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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,
Winston Churchill believed that a pessimist sees the
difficulty in every opportunity; an optimist sees the
opportunity in every difficulty.
There is risk in every opportunity. This is the reason we
need to undrerstand the principles of Opportunity Risk
Management (ORM). Today we have a good example.
“In 1969, on the day before Christmas Eve, Norway as a nation received the
gift of the century: we struck oil!
The Ekofisk oil field was the largest subsea oil field ever discovered. The
discovery of oil was the start of an extraordinary era for the Norwegian
economy.”
This is such an interesting speech by Mr Øystein Olsen, Governor of
Norges Bank (Central Bank of Norway), at the "Desemberkonferansen" oil
and gas conference, Kristiansund.
After some paragraphs, we read: “But this dependence on oil has also made
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the Norwegian economy vulnerable to changes in oil prices or a decline in
petroleum revenues.”
“As activity and earnings from the petroleum sector decline, oil service
companies must seek entry into other markets. With a high domestic cost
level, that task may prove demanding.
“A necessary adjustment of the cost level can occur in two ways: through
lower wage growth than in other countries or through a depreciation of the
krone exchange rate.”
Read more at Number 4 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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Response to the consultative
document ‘Developing Effective
Resolution Strategies and Plans for Systemically Important
Insurers’
The National Association of Insurance Commissioners (NAIC) has
reviewed the Financial Stability Board’s (FSB) consultative document on
“Developing Effective Resolution Strategies and Plans for Systemically
Important Insurers” (the “consultative document”). The NAIC’s comments
on the eight questions on page iv of the consultative document are as
follows.
The US economic outlook and implications for
monetary policy
Remarks by Mr William C Dudley, President and Chief
Executive Officer of the Federal Reserve Bank of New
York, at the Economic Leadership Forum, Somerset, New
Jersey
“My staff and I actively maintain ties with local community, business and
banking leaders, and we always benefit from opportunities to hear about
what is on your mind.
I am particularly delighted to see that community banks are well
represented here today.
The Federal Reserve understands the importance of a vibrant community
banking sector and the crucial role community banks play in supporting
the activities of local businesses and households.
While protecting the safety and soundness of the financial system is an
important part of the Federal Reserve's mandate, I believe that the
regulation of community banks should be appropriately calibrated to
reflect the lower degree of risk they pose to the financial system relative to
larger banks.”
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In other words, community banks should not be subject
to the same set of regulations that are applied to the most
systemically important banking organizations.
Persistent ultra-low interest rates: the challenges
ahead
Closing speech by Mr Jaime Caruana, General Manager of the BIS, at the
Bank of France-BIS Farewell Symposium for Christian Noyer, Paris
“The excellent presentations and discussions we have here today illustrate
not only the complexity of this period, but also the amount of work that has
been done to help understand the many puzzles and challenges - as
François Villeroy de Galhau put it in his opening remarks - and how to
address them.
It is beyond doubt that the swift actions of central banks when the crisis
first hit were crucial for preventing a financial and economic meltdown.
As Christian himself has emphasised, an important element of this crisis
response was the close cooperation among central banks, through constant
dialogue and, more concretely, cooperative
actions such as the establishment of currency
swap lines.”
The PCAOB’s Interests in and Use of
Auditing Research
Jeanette M. Franzel, Board Member
American Accounting Association, 2016 Auditing Section Mid-Year
Meeting, Scottsdale, AZ
Today I participated in a panel session entitled, "Opportunities for
Researchers to Inform the PCAOB," at the Mid-Year Meeting of the
Auditing Section of the American Accounting Association (AAA).
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The panel discussed opportunities for
academics to inform PCAOB policy
and decision making through
research and other collaborative
opportunities with the PCAOB.
Recent initiatives at the Board seek to
advance research related to the role of auditing in the capital markets.
Deutsche Bank response to Financial Stability Board
consultation on guidance on
arrangements to support operational continuity in resolution
Deutsche Bank welcomes the Financial Stability Board’s (FSB) proposed
guidance on operational continuity, to ensure that financial institutions
undertaking resolution planning have arrangements in place to ensure
continuity of critical shared services.
Without these, as the guidance notes, the continuation of critical functions
- a core objective of resolution - is unlikely to be possible.
Overall, we support the draft guidance, as it correctly focuses only services
that are critical to continue in resolution and recognises that a central
feature of operational continuity is effective contractual arrangements.
The guidance also rightly does not prescribe a particular service delivery
model and recognises that changes to achieve operational continuity in
resolution should consider the impact on the
effectiveness of firms’ operations on a going
concern basis.
As with all aspects of resolution planning,
changes to firms’ operating structures to remove
barriers to resolvability should only be
considered where necessary and proportionate to
do so.
The British Bankers’ Association’s (‘BBA’) response
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Guidance on arrangements to support
operational continuity in resolution
“This is the British Bankers’ Association’s (‘BBA’)
response to the above consultation; we welcome the
opportunity to provide our views.
The BBA is the leading trade association for the UK
banking sector with 200 member banks
headquartered in over 50 countries with operations in
180 jurisdictions worldwide.”
International banking statistics at end-September 2015
January 2016
The Bank for International Settlements (BIS) released international
banking statistics at end-September 2015.
Cross-border bank lending shrank for the second consecutive quarter, due
mainly to falling claims on emerging market economies (EMEs).
The global contraction of $151 billion between end-June and endSeptember 2015 was smaller than the previous quarter's and left
outstanding claims at $27 trillion.
Cross-border claims on advanced economies remained virtually unchanged
in Q3 2015, while those on EMEs declined by $142
billion.
The decline was primarily driven by emerging Asia,
and China in particular.
Cross-border bank credit to China fell by $119 billion
between end-June and end-September 2015, or by 17%
from a year earlier. Outstanding claims on China at
end-September 2015 totalled $877 billion, the lowest
in two years.
EIOPA sets out its strategic approach to riskbased and preventive conduct of business
supervision
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The European Insurance and Occupational
Pensions Authority (EIOPA) has published its
Strategy towards a comprehensive risk-based
and preventive framework for conduct of business supervision.
The document outlines EIOPA's strategic approach as well as the tools it
proposes to use to implement this framework.
FSB announces membership of Task Force on Climate-related
Financial Disclosures
Financial Stability Board (FSB) Chair Mark Carney announced in Paris on
4 December 2015 the establishment of an industry-led Task Force on
Climate-related Financial Disclosures (TCFD), with Michael R. Bloomberg
as chair, and that the initial membership of the Task Force would be
announced in due course.
Today the FSB announced the initial membership of the Task Force, which
will develop voluntary, consistent climate-related financial disclosures for
use by companies in providing information to lenders, insurers, investors
and other stakeholders.
The Task Force membership includes a balance between preparers and
users of financial disclosures, and comprises members from both financial
and non-financial companies across a range of countries and relevant areas
of expertise.
Managing Norway's oil wealth
Speech by Mr Øystein Olsen, Governor of Norges Bank (Central Bank of
Norway), at the "Desemberkonferansen" oil and gas conference,
Kristiansund
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In 1969, on the day before Christmas Eve, Norway as a nation received the
gift of the century: we struck oil! The Ekofisk oil field was the largest
subsea oil field ever discovered. The discovery of oil was the start of an
extraordinary era for the Norwegian economy.
Response to the consultative document ‘Developing Effective
Resolution Strategies and Plans for Systemically Important
Insurers’
The National Association of Insurance Commissioners (NAIC) has
reviewed the Financial Stability Board’s (FSB) consultative document on
“Developing Effective Resolution Strategies and Plans for Systemically
Important Insurers” (the “consultative document”). The NAIC’s comments
on the eight questions on page iv of the consultative document are as
follows.
1. Do you agree that authorities should identify institution-specific
resolution objectives as proposed in Section I.? Are there any
considerations relevant to that identification, additional to those
discussed in this document that should be covered in the Guidance?
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The NAIC agrees that group-wide and domiciliary supervisors responsible
for resolution should identify institution-specific resolution objectives.
However, we believe that the consultative document should be augmented
to include other considerations that are discussed below:
Recognition of Actual Jurisdictional Authority as the Basis for Resolution
Strategies and Plans
The consultative document’s introduction (pages 8-9) states that the
guidance "assumes that the Key Attributes have been implemented.
Where jurisdictions have not yet fully implemented the Key Attributes for
the insurance sector, resolution strategies and plans should be developed
on the basis of the powers and tools available under the regimes in force,
and periodically modified to reflect subsequent developments."
