis. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 87 Hence, increasing the relative importance of the standardised approach should help to smooth the credit cycle, in particular by making deleveraging episodes less severe. Securitisation Another important strand of work, strongly pushed by the ECB in collaboration with the Bank of England, is the revitalisation of the securitisation market. When performed with proper regard to loan underwriting standards, securitisation can play a very important role in diversifying bank funding sources, freeing bank capital and allocating risk more efficiently within the EU financial system. This is particularly important in the current stage of bank balance sheet deleveraging when other funding sources must replace shrinking traditional banks. For securitisation to work in stimulating lending to the real economy, we need it to be simple and transparent. This would reduce the post-crisis stigma associated with securitised products and would improve non-bank investors' confidence in securitisations leading to higher demand. In turn this would free-up bank capital and allow banks to expand their own lending to the real economy. Capital Markets Union Finally, let me briefly touch upon a very recent initiative in Europe also aimed at improving financing of the real economy by broadening access to non-bank funding sources. This initiative follows the fashionable title of Capital Markets Union or CMU. Its objectives are very broad and the benefits may only materialise over the long-term. However, in a recently published Green Paper, the European Commission has highlighted a number of reforms which can improve enterprises' funding access also in the short-term. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 88 For example, lowering barriers to capital market access as well as the development of a European private placement market can make a difference in providing finance to the real economy. The shift in financing of the real economy from the banking system to markets and non-bank entities is already taking place. The role of CMU is to foster the effective and efficient allocation of financial resources at the European level while avoiding the vulnerabilities experienced during the recent episodes. As I said before, it is important to finalise these initiatives to address all the lessons we learned from the financial crisis. The current - indeed difficult - environment is the result of the crisis and the pre-crisis regulation. In order to leave this transitory environment and move into a new and more resilient steady state for the good of the financial sector, we need to complete the regulatory reform. Ultimately, this will have a positive effect on the real economy and lead to more sustainable growth. Missing elements: what about the rest of the system We had to make the banking system safer and I believe that, subject to the successful implementation of the measures discussed in the previous section, we are close to achieving this goal. But does this make the financial system as a whole less crisis-prone and more conducive to sustainable economic growth? Have we eliminated the market failures that make financial crises so costly for the real economy? So far, the regulatory reform has largely focused on the banking sector with the effect of pushing activities to less regulated and supervised parts of the financial system. Going forward, we need more information, and need to develop a monitoring framework and macro-prudential tools for the rest of the financial system. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 89 Non-banks can also exert costs on the wider financial system and can, just as easily as normal banks, become excessively risky and too-big-to-fail (just think AIG for example). Our regulatory framework must evolve in two key aspects. First, we need to have in place permanent tools for the more systemic players. Second, we need a toolbox for the less significant financial firms who could jointly destabilise the financial system. This essentially mirrors the macro-prudential approach that we have followed for the banking sector. Identifying systemic non-bank non-insurers In this respect, the current work of the FSB on a methodology for identifying Systemic Non-Bank Non-Insurers, in my view, addresses the first aspect of the remaining challenges. In this regard, let me highlight the importance of developing a framework that captures a wide-set of entities with this methodology. This is necessary for two reasons. First, it sends a signal to the industry that authorities stand ready to apply macro-prudential tools when systemic risks are identified. Second, we need to have a broad set of policy tools ready to address the risks stemming from financial firms at large. Focusing on a limited set of entities will not allow us to fully understand what instruments are needed in our toolbox. Going beyond systemic financial firms, it is necessary to develop appropriate macro-prudential tools to address the systemic risk of the remaining non-bank financial system. This is in the spirit of what has been done for the banking sector, where a range of policy tools is now available to address risks to banks from developments in specific markets and activities. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 90 The FSB's work on asset management goes in this direction and shows the road ahead. The build-up of leverage and the growing exposure to illiquid assets in the asset management sector are clearly relevant developments for macro-prudential supervisors. These need to be carefully monitored and assessed. However, macro-prudential policy cannot stop at this point. It is well-known that the liabilities of asset managers are subject to short-term redemption. Moreover, some asset managers hold a significant share of their assets in illiquid securities and use derivatives and short-term financing transactions to increase leverage and returns. The combination of these factors makes asset managers more prone to runs and asset fire-sales, which may spill-over to other parts of the financial system. A comprehensive toolkit to target these risks is therefore needed. More specifically, additional liquidity requirements and minimum redemption and load fees are potential tools that should be part of the macro-prudential toolbox. Haircuts for Secured Financial Transactions (SFT) and margin requirements for OTC derivatives Haircuts for securities financing transactions are a further tool that could prove to be effective. With countercyclical haircuts, as opposed to a regime with flat minimum requirements, the effects on volatility and leverage in financial markets may turn out to be stronger. Authorities should therefore consider using haircuts as a macro-prudential tool, e.g. by raising the numerical haircut floors and varying them over time in a countercyclical manner. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 91 Macro-prudential haircuts for SFTs could be complemented by similar tools that allow authorities to set countercyclical add-ons to margin requirements applied by CCPs, as well as for OTC derivatives. I would encourage further work to understand the effects of these tools and how to apply them in practice. Concluding remarks To kick-start growth in Europe is one of the most important challenges at present. I believe that the enhanced regulatory framework in place since the crisis can play a positive role in achieving this goal. We want a healthy and competitive financial system that supports sustainable long-term economic development rather than a return to deregulation and boom-bust cycles. As I have discussed, we still have to finish various initiatives, some of which are well under way. I expect these initiatives to help foster an environment of stable and healthy real economy. Challenges remain, of course. In view of the global problem posed by ageing populations, growth may not necessarily pick-up without further structural reforms. Low interest rates brought about by secular stagnation further complicate the tasks of both monetary policy and financial stability. A strong regulatory framework is essential in dealing with these challenges and avoiding future financial crises. However, an effective regulatory framework requires continued vigilance. We are currently experiencing a significant shift away from bank intermediated finance and this process will continue in the future. This requires a broadened toolkit, the ability to take decisive and intrusive macro-prudential policy actions as well as a framework that is capable of _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 92 expanding, in order to encompass all relevant systemic institutions and activities. This becomes even more critical when monetary policy needs to be accommodative, as I expect will be the case for the foreseeable future in the euro area. Thank you for your attention. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 93 Remarks at the Harvard Law School Symposium on Building the Financial System of the 21st Century: An Agenda for Europe and the United States Commissioner Daniel M. Gallagher Frankfurt, Germany Thank you, Hal [Scott], for that kind introduction. I apologize for not being able to address you in person. Back in 2013, I opened a speech to the American Academy in Berlin with a bit of German. While I managed not to call myself a jelly donut, my German was nonetheless so bad that I have been banned from entering the country to speak in a public forum. I applaud Professor Scott and the Harvard Law School for sponsoring this important and timely symposium. After the financial crisis, regulators around the world rushed to take action — any action, it seemed, so long as it allowed them to appear to be responding with alacrity to the greatest financial system upheaval in decades. In 2010, a U.S. congressional majority that was determined not to let a good crisis go to waste passed the Dodd-Frank Act with almost no minority party support. Dodd-Frank predated Congress’s own investigation into the causes of the financial crisis, as well as that of the overtly political majority of the Financial Crisis Inquiry Commission. When it became clear that Dodd-Frank would be a single party, runaway train of legislation, policymakers and special interest groups backed up their dump trucks to fill the statute with decades’ worth of pent-up wish list items. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 94 As a result, the Act as signed into law was a partisan manifesto untethered to the causes of the financial crisis. I call it a manifesto because despite running over two thousand pages long, the Act, laden with ill-defined, socially and politically motivated rulemaking mandates, punted even the rudiments of implementation to putatively independent regulatory agencies. What Dodd-Frank does on a domestic level, the G-20 and its implementing arm, the Financial Stability Board, are doing on an international basis. Although early on, certain U.S. regulators wanted to regulate the world unilaterally, most notably in the derivatives space, more recently, U.S. policymakers have worked hand in hand with the FSB in what passes as a multilateral effort to regulate the world financial markets. In doing so, they hijacked what used to be referred to as “regulatory harmonization” to meet their own ends. On its face, “regulatory harmonization” sounds like a noble goal: if jurisdictions could coalesce around a single set of high-quality standards, compliance burdens could be reduced with no real reduction of investor protections. Since the crisis, however, “regulatory harmonization” has taken on a new and worrisome meaning. Instead of facilitating cooperation among regulators from different jurisdictions, the concept of “regulatory harmonization” has morphed into a top-down, forcible imposition of one-size-fits-all regulatory standards on sovereign nations by opaque groups of global regulators. This “one world, one government” approach to regulation doesn’t allow itself to be bothered by musty old concepts like national sovereignty or consent of the governed. In 2009, the G-20 directed the FSB to coordinate the work of national authorities and multinational standard-setting organizations in the development of effective financial services regulation, with an emphasis on promoting financial stability. However, in reality, the FSB has been doing far more than merely coordinate the efforts of national regulators. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 95 Recently, as evidenced by a memorandum to FSB members from its chairman, Bank of England Governor Mark Carney, the FSB has removed all doubt of its real purpose: to direct national authorities to implement the FSB’s own policies. Mr. Carney explained in his memo that the FSB’s decisions must receive “full, consistent and prompt implementation” in member nations, as this “is essential to maintaining an open and resilient financial system.” And to make sure member nations know the FSB means business, Mr. Carney warned that the FSB’s key findings would be regularly reported to the G-20, the membership of which, it’s worth nothing, requires neither a democratic government nor free and transparent financial markets. In other words, fall in line or we will report you to your President. Even putting aside issues of national sovereignty and economic freedom, it remains the height of regulatory hubris to assume that not only is there a single regulatory solution to any given problem facing our markets, but that a handful of mandarins working in an opaque international forum can find those perfect solutions. In reality, while such regulators may get some things right, they will most certainly get some things wrong — and, having coerced the world to do it all one way, it will go wrong everywhere. There is no better example of this peril of this type of regulatory group-think than the capital standards set by the Basel Committee. In the pre-crisis era, these standards, among other things, classified residential mortgage-backed securities as lower risk instruments than corporate or commercial loans. Banks naturally responded to the incentives set under the Basel rules in constructing their balance sheets, resulting in homogeneous — and, as we now know, ultimately disastrous — business strategies and asset concentrations. When the housing bubble burst, the banks realized too late that these assets were toxic. As for the FSB, it certainly has been successful in its efforts to coerce cooperation from its members. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 96 Its decisions have been adopted with no obvious pushback or dissent from its members. And the member nations are now moving to implement the FSB standards into their domestic law. In the United States, for example, in every case where the FSB made a decision or announced a policy, the Dodd Frank-created Financial Stability Oversight Council, or FSOC, has followed suit. When the FSB announced that it was examining whether to extend its global systemically important financial institution, or G-SIFI, framework to non-bank, non-insurance financial institutions such as asset managers, FSOC’s research arm at Treasury rushed out a fatally flawed report portraying the asset management industry as a ticking time bomb of systemic risk. The FSB is continuing to pursue the potential designation of asset managers as G-SIFIs, and the only entities that would be picked up by the proposed criteria are U.S.-based. Indeed, the actions of the FSB seem tailor-made to provide the FSOC with justification to institute centralized command and control over the asset management industry. When the FSB designated four nonbank U.S. financial firms as G-SIFIs, the FSOC quickly moved to do so as well. And when the FSB recommended that bank-like capital requirements should apply to money market mutual funds that do not adopt a floating net asset value, the FSOC almost immediately pressured the SEC to adopt similar rules for money market funds. No one should be surprised by this. Both the Treasury and the Fed are members of the FSB — indeed, probably its most influential members. It is inconceivable that the designations of U.S. institutions as G-SIFIs would have gotten through the FSB without the express approval of the Fed and the Treasury. As such, even as the FSOC was conducting its supposedly independent analysis, its principal players — the Treasury and the Fed — had already approved designating these institutions as G-SIFIs. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 97 It is hard to avoid the conclusion, therefore, that the, FSOC’s so-called deliberations on whether to designate G-SIFIs as SIFIs were nothing more than show trials with preordained results. It is no wonder the FSOC has been reluctant to open its kimono and provide much needed transparency as it hastens to implement the decisions of an international conclave of unelected bureaucrats. FSB standards have not been ratified by the U.S. Senate, and FSB bureaucrats are not answerable to the U.S. Congress, much less the public. Yet these FSB edicts could work a profound change on the U.S. economy. This will, I believe, be counter-productive in the end. The more that these international bodies become seen as a means for foisting unpopular and antidemocratic decisions on a citizenry lacking any buy-in into the process, the less effective they will be in the end. Come to think of it, such unfettered, unaccountable supranational governance may sound familiar to some of our European friends here today. Let me be clear: I am not calling for the disbanding of international financial regulatory organizations. Rather, we must return these entities to their original pre-financial crisis purposes of facilitating cooperation among regulators from different jurisdictions. The concepts that steered these efforts were regulatory equivalence and substituted compliance. The ultimate goal was for regulators in each jurisdiction to recognize that many of their foreign counterparts had regulatory goals similar to their own, and that their regulatory approaches were of a high quality despite their differences. Indeed, there is usually more than one way to achieve any given regulatory objective, and it’s not always clear which way is “best.” Having acknowledged that there is more than one way to achieve the same goals, we as regulators could voluntarily choose to deem compliance with a _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 98 high quality foreign regulatory regime to qualify as a substitute for compliance with our own domestic requirements. In doing so, we could avoid complicated cross-border regulatory disputes and lend greater certainty and predictability to cross-border transactions. By avoiding layered, duplicative, and sometimes incompatible regulations, we could facilitate smoother and more efficient interactions between our respective capital markets, and by allowing and even encouraging heterogeneity of regulation, we could foster robustness and innovation in our capital markets. The current coercive approach to regulatory harmonization, on the other hand, is flawed as a matter of policy and will become increasingly impractical as the number of nations needing to be coerced grows. It is difficult enough to reach agreement on matters between the U.S. and Europe, despite their many similarities. Other markets, particularly in Asia, the Middle East, and other parts of the developing world, will undoubtedly — and in fact already have — considered going it alone. Others may not have been invited to the party in the first place, and so feel themselves under no obligation to play along. The mindset in many developed markets is to regulate first and ask questions later. This stifles entrepreneurs, their enterprises, and, of course, their employees and customers. Take the U.S. as a case study. We have seen a precipitous decline in the competitiveness of the U.S. capital markets dating back to before the financial crisis. In 2007, a report issued by a bipartisan U.S. Chamber of Commerce committee noted that the United States capital markets were steadily losing market share to other international financial centers. The report cited, among other things, internal, self-inflicted factors — such as an increasingly costly regulatory environment and the burdensome level of civil litigation — as problems that urgently needed to be addressed. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 99 Around the same time, the Committee on Capital Markets, an independent and non-partisan research organization led by my friend Professor Scott, issued a pair of reports also calling attention to the declining competitiveness of the U.S. securities markets. These reports cited a significant decline in the U.S. share of equity raised in global IPOs and a legion of statistics indicating that foreign and domestic issuers were taking steps to raise capital either privately or in overseas markets rather than in the U.S. public equity markets. This past November, the Committee on Capital Markets concluded that, as of the third quarter of 2014, the global competitiveness of the U.S. primary markets was at an historic low. The Alibaba IPO notwithstanding, foreign companies are choosing to raise capital outside U.S. public markets at rates far exceeding the historical average. In addition, foreign companies that raised capital in the U.S. are doing so overwhelmingly through private markets, rather than through initial public offerings. While I am a firm supporter of robust private markets, their popularity should not be the artificial result of extreme burdens we place on public companies. Some of this decline in U.S. competitiveness may simply be natural. As certain areas of the world continue their development, it is unrealistic to think that the traditional finance centers such as London, Frankfurt, and New York would continue their capital markets dominance indefinitely. A large part of this shift, however, is neither natural nor inevitable; rather, the wounds are self-inflicted. Not all jurisdictions have bought into to the mentality that it is best and safest to layer on law after law, regulation after regulation, as the United States and the European Union seem to have done. Middle Eastern and Asian markets did not experience the full brunt of the financial crisis, nor the resulting regulatory over-reaction prevalent in western countries. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 100 So rather than trying to smother their capital markets with new regulations in a misguided attempt to de-risk them, they have instead been spending their time enhancing their competitiveness. The U.S. and Europe must now compete with major markets such as Hong Kong, Singapore, and Shanghai. And there are new, emerging international financial centers, such as the Dubai IFC, designed to promote their countries’ financial sectors and the development of their capital markets through regulatory regimes intended to entice issuers and investors. The U.S. capital markets are significantly more developed than those in Europe. They provide approximately 80 percent of business financing, with the remaining 20 percent coming from banks. The exact opposite ratio applies in Europe. Recently, however, Europe has been taking some very interesting and hopefully beneficial steps towards expanding its capital markets. Specifically, the European Commission is looking at how member nations can build an efficient capital markets union. In February of this year, it issued a Green Paper to solicit comment on how to “unlock investment in Europe’s companies and infrastructure.” The EC is looking to develop stronger capital markets and is setting on the table for discussion how to remove the barriers to doing so. Similarly, there is an open consultation to determine if there are ways to simplify capital formation, particularly for smaller companies. It will be interesting to see what possible changes the EC recommends making in light of the directives coming from the FSB. At least one of the EC’s goals — to encourage high quality securitization — is directly at odds with the FSB’s agenda to increase the amount of capital banks must hold (and thereby not lend), as well as its agenda to crack down on “shadow banking” — which is simply another name for the capital markets financing. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 101 It remains to be seen how the EC will address the incongruity between their pro-capital market initiatives and the FSB’s capital market-killing efforts. In the U.S., the SEC and our fellow financial regulators should focus less on the misguided goal of de-risking our markets and more on eliminating the red tape that prevents small businesses from accessing our capital markets. We should implement these much-needed reforms to promote capital formation enthusiastically, not begrudgingly. When regulators do find a need to impose new regulatory burdens, those burdens must be tailored as narrowly as possible to address clearly identified problems and achieve the regulation’s stated goals. Doing so will require continued improvement of cost-benefit analyses to account not only for the direct and indirect impacts of the rule being analyzed, but also the burdens of the overall regulatory framework imposed on market participants. *** Furthermore, we need a renewed focus on eliminating duplicative or counterproductive regulation. Dodd-Frank has clogged up the SEC’s agenda for years, and I worry about the dampening effect this unending distraction may have on the capital markets pipelines linking investors with entrepreneurs. We need to pursue new initiatives to rejuvenate, not overregulate, our capital markets. To do so, we must increase our efforts to root out existing rules that place unnecessary and overly burdensome requirements on market participants. Internationally, we must find a new way: we must swap our regulatory hubris for humility, and work to find common ground with our international counterparts on areas where cooperation based on mutual respect and recognition can bear the most fruit. One idea along these lines would be to include financial services regulation in the pending Transatlantic Trade and Investment Partnership treaty, or “TTIP”. