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International Association of Risk and Compliance
Professionals (IARCP)
1200 G Street NW Suite 800 Washington, DC 20005-6705 USA
Tel: 202-449-9750 www.risk-compliance-association.com
Top 10 risk and compliance management related news stories
and world events that (for better or for worse) shaped the
week's agenda, and what is next
Dear Member,
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.
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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.
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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.
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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
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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
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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.”
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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.”
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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.
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International Association of Risk and Compliance Professionals (IARCP)
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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?
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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.
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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.
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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
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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
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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.
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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.
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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.
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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
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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.
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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
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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
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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.
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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.
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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.
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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”.
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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.
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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.
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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.
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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.
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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.
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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
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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
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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.
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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.
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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.
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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.
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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.
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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
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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.
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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.
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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.
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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”.
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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.
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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.
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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
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(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.
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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,
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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.
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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.
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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.
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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.
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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;
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•
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.
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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)
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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
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G20’s ultimate objective of strong, sustainable and balanced growth for all
countries.
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