The determination of a preferred strategy (page 11) states that “CMG
authorities should develop a preferred resolution strategy that is best
capable of achieving the institution-specific resolution objectives given the
structure and the business model of the insurer, the resolution regimes
applicable to the legal entities of the group and the resolution tools
available to authorities in all relevant jurisdictions.
In cases where the tools specified in the Key Attributes have not been fully
implemented, authorities should also consider how the preferred strategy
may evolve once the full range of resolution tools is available.”
The NAIC believes that as the Key Attributes have not been fully
implemented in many jurisdictions, these assumptions appear unrealistic.
The NAIC recommends that the guidance should recognize jurisdictional
differences such that resolution strategies and plans consider the actual
resolution regime and legal authorities of the applicable jurisdiction(s)
rather than considering theoretical strategies that are not available.
The NAIC believes that it is important to note that the Foreword of the
FSB’s “Key Attributes of Effective Resolution Regimes for Financial
Institutions (Key Attributes)” states the following: “[t]o promote effective
and consistent implementation across jurisdictions the FSB will continue
to work with its members to develop further guidance, taking into account
the need for implementation to accommodate different national legal
systems and market environments and sectorspecific considerations (e.g.,
insurance, financial market infrastructures).”
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This recognizes that additional work is needed on the KAs, especially with
regard to insurance and jurisdictional items.
Although the consultative document does make some advancements in this
regard, utilization of the Resolution Key Attributes as a starting point for
this guidance continues to be problematic because the KAs, despite
including an annex for insurance, do not account for the many ways
resolution in the insurance context is different from resolution of other
financial institutions, like banks (e.g., differences in liability structures and
time frames), and do not adequately recognize the jurisdictional
differences throughout the world (e.g., national or federal vs. state or local
based regulatory structures).
Therefore, for example, applying the current KAs to the way insurance
companies are resolved under the U.S. state-based system poses a
challenge.
The consultative document throughout does not sufficiently implement the
above-stated goal of “accommodating different national legal systems.” The
NAIC believes that there needs to be greater recognition of the legal
differences between regulatory jurisdictions in the guidance.
For example, pursuant to U.S. federal law (McCarran Ferguson 15 U.S.C. §§
1011- 1015), U.S. State regulators are the primary regulators of insurance
groups in the U.S. Even after enactment of the federal Dodd-Frank Act (12
U.S.C. § 5301 et seq.), the powers of U.S. State regulators with regard to
U.S. systemically important financial institutions (SIFI) and global
systemically important insurers (G-SII) are not pre-empted, and this
includes resolution powers. See, 12 U.S.C. § 5374 (general prohibition
against preemption of U.S. state agencies); 12 U.S.C. § 5383(e) (provides
U.S. state laws shall apply to insurance company resolutions).
Policyholder Protection vs. Financial Stability
In the U.S. and other countries the business of insurance is affected with
the public’s keen interest in making sure that insurance companies are able
to pay policyholder claims whenever they come due, which is why in the
U.S. the primary objective of insurance regulation is policyholder
protection.
This strong public policy in favor of policyholder protection in the U.S. is
reflected in the priority provisions contained in laws governing insurer
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resolutions and the robust policyholder protection schemes available in the
U.S.
Although the consultative document is aimed at providing guidance for the
resolution of insurance groups designated as systemically important and
thus strategies for limiting systemic disruption should be implemented, we
believe that the consultative document needs to better acknowledge
jurisdictional differences with regard to resolution objectives.
The consultative document states that “[a]uthorities should develop
resolution strategies with the aim of maintaining financial stability and, to
the fullest extent possible, protecting policyholders when an insurer fails.”
The primacy of financial stability in this statement fails to recognize
jurisdictional differences.
For example, under U.S. law and as noted above, U.S. state regulators will
be responsible for conducting the resolution of the U.S. insurance entities
and the primacy of policyholder protection under those U.S. state laws has
not been preempted by federal law.
Thus, despite designation of a U.S. insurance group as a SIFI or a G-SII,
the U.S. federal authorities (Federal Reserve and the FDIC) do not have the
power to ignore state receivership laws or the primacy of policyholder
protection in the U.S. insurance resolution regimes.
While the Dodd-Frank Act does grant the Federal Reserve and FDIC
additional powers, which could be used to address concerns about financial
stability, those powers do not supersede policyholder protection objectives
inherent in the U.S. system.
While the NAIC agrees that institution-specific resolution objectives for
systemically important insurers should be identified, we note that such
resolution objectives should be developed in consideration of the unique
characteristics of insurance, as well as the requirements of the applicable
legal regime and jurisdiction(s).
Recognition of policyholder priority, the existence and role of policyholder
protection schemes, separate legal entity structures, and the general
principal of equal (parri passu) treatment of creditors of the same class are
paramount objectives that must be protected in any resolution strategy.
Accordingly, we question the legitimacy of a resolution strategy that would
deprive policyholders of fundamental contractual or statutory rights,
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including the absolute priority that insurance receivership statutes give
policyholders over the lower ranking claims of general and subordinated
creditors.
Home vs. Host Authorities
Generally, throughout the consultative document, use of the terms “home”
and “host” authorities is problematic because it fails to capture the
structure of various jurisdictions.
For example, even after the Dodd-Frank Act, the U.S. system of statebased
insurance regulation provides that insurance groups may have two groupwide, and thus “home,” supervisors - one federal and one state.
The NAIC recommends substitution of the term “group-wide
supervisor(s)” for home authorities or a definition of home authorities that
captures this U.S. regulatory structure.
We believe that a change in this regard will better align this document (and
the Resolution KAs if amended thereafter) with International Association
of Insurance Supervisors (IAIS) Insurance Core Principles (ICP) 23 and 25.
Review of Strategies & Plans
The NAIC agrees that resolution strategies and planning should serve as a
non-prescriptive guide to authorities for achieving orderly resolution in the
event that recovery attempts are ineffective.
However, we believe that the regular review of these strategies/plans
should be conducted not only by the Crisis Management Group (CMG)
through the Resolvability Assessment Process (RAP), but also during any
applicable supervisory colleges conducted by group-wide supervisors with
all other invited domiciliary and non-domiciliary jurisdictions.
The addition of this will better align the consultative document with the
descriptions of group-wide supervisors and the supervisory colleges in
ICPs 23 and 25.
2. Are the considerations for determining “points of entry into resolution”
as discussed in Section I.1 appropriate and relevant for the insurance
sector?
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The consultative document identifies several factors that should be taken
into account when identifying points of entry into resolution.
The NAIC recognizes that identifying points of entry into resolution is
appropriate for an insurance sector resolution strategy.
The considerations identified in the consultative document are all relevant.
Additional considerations may also exist and be identified, depending on
the unique nature and characteristics of the targeted institution and the
requirements of the legal regime and relevant jurisdictions.
Existence of a policyholder protection scheme (or guaranty association
coverage, in the U.S.) should be added to the list.
In the U.S., the statutory coverage obligations of guaranty associations are
triggered by an order of liquidation and a finding of insolvency, which
might not occur if resolution occurred only at the holding company level.
Further, depending on the cause of the financial distress within the group,
the insurance entities may be financially secure and able to satisfy all of
their financial obligations (AIG’s experience is a prime example).
Resolution planning, and evaluation of the appropriate point of entry, must
also consider whether the insurance entities may provide significant value
to the enterprise and whether the appropriate point of entry is separate
from the insurance operations.
3. Do you agree with the considerations in Section II and underlying
analysis in Section III for determining a preferred resolution strategy?
Are there other relevant factors that should be taken into account?
The NAIC agrees that the considerations identified in Section II of the
consultative document represent the primary categories for the evaluation
of a preferred resolution strategy with a few exceptions/questions noted
below.
The underlying analysis in Section III is also very helpful.
Final analysis of a preferred resolution strategy must include analysis of
the business segments and potential risks associated with a particular
target institution, as well as recognition of the requirements of the legal
regimes of the relevant jurisdictions for each institution.
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Comments on specific sections or topics are as follows:
Determination of a Preferred Strategy
Section II, 1, of the consultative document discusses the considerations
that should be used for determining appropriate point(s) of entry into
resolution.
Although the introduction of Section II acknowledges that a preferred
resolution strategy must take into consideration the “resolution regimes
applicable to the legal entities of the group and the resolution tools
available to authorities in all relevant jurisdictions,” the discussion of how
to choose appropriate points of entry does not include such considerations.