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 102 If financial services regulation is considered important enough to command the full-time attention of the G-20 and the FSB, then why not cover these issues legitimately and legally in a treaty ratified in the U.S. by the U.S. Senate? Halfway into a “lost decade” of stagnant growth, low job creation, and popular dissatisfaction, we must start to address these issues, and we must start now. Thank you for the opportunity to speak with you this evening. I would be happy to take any questions you may have. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 103 Issues for the Academic Community to Consider Steven B. Harris, Board Member PCAOB/AAA Annual Meeting Washington, DC Welcome to the 2015 PCAOB Academic Conference. The Board always benefits greatly from your participation at this forum. I think it is fair to say that by effectively educating future accountants and auditors, you play an essential role in protecting the integrity of financial statements upon which our capital markets are dependent. Before I continue, let me say that the views I express are my own and do not necessarily reflect the views of the Board or the PCAOB. Today I will touch on three topics: the evolving audit firm business model; recruitment at the firms and the various new skills sought by the firms; and the importance of diversity in the profession. I hope that you will consider examining each of these topics in your future research. Business Model of the Firms Both the PCAOB Investor Advisory Group and the International Forum of Independent Audit Regulators' (IFIAR) Investor and Other Stakeholders Working Group, each of which I chair, have raised concerns about the rise of advisory and consulting services at the largest accounting firms. Investor representatives are concerned that auditor independence and audit quality could be threatened by this growth. As you know, the rise in advisory and consulting services in the 1980s and 1990s is generally considered to have fundamentally changed the culture and tone at the top at the firms. Today we are told that, in some cases, firm leaders may be focusing more on offering broader services to audit clients and less on their core audit services, audit quality, and investor protection. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 104 Following the passage of the Sarbanes-Oxley Act, which prohibited the provision of a number of non-audit services by auditors to audit clients, three of the four major firms divested their advisory and consulting practices. Since then, however, each of these firms has rebuilt its advisory and consulting practice. And, today, these practices at the Big Four are growing much faster than other service lines. In 2014, at both the global level and domestically, revenues from non-audit services represented a larger percentage of total revenues than audit services. Here in the United States, revenues from advisory alone represent a larger percentage of total revenues than audit for the Big Four audit firms, on an aggregate level. Several indicators point to firms wanting to make advisory services an even more pronounced source of revenue in the future. These developments raise some fundamental concerns for investors, including: - Potential distraction by the firm and firm leaders away from audit and its core values, such as audit quality, independence, and investor protection, as they try to grow their advisory and consulting practices. - Potential use of inappropriate partner and staff performance measurements, such as emphasizing the promotion of new business and profits over audit quality. - Potential independence impairment stemming from insufficient monitoring of various services provided to audit clients by the firm and its affiliates. - Potential rise of internal conflicts within the firm resulting from (1) increasing conflicts between audit and advisory and consulting practices and _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 105 (2) non-audit service lines no longer needing the audit practice for brand recognition and business development. At the extreme case, this could cause instability in the firm and distract partners while the firm determines how to address these conflicts. Audit regulators around the world believe that this trend in the profession should be evaluated with considerable care to ensure that the rise in advisory and consulting at the firms do not adversely impact independence and audit quality and hence investor protection. This topic was discussed by the PCAOB's Investor Advisory Group at its October 2014 meeting and will be a major focus at the meeting of the International Forum of Independent Audit Regulators next week in Taipei. Concerns about the rise in advisory and consulting were also raised at the last IFIAR meeting held in Washington, D.C. in April 2014 by Ralph Whitworth, then Chairman of the Hewlett-Packard Board of Directors and Founder of Relational Investors LLC. At that meeting, Mr. Whitworth cautioned that, "audit regulators and audit firms must be constantly reminded of the Enron experience, and related scandals, so that we do not repeat the past." He went on to state: "I'm concerned that audit firms, by increasingly diversifying into non-audit corporate services, are beginning to fall victim to the incentives and dynamics that prevailed in the early 2000s. This will inevitably lead to a decline in audit quality, and likely already has…. To enhance audit quality, audit regulators should ensure that audit firms remain primarily focused on conducting effective independent audits." So, I encourage you to look at this issue. Attracting and retaining top talent A related topic that we continually hear about is the ongoing need for audit firms to attract and retain the best and brightest students to their audit practices. Some firms have justified the expansion of advisory and consulting services as a method to attract top talent for the audit service line. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 106 While I do not believe this is the only or best way to attract talent, I agree with the underlying premise that actions need to be taken to ensure top students are attracted to the profession. In the current market environment, the top students clearly have many options within an audit firm, including choosing to work for practices other than audit. The Board has heard, for example, that some students are questioning their decision to study accounting because of the higher salaries offered by the advisory and consulting practices of the firms. The audit practices of firms are facing these recruitment challenges at a time when they are also incorporating into their audit methodologies sophisticated data analytical tools through the use of emerging technologies that enable them to examine large amounts of data. As a result, the Board has been told that the hiring by audit firms of students in other fields of study, such as information technology, computer science, organizational change, finance, and statistics has increased in recent years. We are told that today incoming auditors must possess an ever-expanding portfolio of skills in order to be successful. For example, in a report released earlier this year, PricewaterhouseCoopers identified a number of new skills that incoming auditors must have in addition to an understanding of accounting and auditing. These new skills include: 1. An ability to research and identify anomalies and risk factors in underlying data. 2. An ability to mine new sources of data, and use insights to bring new value to the business. 3. A deep understanding of various types of databases. 4. An ability to use various statistical methodologies, visualization tools and predictive analysis tools. And, _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 107 5. An ability to use new data analysis techniques and algorithms to isolate and investigate specific processes that might have led to changes to the data and/or accounting ledgers. This raises the question of whether accounting programs should be altered in any way to better prepare students who are entering such a rapidly changing audit environment. For example, PwC suggests that data analytics, information systems, and statistics should become an even more integral part of the accounting curriculum. At the same time, however, there needs to be ongoing focused education regarding the nature of the underlying data and financial analytical training so that there can be insight into the meaning of data with the realization that auditing will always require judgment and insight and, in the future, likely greater analysis. I leave the feasibility of such changes to you and your respective universities. In any event, it is clear that the audit firms are moving ahead and using technology in new and innovative ways to potentially enhance the audit by providing 100 percent sampling, and it follows that audit firms now are in need of students graduating with the skill sets to match these enhanced auditing techniques. All of this raises a somewhat unrelated question, but one that I think also warrants your attention, and that is whether the firms' current pyramid staffing model with relatively few partners and managers overseeing many junior staff presents the best model for auditing large complex organizations, particularly given the growing complexity of audits and the judgment areas involved. Diversity Finally, I would like to offer a word about diversity and inclusion in the accounting profession. Last year at this time I noted that although all the major accounting firms, and for that matter many Fortune 500 companies, are increasingly focused on the concept of diversity and inclusion, we continue to hear that minority students are not particularly attracted to the accounting field. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 108 I also noted that, according to the 2012 U.S. Census Bureau Report, by 2043 there will be no single ethnic or racial majority group in the United States as the share of non-Hispanic whites falls below 50 percent. Since last year, more demographic information has come to my attention related to accounting firms. According to the AICPA's 2013 Trends in the Supply of Accounting Graduates and the Demand for Public Accounting Recruits, the career projection of minorities in accounting firms still lags significantly compared to their white counterparts even though the number of minorities in firms is increasing. I believe that the profession should continue to commit not only to attracting talented minorities to the profession, but also continue to put a high-level focus on creating the sort of inclusive environments where those individuals want to stay, contribute, and feel that they are an invaluable part of the team. We simply cannot afford old ways of thinking when America is going to look very different in the future. In addition, a growing body of research continues to show that having diverse work groups leads to greater organizational innovation and also may improve the bottom line of companies. It is quite simply a virtuous cycle of rewards when the accounting profession commits to these core values. So, I hope you will continue the work of increasing the recruitment, participation, and promotion of underrepresented groups in the profession. Such efforts, I believe, will position the profession well in our rapidly changing demographic universe. Conclusion Thank you again for coming today. I look forward to hearing more of your views on actions that the PCAOB should undertake as we continue to work toward protecting investors by improving audit quality. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 109 To G20 Finance Ministers and Central Bank Governors Financial Reforms – Progress on the Work Plan for the Antalya Summit In February in Istanbul, we agreed the following priorities for the FSB’s G20 financial regulation agenda: • full, consistent and prompt implementation of agreed reforms; • finalising the design of remaining post-crisis reforms; and • addressing new risks and vulnerabilities. These priorities support the focus of the Turkish G20 Presidency on the three “I’s” – Implementation, Investment and Inclusion by • monitoring, reporting and encouraging implementation of the agreed reforms; • addressing new risks to the financial system that could hinder its ability to finance investment in the real economy; and • tackling issues such as financial misconduct that can inhibit financial inclusion. This letter provides an update on progress at last month’s FSB Plenary meeting in Frankfurt. FULL, CONSISTENT AND PROMPT IMPLEMENTATION OF AGREED REFORMS Full, consistent and prompt implementation remains essential in order to maintain an open and resilient global financial system. To streamline and enhance reporting to the G20, the FSB Plenary agreed an outline of our first annual consolidated report on the implementation of the regulatory reforms and their effects, to be delivered to the Antalya Summit and published. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 110 The annual report will help underline those areas where the support of ministers is required to maximise the benefit from previously endorsed policy actions. The report will highlight progress, good practice and shortcomings and evaluate where there are either inconsistencies in implementation or unintended consequences that need to be addressed. Over time, these annual reports will enable the G20 to assess whether its reforms are achieving their intended results in an effective and efficient manner. National jurisdictions can help by contributing domestic evaluations of effects and unintended consequences of regulatory change. This report will also incorporate the outcomes from the FSB’s peer reviews, those of the standard setting bodies, our impact assessments, and analysis of the effects of reforms on long- term finance and on emerging market economies. One such peer review, which the FSB will publish shortly, covers members’ implementation of stronger frameworks and approaches for supervision of systemically important banks, aimed at delivering a more intensive and effective approach to supervision. FINALISING THE REMAINING POST-CRISIS REFORMS My February letter outlined further work this year on the international design of reforms in three areas: completion of the capital framework for banks; measures to help end too-big-to- fail; and initiatives to make derivatives markets safer. I reported in February on the actions being taken by the Basel Committee in the first of these areas, and will focus in this letter on the additional steps agreed in the second and third areas. Ending too-big-to-fail The FSB is reviewing the consultation responses on the proposal for total loss absorbing capacity (TLAC) published last November, and the various TLAC impact assessment studies are well underway. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 111 While there are a number of issues to be addressed, work is on track for the FSB to finalise the international standard by the Antalya Summit. We look to Ministers and Governors to support us in delivering on this commitment to Leaders. The FSB also reviewed steps to finalise policy measures for statutory and contractual approaches to cross-border recognition of resolution actions following the recent public consultation. As part of this initiative, work is underway to promote broad adoption of contractual recognition clauses to make temporary stays in respect of early termination rights effective in a cross-border context. We are also taking further steps this year to end too-big-to-fail for financial entities other than banks. The International Association of Insurance Supervisors (IAIS) will, by Antalya, finalise higher loss absorbency requirements for global systemically important insurers. The FSB published in March a second consultative paper on methodologies to identify non- bank, non-insurer global systemically important institutions. The growing use of CCPs for standardised OTC derivatives transactions is reducing systemic risks, but we must also ensure that CCPs themselves are not too big to fail. As you requested at your meeting in February, the FSB is pursuing with CPMI, IOSCO and BCBS a coordinated work plan to promote CCP resilience, recovery planning and resolvability. Key elements include: • evaluating existing measures for CCP resilience, including loss absorption capacity, liquidity and stress testing; • conducting a stock-take of existing CCP recovery mechanisms, including loss allocation tools, and considering whether there is a need for more granular standards; _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 112 • reviewing existing CCP resolution regimes and resolution planning arrangements, and considering whether there is a need for more granular standards or for additional prefunded capital and liquidity resources in resolution; and • analysing the interconnections between CCPs and the banks that are their clearing members, and potential channels for transmission of risk. Making derivatives markets safer As I reported in February, the G20 needs to ensure that the extensive work to date to introduce comprehensive trade reporting of OTC derivative markets is truly effective in providing authorities with an overview of systemic risks and reducing the opacity of these markets. To that end, the FSB has agreed a work plan to take forward, with CPMI and IOSCO, the standardisation and aggregation of OTC derivatives trade reporting data. This will identify where legal and other blockages to the reporting, sharing and aggregation of key information regarding trades need to be removed. In some jurisdictions, ministerial action may be required. ADDRESSING NEW RISKS AND VULNERABILITIES Following your meeting in Istanbul, the FSB has developed work programmes to address two specific emerging vulnerabilities: market-based finance and misconduct. Risks stemming from market-based finance The ongoing disconnect between risk-taking in financial markets and developments in real economies continues to pose the threat of disorderly adjustments in financial markets. While the trend towards greater market-based intermediation through asset management entities is welcome and should contribute to the overall resilience of the financial system by providing alternative sources of funding, it is important to ensure that any financial stability risks are properly understood and managed. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 113 With net credit creation largely reliant on bond finance, and emerging markets tripling annual issuance of international bonds since the crisis, there is a risk that a disorderly portfolio reallocation could generate a pronounced tightening of credit conditions for the real economies across the G20. Against this backdrop, the FSB is prioritising work to understand and address vulnerabilities in capital market and asset management activities. This will comprise two linked projects. The first will examine the likely near-term risk channels and the options that currently exist for addressing these. The second will consider the longer-term development of these markets and whether additional policy tools should be applied to asset managers according to the activities they undertake with the aim of mitigating systemic risks. Misconduct risks As discussed in Istanbul, the scale of misconduct in some financial institutions has risen to a level that has the potential to create systemic risks. To address misconduct risks, the FSB has agreed a work plan that will examine: • whether the reforms to incentives, for instance to risk governance and compensation structures, are having sufficient effect on reducing misconduct and whether additional measures are needed to strengthen disincentives to misconduct; • the progress of ongoing reforms to benchmarks, and whether steps are needed to improve global standards of conduct in the fixed income, commodities and currency markets; and • together with the World Bank and other relevant bodies, the extent of potential withdrawal from correspondent banking, its implications for financial exclusion, as well as possible steps to address this issue. EMERGING MARKET AND DEVELOPING ECONOMIES (EMDES) _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 114 With your support, the FSB has taken further steps to ensure that the issues of most importance to EMDEs are identified and addressed. When the FSB was established in 2009, participants from all G20 jurisdictions were included as founder members. And our work has benefited greatly from the global perspective that this has brought. To reflect the steady increase in the importance of EMDEs, at Frankfurt the FSB welcomed five new institutions as Plenary members – the ministries of finance or treasuries for Argentina, Indonesia, Saudi Arabia and Turkey and the South African Reserve Bank. Increased representation for emerging markets has delivered a key objective of the FSB’s 2014 review of the structure of its representation. Ahead of the Plenary meeting, the FSB held an Emerging Market Forum to discuss financial stability issues of particular relevance to these jurisdictions. The discussion centred on implementation of agreed reforms (including proportionality and sequencing), notably for Basel III, OTC derivative reforms and resolution. Discussions covered both implementation by EMDEs themselves and spill-overs from the way reforms are being implemented in advanced economies. We also discussed experience with macro-prudential policies in emerging markets, concerns about reduced availability of correspondent banking services, and the continued need to make local capital markets deeper and more resilient, as well as sovereign debt restructuring processes. The FSB, with the standard-setting bodies and international financial institutions, will now consider how they can best incorporate the points raised into their work plans. CONCLUSION Under the G20’s leadership, the FSB has a full and challenging agenda to build a resilient, open, and trusted global financial system that supports the _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 115 G20’s ultimate objective of strong, sustainable and balanced growth for all countries. _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 116 Disclaimer The Association tries to enhance public access to information about risk and compliance management. Our goal is to keep this information timely and accurate. If errors are brought to our attention, we will try to correct them. 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You may visit: www.risk-compliance-association.com/How_to_become_member.htm If you plan to continue to work as a risk and compliance management expert, officer or director throughout the rest of your career, it makes perfect sense to become a Life Member of the Association, and to continue your journey without interruption and without renewal worries. You will get a lifetime of benefits as well. You can check the benefits at: www.risk-compliance-association.com/Lifetime_Membership.htm 2. Weekly Updates - Subscribe to receive every Monday the 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: http://forms.aweber.com/form/02/1254213302.htm 3. Training and Certification - Become a Certified Risk and Compliance Management Professional (CRCMP) or a Certified Information Systems Risk and Compliance Professional (CISRSP). The Certified Risk and Compliance Management Professional (CRCMP) training and certification program has become one of the most recognized programs in risk management and compliance. There are CRCMPs in 32 countries around the world. Companies and organizations like IBM, Accenture, American Express, USAA etc. consider the CRCMP a preferred certificate. You can find more about the demand for CRCMPs at: www.risk-compliance-association.com/CRCMP_Jobs_Careers.pdf _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP) P a g e | 118 You can find more information about the CRCMP program at: www.risk-compliance-association.com/CRCMP_1.pdf (It is better to save it and open it as an Adobe Acrobat document). For the distance learning programs you may visit: www.risk-compliance-association.com/Distance_Learning_and_Certificat ion.htm For instructor-led training, you may contact us. We can tailor all programs to specific needs. We tailor presentations, awareness and training programs for supervisors, boards of directors, service providers and consultants. 4. IARCP Authorized Certified Trainer (IARCP-ACT) Program - Become a Certified Risk and Compliance Management Professional Trainer (CRCMPT) or Certified Information Systems Risk and Compliance Professional Trainer (CISRCPT). This is an additional advantage on your resume, serving as a third-party endorsement to your knowledge and experience. Certificates are important when being considered for a promotion or other career opportunities. You give the necessary assurance that you have the knowledge and skills to accept more responsibility. To learn more you may visit: www.risk-compliance-association.com/IARCP_ACT.html 5. Approved Training and Certification Centers (IARCP-ATCCs) - In response to the increasing demand for CRCMP training, the International Association of Risk and Compliance Professionals is developing a world-wide network of Approved Training and Certification Centers (IARCP-ATCCs). This will give the opportunity to risk and compliance managers, officers and consultants to have access to instructor-led CRCMP and CISRCP training at convenient locations that meet international standards. ATCCs use IARCP approved course materials and have access to IARCP Authorized Certified Trainers (IARCP-ACTs). To learn more: www.risk-compliance-association.com/Approved_Centers.html _____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)