The consultative document when providing guidance on point(s) of entry
only provides for consideration of the group structure of the firm and the
way its activities are organized.
These considerations are important; however, the resolution authorities
can only act as permitted under the applicable laws enabling resolution
proceedings.
Thus, the NAIC believes that consideration of the applicable legal
authorities for resolution in a given jurisdiction should be added to the
considerations to be reviewed when determining appropriate point(s) of
entry.
Policyholder Protection Schemes
In the U.S., policyholder protection schemes (PPS) are an important
partner in the resolution process for insurance insolvencies. Section II, 3,
discusses PPS in a way that relegates consideration of the existence of such
important resolution tools to an evaluation of how they can support other
aspects of resolution, like the funding of a bridge institution.
Given the above-stated primacy of policyholder protection under
applicable U.S. laws, the NAIC believes that a more fulsome discussion of
the legitimacy and importance of PPSs as (1) vehicles that promote
financial stability through the protection of policyholders and (2) critical
participants in the resolution planning process (see Response 8 below)
should be incorporated into the consultative document.
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For example, the consultative document should consider the availability
and effectiveness of a PPS and whether it might mitigate the fear of access
to cash value becoming unavailable.
Additionally the consultative document should discuss that the existence of
a PPS may have an impact on the point of entry determination and run-off
strategies. (This comment also applies to Section III, 5.)
The consultative document says that if an asset shortfall cannot be met by a
contribution from a PPS (if available), it may be necessary to restructure
policyholder liabilities to enable a portfolio transfer.
This statement appears to view PPS solely as a source of funding (as is
often the case in a bank insolvency) and not as a participant in ensuring
continuation of policy obligations (as is the objective under U.S. insurance
laws).
We therefore disagree with this aspect of the statement. But we do agree
that there are circumstances in which protection of policyholders can be
enhanced through restructuring of policyholder obligations to enhance a
portfolio transfer.
The consultation document also says that, where liabilities to policyholders
need to be restructured in a solvent run-off, the policyholder protection
scheme (if available) may be able to make a contribution.
We do not understand why policyholder liabilities ever would need to be
restructured in a solvent run-off, or why a PPS should be called upon to
provide financial support in a solvent run-off.
In any event, in most jurisdictions in the U.S., guaranty association
protection is generally not available in the absence of a receivership order
with a finding of insolvency.
Further, we believe that reliance on a PPS in a solvent run-off increases
moral hazard if the management of an entity believes that it might be able
to rely on a PPS to assist in correcting poor management decisions.
“Wind down Tools”
On page 13, the "wind down tools" for an orderly run-off include terms and
descriptions that appear incongruous.
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A "run-off on an insolvent basis" is described as a process in which a
shortfall is allocated across creditors and policyholders, subject to the
creditor hierarchy.
A run-off in which policyholders and policy claimants absorb losses is
functionally similar to liquidation.
A "liquidation and winding-up" is listed as a separate "wind down" tool for
an orderly run-off. It might be clearer if the guidance did not use similar
and potentially confusing terms.
4. Are the resolution tools that are described in Section II.2 appropriate
for use in a resolution of an insurer? Should other tools be considered?
The NAIC agrees that the resolution tools identified in Section II. are
appropriate for consideration of an insurer resolution strategy.
Other tools may be identified and developed based on the legal authorities
of the jurisdiction, the unique characteristics of the targeted institution and
the applicable policyholder protection schemes.
5. Is the proposed framework for developing effective resolution
strategies and plans for systemically important insurers flexible enough
to take due account of the different types of business undertaken by
systemically important insurers?
The NAIC agrees that the framework proposed in the consultative
document for developing effective resolution strategies and plans contains
and should contain sufficient flexibility to account for the different types of
business undertaken by a target institution.
While maintaining flexibility in the framework, recognition of policyholder
priority, the existence and role of policyholder protection schemes,
separate legal entity structures, and the general principal of equal (parri
passu) treatment of creditors of the same class must be protected.
6. Is the proposed approach for identifying (i) critical functions (Section
III.2) and critical shared services (Section III.3) appropriate and relevant
for supporting the development of effective resolution strategies and
plans for systemically important insurers? If not, what aspects, if any,
are missing or need to be changed?
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The NAIC agrees that the proposed approach contained in the consultative
document is relevant and appropriate for developing effective resolution
strategies.
A resolution strategy should also include analysis of the regulatory
authority governing and potential legal impediments to continuation of
critical functions, continuity of insurance coverage, and operational
continuity, based on the legal regimes and jurisdictions applicable to
resolution of the targeted institution.
7. Are there arrangements, in addition to those set out in Section IV of the
draft Guidance, that may be needed to ensure that a resolution strategy
for an insurer can be implemented and that should be covered by this
guidance?
Section IV, 1 - The NAIC agrees that operational plans for implementation
of resolution strategies need to be developed.
However, it is unclear whether this section envisions development of an
operational resolution plan by applicable resolution authorities that is
separate from resolution planning by the designated insurance group. This
point needs to be clarified.
Also, in Section IV, 1, (i), the elements of the plan needs to be amended to
recognize jurisdictional differences discussed above.
Use of the term “national authorities” in this sub-paragraph is misleading
and should be eliminated.
We recommend the following substitute language: “different resolution
authorities, communication plans, etc.”
Similarly, in Section IV., 3, (i), use of the term “under the relevant national
regimes” is also misleading and fails to account for jurisdictional
differences in insurance regulation, including resolution as discussed
above.
We recommend the following substitute language: “under the relevant
resolution regimes.”
As discussed above, the NAIC believes that Section IV., 4, (i) and (iii)
should add supervisory colleges as another vehicle, in addition to CMGs,
through which establishment of the objectives and processes for
cooperation can be implemented by group-wide supervisors among all
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home and host authorities in order to better align the consultative
document with ICPs 23 and 25.
8. Are there any other issues in relation to resolution strategies and tools
or the resolution of insurers generally that it would be helpful for the FSB
to clarify in further guidance?
While prior FSB guidance emphasized the need for coordination between
resolution authorities and policyholder protection schemes, the
consultative document seems to view policyholder protection schemes only
as a source of funds, and not as an important partner in the insurance
resolution process.
In the U.S., regulators, receivers and the insurance guaranty system (or
PPS) work together closely to protect policyholders.
Our joint efforts have included contingency planning for the possible
liquidation of large and complex insurers and multi-insurer groups that
were experiencing financial challenges.
We believe that policyholder protection schemes can and should play an
important role in developing or assessing resolution strategies, and
therefore they should be part of crisis management groups and other
coordination efforts.
The NAIC appreciates the opportunity to submit comments.
If you have any questions, please contact Rashmi Sutton
([email protected]).
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The US economic outlook and implications for monetary policy
Remarks by Mr William C Dudley, President and Chief Executive Officer of
the Federal Reserve Bank of New York, at the Economic Leadership
Forum, Somerset, New Jersey
It is a pleasure to have the opportunity to join you again at the Economic
Leadership Forum.
I would like to thank John McWeeney of the New Jersey Bankers
Association and Rutgers University for the invitation to be here today.
Northern New Jersey is a vital part of the New York Fed's district, and I
don't just say that because I live here.
My staff and I actively maintain ties with local community, business and
banking leaders, and we always benefit from opportunities to hear about
what is on your mind.
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I am particularly delighted to see that community banks are well
represented here today.
The Federal Reserve understands the importance of a vibrant community
banking sector and the crucial role community banks play in supporting
the activities of local businesses and households.
While protecting the safety and soundness of the financial system is an
important part of the Federal Reserve's mandate, I believe that the
regulation of community banks should be appropriately calibrated to
reflect the lower degree of risk they pose to the financial system relative to
larger banks.
In other words, community banks should not be subject to the same set of
regulations that are applied to the most systemically important banking
organizations.
In my remarks, I will discuss the U.S. economic outlook and the
implications for U.S. monetary policy.
I will focus primarily on last month's Federal Open Market Committee
(FOMC) "lift-off" decision - the first increase in the federal funds rate
target range in nearly 10 years.
I'll explain what motivated my vote to begin to normalize U.S. monetary
policy.
I'll also offer a preliminary assessment of how things are going so far - both
with respect to how the U.S. bond market reacted to lift-off and how well
our new tools are working as we begin to push up short-term interest rates.
Both issues are pertinent, as money market rates have spent a very long
time close to zero and we have never attempted to tighten monetary policy
with such a large balance sheet and high level of excess reserves.
To summarize my conclusions: Generally so far, so good on both fronts.
Looking ahead, I'll talk about what comes next. No surprises here - it
depends on the data.
As noted in the December FOMC statement, we expect that the
normalization of monetary policy will be quite gradual. But, there is no
commitment here.
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The flow of the data - broadly defined - will drive our actions as it
influences our assessment of the economic outlook and our view of the
stance of monetary policy best suited to achieve our dual mandate
objectives of maximum sustainable employment and price stability.
As always, what I have to say reflects my own views and not necessarily
those of the FOMC or the Federal Reserve System.1
In terms of the economic outlook, the situation does not appear to have
changed much since the last FOMC meeting. Some recent activity
indicators have been on the softer side, pointing to a relatively weak fourth
quarter for real GDP growth.
But this needs to be weighed against the strength evident in the U.S. labor
market.
I continue to expect that the economy will expand at a pace slightly above
its long-term trend in 2016.
In other words, I anticipate sufficient economic strength to push the
unemployment rate down a bit further and to more fully utilize the nation's
labor resources.
Turning to inflation, we continue to fall short of our 2 percent objective for
the personal consumption expenditure (PCE) deflator.
But I take it as a positive sign that the core PCE inflation rate - that is,
excluding food and energy - has been quite stable despite the downward
pressure being exerted by lower energy prices on the prices of non-energy
goods and services, as well as the drop in non-energy import prices from a
firmer dollar.
Going into more detail, U.S. economic activity has areas of both strength
and weakness.
On the stronger side of the ledger, domestic demand is doing reasonably
well.
In particular, consumption and housing activity continue to expand at a
moderate pace.
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Consumer spending has been supported by solid real disposable income
growth, which has been underpinned, in turn, by sturdy job gains and
falling energy prices.
Residential investment has been slowly increasing for several years and
that trend seems likely to continue in 2016.
Housing starts are still well below the rate consistent with the nation's
population growth rate, and the fundamentals of housing demand remain
positive.
Rising employment is likely to boost the household formation rate and low
mortgage interest rates should keep housing relatively affordable, despite
the ongoing recovery in home prices.
Last month's passage of a fiscal 2016 budget package should also provide
support to economic activity.
Not only does this budget package reduce uncertainty about the budgetary
outlook, but its extension of a number of tax breaks and easing of the caps
on domestic and military spending means that fiscal policy in 2016 will
likely turn somewhat stimulative.
On the weaker side, the collapse in energy prices continues to pull down
domestic investment in oil and gas drilling projects.
Although this adjustment is now well-advanced, I suspect that there
remains a further leg down given the sector's diminished cash flows and
the reduced access to credit.
In addition, manufacturing remains very soft - hurt by the drop in energyrelated investment, an ongoing inventory adjustment and the loss of
competitiveness caused by the persistent strength of the U.S. dollar.
Even the one bright spot in manufacturing over the past year - the auto
sector - seems to be close to a cyclical peak.
Thus, I suspect manufacturing will continue to be soft in 2016.
Overseas developments, especially with respect to the emerging market
economies, pose a risk to the U.S. economic outlook - potentially exerting
greater restraint on the demand for U.S. exports and contributing to
greater turbulence in global financial markets.
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Putting these positives and negatives together, the most likely outlook
seems to be more of what we have experienced in this expansion - an
economy that grows at slightly above a 2 percent annual rate this year.
The inflation outlook also has not changed much. Inflation remains well
below the Federal Reserve's 2 percent objective.
In my assessment, this is due mainly to weaker energy prices and the
impact of a stronger dollar on non-energy import prices.
However, the fact that core measures of inflation are considerably higher
than the headline readings, and have been quite stable in recent months,
suggests to me that we are likely to see inflation rise once energy prices
stop falling and the dollar stops appreciating - clearly neither trend can
persist indefinitely.
Of course, this assumes that the U.S. economy grows sufficiently rapidly so
that pressure on available labor and capital resources continues to
increase.
With respect to the risks to the inflation outlook, the most concerning is
the possibility that inflation expectations become unanchored to the
downside.
This would be problematic were it to occur because inflation expectations
are an important driver of actual inflation.
If inflation expectations become unanchored to the downside, it would
become much more difficult to push inflation back up to the central bank's
objective.
Japan's difficult experience indicates the importance of avoiding such an
outcome.
For this reason, we closely monitor inflation expectations. Inflation
measured by the PCE deflator has been running below the FOMC's
objective since May 2012.
A concern is whether these persistent underruns in inflation may be
beginning to weigh on inflation expectations.
Some surveys of inflation expectations have softened recently.
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For example, the University of Michigan measure of median long-term
household inflation expectations - that is, expected inflation at a five-to
ten-year horizon - is currently at 2.6 percent.
This is near the very bottom end of its range over the past two decades.
The New York Fed's Survey of Consumer Expectations also shows softness.
The median of 3-year inflation expectations has declined over the past
year, falling by 22 basis points to 2.8 percent.
While the magnitude of this decline is small, I think it is noteworthy
because the current reading is below where we have been during the survey
history.
Up until July 2014, the median largely stayed in the range from 3.2 to 3.4
percent, and from July 2014 to July 2015 it remained near 3 percent.
While it has a short history, I put more weight on the New York Fed's
survey because its methodology should be more robust in accurately
assessing consumer inflation expectations.
Compared to the more widely followed University of Michigan survey, for
example, the New York Fed survey has several advantages.
The sample size is larger, most of the people that are interviewed are the
same each month, and the inflation expectations question is posed
differently to focus the respondent's attention on inflation rather than on
prices.
We believe that all these factors lead to a more reliable estimate of inflation
expectations.
Obviously, I didn't think the degree of weakness we have seen in our survey
measure of inflation expectations was of sufficient concern to defer the
start of monetary policy normalization.
And, as long as the economy continues to grow at an above-trend pace, I
expect the increase in resource utilization will be sufficient to push both
inflation and inflation expectations higher over time.
That said, should the economy unexpectedly weaken, then this fall in
inflation expectations would become more concerning.
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Assuming, as I anticipate, that inflation does move back towards our 2
percent target, I am often asked how tolerant would I be of an overshoot?
In other words, is the 2 percent inflation target a ceiling or not?
I don't think of the 2 percent objective as a ceiling. I would be equally
intolerant of misses relative to 2 percent in both directions, above or below,
with my intolerance growing the further we deviated from our 2 percent
objective.
We will almost certainly never be precisely at our 2 percent objective for
any length of time given all the forces - many of which are not under our
control - that influence actual inflation outcomes over a business cycle.
Thus, with a neutral monetary policy, my goal would be to spend about the
same amount of time slightly above as slightly below our 2 percent
objective.
Turning now to U.S. monetary policy, why did I favor raising the federal
funds rate target last month?
Basically, my assessment was that our conditions for lift-off had been met.
Recall, these two conditions were:
1) further improvement in the labor market that we anticipated would be
sustained in 2016, and
2) greater confidence that inflation would begin to move back towards our
2 percent inflation objective over the medium term.
The timing of policy normalization involves a balancing of risks. I don't
disagree with our critics that there were risks from lifting off in December
versus waiting a little longer.
First, the economy might turn out to be more fragile than we anticipate, or
economic shocks could push the economy off-course relative to our
expectations. In other words, our economic projections might be too
optimistic.
Second, the first tightening move might itself provoke another taper
tantrum characterized by higher bond yields and tighter financial market
conditions that could be sufficiently strong to impede the economic
recovery.
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My judgment was that these risks were manageable.
First, downside forecast errors are certainly possible, but the U.S. economy
appears to be on sufficiently sound footing to withstand downside shocks
better than was the case a few years ago.
Second, I felt that the likelihood of a substantial tightening in financial
market conditions due to lift-off was relatively low, in part, because the
rate hike was widely anticipated.
Market conditions had adjusted quite smoothly - except for some strains
observed in the high-yield debt market - as market participants placed
higher odds of tightening in the weeks preceding the December FOMC
meeting.
This reinforced that conclusion. A large market reaction would have been a
surprise given that this was one of the most anticipated monetary policy
events in history.
Also, the policy action needs to be viewed in context.
While this decision was the first upward adjustment to short-term rates in
nearly 10 years, the actual move was small - only 25 basis points - which,
by itself, should have only a very mild impact on the overall trajectory of
the economy.
As we noted in the FOMC statement and as Chair Yellen pointed out in her
December press conference, even after this rate hike, the stance of
monetary policy remains accommodative.
Moreover, it is important to recognize that there are also significant risks
from waiting longer to lift off.
Upside forecast errors are also certainly possible. For example, while the
pace of growth has generally been weaker than expected in recent years,
the pace of labor market improvement has generally been stronger.
By waiting, we would increase the risk that we would need to raise rates
more aggressively in the future.
This could unduly threaten the economic expansion. In balancing these
risks, relatively "early and slow" seems like a better strategy than "late and
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fast" - especially when one is uncertain both about the degree of
accommodation being provided by monetary policy and the level of
unemployment consistent with our price stability mandate.
Because monetary policy works with a lag, policy normalization needs to
begin before the economy reaches its employment and inflation objectives.
That is, if we are to get to a neutral monetary policy setting before inflation
materially overshoots our 2 percent objective, then we need to get started.
Once underway, the pace of policy tightening can be calibrated to how the
economy and financial market conditions are responding.
A particular risk of late and fast is that the unemployment rate could
significantly undershoot the level consistent with price stability.
If this occurred, then inflation would likely rise above our objective.
At that point, history shows it is very difficult to push the unemployment
rate back up just a little bit in order to contain inflation pressures.
Looking at the post-war period, whenever the unemployment rate has
increased by more than 0.3 to 0.4 percentage points, the economy has
always ended up in a full-blown recession with the unemployment rate
rising by at least 1.9 percentage points.
This is an outcome to avoid, especially given that in an economic downturn
the last to be hired are often the first to be fired. The goal is the maximum
sustainable level of employment - in other words, the most job
opportunities for the most people over the long run.
Some of you may be wondering whether the risk of a recession isn't already
quite high? And, if so, doesn't this imply a need for special care in adjusting
monetary policy?
After all, the current economic expansion is more than six years old - a bit
long in the tooth by post-war standards.
Even so, recession risk did not play a major factor in my thinking.
Economic expansions don't simply die of old age.
They primarily end either because monetary policy is kept too loose for too
long, thereby necessitating a subsequent sharp tightening in monetary
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policy to prevent a significant inflation overshoot, or because some large
adverse shock hits the economy that the central bank cannot easily offset.
Mitigating the first risk of being forced to choke off the expansion argues
for getting started with policy normalization now rather than holding off.
With respect to the second risk of unanticipated shocks, this is obviously
very difficult for the central bank to insulate the economy from. Making
sure the financial system is robust and resilient is probably the most
important thing the central bank can do in this respect.
I would like to turn now to the issue of how the initial step in normalization
is going. The U.S. bond market response to lift-off has been very mild.
There has been no bond market "taper tantrum" such as what occurred in
2013 when Chairman Bernanke discussed the possibility of tapering
Federal Reserve asset purchases.
Normalization is also going very well in the sense that, even with an
extraordinarily large balance sheet, the tools we have developed to raise the
federal funds rate (and other money market rates) have so far worked well.
The federal funds rate is trading close to the middle of the new target range
of 25 to 50 basis points and other money market rates have moved up in
tandem.
Why is this noteworthy? To explain, I'll first have to provide some
background on how monetary policy used to work before the crisis and
then compare that regime with how it works now.
Before the financial crisis, banks valued reserves - even though the Federal
Reserve paid no interest on them - because the Federal Reserve kept their
supply scarce.
When the FOMC wanted to adjust its federal funds rate target - that is, the
interest rate banks earn or pay when lending or borrowing overnight
reserves with another bank - it directed the System Open Market Account
(the Desk) manager in New York to alter the supply of reserves within the
banking system (up or down) as needed to match the estimated demand
for reserves in order to keep the federal funds rate very close to the FOMC's
target.
In this setup, the amount of banking reserves in the system - required and
excess - was very small and the Desk typically conducted open market
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operations that added or drained no more than a few billion dollars of
reserves from the banking system to ensure that the federal funds rate
traded around the FOMC's target.
In October 2008, after passage of the TARP legislation, the Federal
Reserve was authorized to implement a new tool, the ability to pay interest
on required and excess reserves.
This tool was significant because it meant that the FOMC would be able to
control interest rate policy even with a much larger balance sheet and a
much larger amount of excess reserves in the banking system.
This was important because it gave us more scope to expand the Federal
Reserve's balance sheet to help address the financial crisis and to provide
support for the economic recovery, knowing that later, when the recovery
took hold, we could raise interest rates even with an enlarged balance
sheet. The Fed wouldn't necessarily be forced to return to the much smaller
balance sheet we had prior to 2008 before we could begin the monetary
policy normalization process.
When interest is paid on reserves, these reserves retain value even when
they are no longer scarce.
Banks may be able to borrow funds at lower interest rates from financial
entities such as money market funds that are not permitted to hold
deposits at the Federal Reserve and place these borrowed funds with the
Federal Reserve to earn the higher interest rate paid on reserve balances.
How well the ability to pay interest on reserves works in practice in raising
the entire constellation of short-term interest rates depends critically on
the willingness of banks to engage in such arbitrage activity.
Prior to lift-off, we were uncertain how much friction there might be that
would limit the willingness of banks to expand their balance sheets.
These frictions include limits on bank leverage that can make the use of
balance sheet capacity costly, competitive frictions given the relatively
narrow range of banks that are viewed as sufficiently creditworthy to
warrant being recipients of large uncollateralized loans and, for those
banks that accept FDIC insured deposits, insurance premiums that
increase when they borrow reserves and their total liabilities increase.
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To help ensure that money market rates would track the federal funds rate
regardless of these frictions, the FOMC developed a second tool - the
overnight, fixed-rate, reverse repurchase facility (overnight RRP).
In this facility, a number of financial entities, such as money market funds,
that cannot hold reserves at the Federal Reserve can lend funds overnight
to the Federal Reserve against the Fed's Treasury collateral and receive the
overnight RRP rate - currently 25 basis points.
The overnight RRP provides these institutions with an alternative
investment if the interest rate offered by banks is unattractive.
Consequently, these financial entities should be unwilling to lend funds to
banks and others at lower rates than the overnight RRP rate.
The overnight RRP rate should act, therefore, as a floor on money market
rates.
As I noted earlier, the tools are working as anticipated.
Not only is the federal funds rate trading close to the middle of the new 25
to 50 basis point target range, but the entire complex of money market
rates, such as LIBOR deposits and GCF repo, has also risen as well.
Moreover, apart from a temporary spike in usage around year end, which
was expected, the usage of the overnight, fixed rate reverse repo facility has
fallen back to levels similar to what we saw during the testing phase.
In recent days, usage has averaged less than $100 billion per day.
Thus, the facility has been absorbing only a small fraction of the $2.4
trillion of excess reserves in the banking system.
This demonstrates that to firm interest rates, we don't necessarily have to
drain reserves or shrink the size of our balance sheet.
We are very pleased by how well our tools are working, and this has
reinforced our confidence that they will support the policy normalization
process going forward.
This is what we expected given our extensive testing, but there are always
uncertainties that only can be resolved by actually getting underway.
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For example, there was some residual uncertainty about how important a
factor the zero lower bound of interest rates had been in supporting the
federal funds rate and other money market rates.
This uncertainty now has been at least partially resolved.
Even as we have moved away from the zero lower bound, the relative yield
relationships we saw before December's federal funds rate hike have
persisted.
So what's on the docket for monetary policy in 2016?
The answer is that it depends on how the incoming data weighs on the
outlook, and how changes in the outlook influence our views on the
appropriate setting for monetary policy.
What I can say is that our expectation at the December FOMC meeting was
for further interest rate hikes in 2016 and beyond. Participants anticipated
that the federal funds rate would likely continue on a gradual upward path.
Over the longer term, FOMC participants expected that the federal funds
rate would eventually reach 3 to 4 percent as inflation rose back to our 2
percent objective and the headwinds from the financial crisis that had been
restraining economic activity fully dissipated.
Even though this path is shallow relative to previous tightening cycles, the
median federal funds rate path of FOMC participants in the December
Summary of Economic Projections (SEP) is well above the path implied by
the federal funds futures market.
Should this be a concern? Does this imply that there is a significant risk of
an abrupt future spike in short- and long-term interest rates as market
rates realign to levels more consistent with the median FOMC participants'
projections?
I don't think so for several reasons.
First, the SEP projections are modal forecasts - that is, what the
participants believe is most likely to happen - whereas those embodied in
market prices are a mean - that is, an average across all possible outcomes.
One might reasonably expect these modal forecasts to be above the mean
when inflation is low and the economic outlook is uncertain.
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Second, the median federal funds rate forecasts for primary dealers and for
buyside participants surveyed just prior to the December FOMC meeting
differed only marginally from the December SEP median projections of
FOMC participants. This reinforces my judgment that the difference
between means and modes is the main factor for the gap between the
federal funds futures market and the SEP paths.
Third, the differences between the interest rates implied by futures
markets and the SEP have been quite small at shorter-term time horizons,
such as the end of 2016, and grow much larger as the time horizon
lengthens.
I think this is noteworthy because the confidence one has at longer
horizons should be much lower than at shorter horizons.
Because I do not know what the federal funds rate target range will be at
the end of 2017 or 2018 with any confidence, I am not very concerned if
others have a different modal forecast.
Projections will adjust as incoming information changes the economic
outlook.
I would expect convergence over time of the SEP and market expectations
as new information informs the outlook.
Let me close with some observations about my current thinking concerning
our reinvestment of maturing Treasury securities and paydowns in our
agency MBS holdings.
As we noted in the December FOMC statement, we anticipate that we will
continue reinvestment "until normalization of the federal funds rate is well
underway."
I think this policy makes sense not only because the decision to end
reinvestment will represent a further tightening of monetary policy, but
also because it is difficult to assess ahead of time the impact of such a
decision on financial market conditions given the lack of historical
experience.
I also believe that continuing reinvestment until the federal funds rate
reaches a higher level makes sense.
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We want to ensure that we have the ability to respond to adverse shocks by
easing monetary policy by lowering the policy rate.
Having more "dry powder" in the form of higher short-term interest rates
seems more desirable than less dry powder and a smaller balance sheet.
Now the words "well underway" in the FOMC statement are vague - what
does that mean in terms of the level of the federal funds rate?
Reiterating the disclaimer that I am speaking for myself, my view is that we
should not set a numerical tripwire for ending reinvestment.
If the economy were growing very quickly and the risks of an early return
to the zero lower bound for the federal funds rate were deemed to be low,
then I could see ending reinvestment at a relatively low federal funds rate.
In contrast, if the economy lacked forward momentum and the risks of a
return to the zero lower bound were judged to be considerably higher, I
would want to continue reinvestment until the federal funds rate was
higher. Consistent with the general principles I mentioned before, the
evolution of the overall monetary policy stance - both interest rate
decisions and balance sheet developments - should be data dependent.
In my view, good monetary policy-making requires ongoing assessment
and judgment, not the adherence to mechanical rules.
I know market participants desire certainty, but in the uncertain world in
which we live, that desire is not consistent with the policy that would best
achieve our objectives.
We will strive to communicate as clearly as we can so you can think along
with us and alter your expectations just as we do in response to incoming
information.
Thank you for kind attention. I would be happy to take a few questions.
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Persistent ultra-low interest rates: the challenges ahead
Closing speech by Mr Jaime Caruana, General Manager of the BIS, at the
Bank of France-BIS Farewell Symposium for Christian Noyer, Paris
It is a great pleasure and privilege for the BIS to co-organise and to
participate in this symposium in honour of Christian Noyer.
Christian has served as a central banker in an era of unprecedented
challenges. One major challenge was the establishment of the euro, to
which Christian made a major contribution as Vice-President of the ECB.
Those were quite exciting days, but in retrospect they were really days of
tranquillity. A far greater challenge for central banks, and for Christian as
Governor of the Bank of France, has been the management of the various
stages of financial and economic crisis since 2008.
The excellent presentations and discussions we have here today illustrate
not only the complexity of this period, but also the amount of work that has
been done to help understand the many puzzles and challenges - as
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François Villeroy de Galhau put it in his opening remarks - and how to
address them.
It is beyond doubt that the swift actions of central banks when the crisis
first hit were crucial for preventing a financial and economic meltdown.
As Christian himself has emphasised, an important element of this crisis
response was the close cooperation among central banks, through constant
dialogue and, more concretely, cooperative actions such as the
establishment of currency swap lines.
As the acute phase of the crisis is now well behind us, the key question
becomes how central banks can best support the recovery, to make it not
only more robust than what we have seen so far but also sustainable.
This has proven to be a very challenging question. In the aftermath of the
crisis, central banks have had to operate in uncharted waters, characterised
by low growth, below-target inflation and unusually low interest rates - as
well as financial fragility and rising debt.
In one of his speeches, Christian has highlighted the need to broaden the
spectrum of views available to policymakers in order to avoid "groupthink"
and "intellectual capture".
In this vein, the debates we have here today are important because there is
not yet the necessary convergence of minds about the right analytical
framework to use for understanding the new reality we face.
Central banks have been working hard to update their analytical tools, and
so have international organisations such as the IMF.
The BIS, as well, has played a part. Under the guidance of our Board,
chaired by Christian until late last year, and in collaboration with the
various Basel-based international committees, we have been promoting the
exchange of views and cooperation in different areas.
Our own research has also been striving to better understand the
phenomenon of low growth, low inflation and low rates - as well as its
complex relationship with financial booms and busts (ie financial cycles).
We have sought to contribute to the debates by bringing a perspective that
is longer-term than the typical policy horizon.
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As such, we put less emphasis on the cyclical aspects of aggregate demand,
and pay more attention to the more entrenched impediments to growth factors that are slow-moving but whose effects cumulate over time.
In particular, we focus on impaired balance sheets and resource
misallocations.
Since these impediments cannot ultimately be removed exclusively by
expansionary monetary policy, prolonged monetary easing alone may not
succeed in reviving economic dynamism.
A combination of policies will be required.
And from this longer-horizon perspective, we see persistently low or
negative interest rates - which are the result of not only central bank
actions but also market participants' perceptions - as not a sustainable
equilibrium, but rather at least in part a disequilibrium phenomenon.
Let me briefly elaborate.
Why are interest rates so low?
In the BIS view, the recession that accompanied the Great Financial Crisis
was not a typical postwar business cycle recession. Rather, it was a balance
sheet recession, associated with the bust phase of the financial cycle.
Balance sheet recessions commonly coincide with permanent output losses
and weak recoveries. The permanent output losses after the financial bust
reflect, to a considerable extent, the fact that output growth was
unsustainable during the preceding boom.
Two legacies of the boom require further analysis. One is the combination
of a debt overhang and disruptions to financial intermediation. This is
quite well known. A lot of work has been done in the wake of the crisis to
improve the workings of the financial system.
The other, perhaps less well analysed so far, is the drag on growth that
arises from the resource misallocations that occur during the credit boom.
Recent BIS research using data from 21 advanced economies since 1979
finds evidence that credit booms undermine productivity growth, primarily
through the misallocation of resources.
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During periods of strong credit growth, workers shift to sectors with lower
productivity gains, notably construction.
This reallocation depresses aggregate productivity growth and thus
potential output.
Importantly, even though the misallocations take place during the boom,
their effects linger on and become much more impactful if a financial crisis
materialises, as the economy then needs to shift workers away from the
previously overextended sectors.
Our analysis suggests that the magnitude of these effects is not negligible.
What does all this imply for interest rates?
Clearly, monetary policy is essential in a crisis for stabilising the financial
system and the macroeconomy.
But in the wake of a balance sheet recession, where weak demand may not
be the only problem, monetary easing cannot be the only answer.
If we accept that some deeper, often country-specific, impediments to
growth are at work, then the appropriate policy response needs to include
measures such as determined balance sheet repair and structural reforms
to facilitate resource reallocations.
A resilient financial system and flexible economy make monetary policy
more efficient.
Moreover, relying too much on the support from monetary policy may,
over time, weaken the incentives for other actors to address the underlying
problems through repairs and reforms.
If this reliance persists, low rates could become self-validating.
This is a key concern.
There are other concerns as well. As mentioned by a number of speakers
today, a prolonged period of very low interest rates can have unintended
consequences in the financial sector: erosion of interest margins for
financial institutions, incentive for excessive financial risk-taking, asset
price inflation, etc.
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There can also be consequences in the real sector. For example, as people
in ageing societies worry more about their retirement, persistently low
interest rates may increase precautionary savings and weaken
consumption.
Analogously, funding deficits in corporate pension plans may constrain
companies' capacity to make new investments. These effects warrant
further investigation.
Furthermore, there are spillovers and spillbacks. Persistently low interest
rates in the core advanced economies have spilled over to other economies
less affected by the crisis.
These spillovers work through various channels: from investors' search for
yield and co-movements in global bond markets to policy reactions to
avoid large interest rate differentials.
These spillovers can fuel the build-up of financial imbalances in the
receiving economies.
Rapidly rising property prices, expanding credit and increasing
indebtedness, including in foreign currency debt, point to such imbalances.
When these economies enter the late stages of the boom, their
vulnerabilities may spill back to the originating economies.
Challenges ahead
What are the challenges ahead?
As mentioned by Stan Fischer, quantifying the trade-offs is a challenge.
Part of the difficulty in assessing the costs and benefits of alternative
policies is that the traditional analytical frameworks do not take enough
account of the endogenous build-up of financial imbalances, which may
accumulate slowly but then assert themselves quite powerfully.
As such, these frameworks tend to underestimate the influence of
monetary policy on the financial cycle.
They also tend to underestimate the international dimension, in the form
of policy spillovers and spillbacks.
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This suggests that we need to develop better analytical frameworks that can
allow us to study the interaction between finance and macroeconomics.
In addition to taking a long-term perspective, this effort will require two
things.
One is to think holistically.
A holistic approach to macroeconomic and financial stability will involve a
suite of policies: prudential, macroprudential, monetary and fiscal policies
- and no less importantly, structural reforms.
Since the interest rate determines the universal price of leverage in a given
currency, monetary policy is a key factor in the financial cycle.
A holistic approach would call for a monetary policy that responds more
symmetrically to the financial cycle to help contain financial imbalances.
Fiscal policy, for its part, should ideally create some additional fiscal space
during financial booms in order to have enough capacity to address
financial busts.
All this will have to be complemented with a greater degree of attention to
the slow-moving factors that sap productivity.
Such drags on long-term growth tend to be not visible during financial
booms, but become apparent during the busts.
The other requirement is to think globally.
An important element for greater global financial stability is a better
appreciation of cross-border spillovers in the conduct of national policies.
Importantly, thinking global is not incompatible with central banks'
domestic mandates - consider it a kind of enlightened self-interest.
In improving our collective understanding of how spillovers and spillbacks
work, central bank dialogue and cooperation are essential ingredients.
Conclusion
Let me conclude by noting that, in confronting and tackling these
challenges, we would be well advised to follow Christian's example and his
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work - always inspired by pragmatism, inclusiveness, cooperation and
good governance.
Indeed, Christian has been a key player in crisis management, in
endeavours to improve policy frameworks and in strengthening central
bank cooperation.
Christian, you have worked steadily and effectively for the collective good
of this community.
As BIS Chairman, you gave direction and guidance in times when central
banks faced unprecedented challenges.
Under your chairmanship, many initiatives that are crucial for the BIS
itself and for its collaboration with central banks and other institutions
came to fruition.
We have to build on to this work and to nurture the close cooperation
among central banks in order to successfully meet the challenges of the
future.
In closing this symposium, I would like to thank the Bank of France for
inviting the BIS to be a part of this special event and for the excellent
organisation.
Many thanks also to the speakers. But most of all, I want to thank you,
Christian.
We as a community owe you an enormous debt. It is a debt of gratitude the only type of debt we won't mind having more of! We wish you all the
best in your future endeavours.
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The PCAOB’s Interests in and Use of Auditing Research
Jeanette M. Franzel, Board Member
American Accounting Association, 2016 Auditing Section Mid-Year
Meeting, Scottsdale, AZ
Today I participated in a panel session entitled, "Opportunities for
Researchers to Inform the PCAOB," at the Mid-Year Meeting of the
Auditing Section of the American Accounting Association (AAA).
The panel discussed opportunities for academics to inform PCAOB policy
and decision making through research and other collaborative
opportunities with the PCAOB.
Recent initiatives at the Board seek to advance research related to the role
of auditing in the capital markets.
These initiatives have created new opportunities to enhance PCAOB's
collaboration with the academic community in ways that further the public
interest in auditing to protect investors.
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I am publishing this statement to provide a broader distribution among the
academic community of this information about the PCAOB's interests in
and use of auditing and related research.
I start by recognizing PCAOB's evolving relationship with academia over
the past decade of transformation in audit oversight, which has coincided
with some changes in the direction of auditing research within the
academic community.
I then offer a brief summary of several PCAOB initiatives aimed at
promoting relevant research and enhancing our use of research in our
audit oversight activities.
As a guide to academics interested in conducting research of interest to the
PCAOB, I set out a more detailed description of the operational aspects of
PCAOB's role and interests in auditing research.
Finally, I suggest some opportunities to further PCAOB's recent initiatives
to more efficiently and effectively foster relevant research.
The views expressed are my own, and do not necessarily reflect those of the
PCAOB Board, individual Board members, or staff.
PCAOB's Historical Relationship with Academia
The establishment of the PCAOB in 2002 and the commencement of
PCAOB operations in 2003 marked a significant change in the
environment for academic research related to auditing.
A brief summary of the PCAOB's relationship to academia provides a useful
frame of reference for considering the direction of the Board's current
initiatives and our mutual interests with the academic community.
There is a rich history of academic and other research on topics related to
accounting and auditing practice and theory.
As the PCAOB assumed the role of public company audit regulator in the
U.S. capital markets, the Board identified a number of areas where
research could help us diagnose problems facing the profession and
understand the potential relationships among and impacts of different
auditing and regulatory practices.
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The PCAOB established close ties to the academic community, actively
exchanging information related to PCAOB's mission and standard-setting
activities and related needs for research.
In fact, two prominent academics established PCAOB's standard-setting
and research functions. PCAOB's first Chief Auditor, Doug Carmichael, had
a long and distinguished career in academe prior to joining the PCAOB in
2003.
Another distinguished academic, Gary Holstrum, joined PCAOB in 2003 as
Associate Chief Auditor and Director of Research.
The PCAOB held its first annual academic conference in 2004 and worked
with the Executive Committee of the Auditing Section of the AAA to
establish an unprecedented project — nine teams conducted syntheses of
existing research that addressed issues faced by the Board in formulating
its auditing standards and other issues brought up by the PCAOB's
Standing Advisory Group (SAG).
Since then, the PCAOB and the AAA have maintained a working
relationship, holding 11 annual academic conferences (coordinated by the
PCAOB Office of the Chief Auditor), and undertaking a second project to
synthesize existing research on topics relevant to PCAOB standard setting.
The PCAOB also has continuously appointed academics to its SAG and
Investor Advisory Group (IAG) to provide advice and input to the Board on
establishing professional standards and on investor protection.
In addition, academics have provided input into policy discussions through
their participation in PCAOB public meetings and conferences.
PCAOB Board members and staff also participate in various AAA and other
academic conferences to exchange information about pending policy issues
and ongoing research projects.
In December 2009, the PCAOB announced the establishment of an
Academic Fellowship Program to assist the Board's Office of Research and
Analysis (ORA), which has resulted in three successive academic
fellowships involving accounting professors.
The Academic Fellows complemented the staff of accountants, analysts,
and researchers in ORA, which evaluates current trends and developments
affecting audit firms and their audit clients, monitors academic research on
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the auditing profession, and analyzes information derived from PCAOB
inspections.
In turn, changes in oversight of the auditing profession and other capital
market developments have provided an impetus for new research. A recent
archival review of auditing research noted "a surge in research that seeks to
better understand the drivers of audit quality."
Coinciding with PCAOB's establishment of its oversight programs and
building of a working relationship with academics, the accounting and
auditing profession also has invested significant effort in self-reflection on
the approach, quality, and relevance of auditing research, as reflected in
the 2008 report of the U.S. Department of the Treasury's Advisory
Committee on the Auditing Profession (ACAP).
The ACAP called for more interaction between academia and the
profession.
During its study, the ACAP also heard concerns regarding the
unavailability of data related to auditing practice and the potential for a
decline in auditing research and doctoral students specializing in auditing
if such data is not available for research and study.
In response, the AAA, the American Institute of Certified Public
Accountants, and the Center for Audit Quality (CAQ) engaged stakeholders
in efforts to study these matters and improve auditing research.
These efforts included the establishment of the CAQ's Research Advisory
Board in 2008 and the Pathways Commission in 2010.
I understand that the academic community has recently examined
questions about the approach and focus of archival auditing research.
For example, in late 2014, in light of "changes of unprecedented magnitude
[that] have fundamentally altered the audit market landscape for both
auditors and their clients," several academics engaged in a debate over the
nature, quality, and future direction of empirical research into audit
quality.
Some academics have recently sought to stimulate research using a range
of methodologies, or re-engaging with underused methodologies, that start
their inquiries with expectations from within accepted theoretical
frameworks. For example, some have sought to publish an organized
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collection of research synthesis review papers by "positioning each review
within an appropriate theoretical framework," according to relevant
auditing themes.
In the view of these academics, such an approach will stimulate researchers
to produce "a body of research that is coherent and generalizable and will
help to overcome some of the limitations of existing research."
Also, in a recent Research Forum on Qualitative Studies in Auditing,
academic commentators suggested a methodological framework for
qualitative research in accounting and auditing, noting, "The practice and
problems of auditing are a source of continuous curiosity and fascination to
scholars, and necessarily amenable to many different kinds of
investigation."
And on a broader note, the Pathways Commission identified in its 2012
report a number of pressures, institutional biases, and trends faced by
academics that could impede innovation in research techniques and inhibit
publication of practice-oriented research.
Needless to say, the PCAOB and the academic community have been
working in a challenging environment while building an effective and
productive working relationship.
As a new organization, the PCAOB was going through its own growing
pains while establishing new regulatory programs that needed the benefit
of solid research relevant to audit quality and audit firm oversight.
At the same time, the academic community seems to be exploring a need
for changes in the approach to auditing research.
In my view, the PCAOB and the academic community have worked
remarkably well together during these challenging circumstances.
The academic community has provided great value and insights to the
PCAOB during the development of our programs and activities to oversee
the audits of issuers and broker-dealers.
Academic research in critical areas has contributed to the establishment of
PCAOB's standards and oversight activities during the first 12+ years of
operations, and will continue to be valuable as we examine the critical
issues impacting audit quality in the future and pursue the many items on
our standard-setting and oversight agenda.
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Recent PCAOB Initiatives to Promote Audit-Related Research
In 2012, the PCAOB articulated near-term priority initiatives that each
involved contributions from academia in addition to internal PCAOB
research. These included a project to identify measures of audit quality, an
investment in improving the analysis of inspection findings to better
understand audit quality, and an effort to enhance the effectiveness of
PCAOB's framework for standard setting.
In late 2013, the PCAOB announced the establishment of its Center for
Economic Analysis to study the role and relevance of the audit in capital
formation and investor protection.
Details about the Center's mission and operations and how it would
interface with the accounting and auditing academic community have
taken some time to develop.
The Center began operations in 2014 with a staff of economists,
accountants, researchers, and economic research fellows. In 2015, the
PCAOB transferred all of its other staff economists who provide support for
standard setting into the Center.
The Board also approved the mission of the Center, "to study and advise
the Board and PCAOB staff on the role of the audit in capital formation and
investment protection and how economic theory and analysis can be used
and further developed to enhance the effectiveness of PCAOB programs."
The Center works to integrate economics and rigorous data analysis across
the entire range of PCAOB programs, including standard setting,
inspections, enforcement, and risk assessment. The Center's activities
include:
-
Fostering economic research on audit-related topics, including the role
and relevance of the audit in capital markets;
-
Preparing economic analysis to inform standard setting and other
PCAOB rulemaking; and,
-
Developing empirical tools for use in PCAOB oversight programs.
The PCAOB's new strategic plan articulates eight discrete strategies to
support the Board's objective of "[using] the Center to enhance the use of
economic analysis, empirical tools and analysis throughout PCAOB
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programs." The strategic plan also now includes measures to track some of
the activity in these areas.
The Center has become the primary vehicle through which the PCAOB
seeks to enhance its role in and meet its needs for auditing and related
research.
PCAOB's Role and Interests in Auditing Research
The PCAOB's interests in high-quality auditing research are manifold.
As stated on the Center's public webpage, "High quality, independent
academic research on audit-related topics, including the role and relevance
of the audit in capital markets, informs the PCAOB in its oversight
activities and provides evidence regarding the possible outcomes of policy
decisions."
The PCAOB continues to have an interest in a multitude of
interdisciplinary issues raised by our standard-setting activities.
All of the PCAOB's oversight functions benefit from research that promotes
insight and understanding of the impact of PCAOB oversight and rules on
auditing, financial reporting, and the broader capital and financial
markets.
And cutting across all of these is an interest in a deeper understanding of
audit quality, its proxies and measurement, as demonstrated by our Audit
Quality Indicators (AQI) project and enhanced analyses of inspections
findings.
To realize these interests in research, the PCAOB has undertaken a number
of new initiatives involving (to borrow a phrase from the SEC's Chief
Economist) both the contribution to and consumption of current research.
FOSTERING RESEARCH
The Board engages with academics and other researchers through its
fellowship programs, annual conferences with academics, internal PCAOB
seminars, and PCAOB advisory groups and public meetings.
Of course, the Board continues to engage with academics through
interactions at conferences, such as this one, and other formal and
informal meetings.
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The Board's initiatives and activities over the years have provided
academics with opportunities to explore new research topics and
techniques, using newly available information and data from PCAOB
oversight activities to study issues related to public company auditing and
audit quality.
This research, in turn, helps to inform PCAOB policy making.
Fellowship Programs
The Center conducts an Economic Fellowship Program and is authorized to
continue the Board's previously established Academic Fellowship Program.
The Center currently has a budget for up to four economic research fellows,
with three fellows currently on board.
The staff publishes a call for applicants once a year on the PCAOB website
(in the mid-fall timeframe), the AAA career web page, as well as the job
openings listings from the American Finance Association and the American
Economic Association, and various relevant journals of SSRN (Accounting
Research Network, Financial Economics Network, Economics Research
Network, Legal Studies Network).
In addition, PCAOB staff reaches out to members of the AAA Auditing
Section via the section's listserv, with the help of the section president
(thanks to Chris Hogan on this most recent round).
The unique benefit of the Economic Fellowship Program is the opportunity
to conduct original, publishable research using PCAOB's proprietary data,
much of which is subject to statutory confidentiality restrictions.
The Board continues to consider other ways to make that data available to
researchers, and I want to express my appreciation to the AAA leadership
for making constructive suggestions.
PCAOB's current call for applicants for the 2016-2017 academic year lists
the following 10 topical areas for research interest to the PCAOB:
- the role of the audit in capital formation and economic growth;
applications of regulatory economics to auditing;
-
the market impact of audit regulation and oversight;
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the industrial organization of the audit profession;
-
economic and social incentives in the audit profession;
-
the role of the audit in promoting access to public markets for small
enterprises;
-
the effects of audit and financial reporting failures on financial
markets;
-
the effects of multi-layered principal-agent relationships present in
auditing;
-
applications of behavioral economics to auditing and financial
reporting; and,
-
proxies for and indicators of audit quality and their potential usage and
impact.
Applicants must submit, among other things, at least one research
proposal, although we encourage applicants to submit more than one.
The above categories of topics are intentionally broad so that researchers
can select specific topics of interest for their research proposals.
We've also found that the research fellow's proposals evolve after they have
the opportunity to learn more about the PCAOB data available to them.
Economic Fellows have an opportunity to publish their research under
their own name (disclaimed by the PCAOB). For example, the independent
research conducted by PCAOB fellows has generated several working
papers that may be submitted by the fellows for publication.
In addition to publication, fellows have access to PCAOB staff and Board
members, and the opportunity to gain an understanding of the regulatory
process, gain firsthand experience with the PCAOB's emphasis on audit
quality and investor protection, and participate in the PCAOB's goal of
fostering high-quality research.
Annual Conferences
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The PCAOB continues to hold a two-day annual meeting in conjunction
with the AAA Auditing Section (previously known as the Academic
Conference) to exchange information and ideas on matters of mutual
interest. This spring, we plan to hold our 12th PCAOB/AAA annual meeting
in Washington, DC.
And two years ago, our Center began to host an annual, invitation-only
Conference on Auditing and Capital Markets, organized in conjunction
with the Journal of Accounting Research.
The conference, attended by researchers from around the world, promotes
academic research that studies the economic impact auditing has on capital
markets.
The goal is to consider the characteristics of an audit, audit firms and the
structure of the audit market in order to help inform the work of
regulators.
The PCAOB issues a call for papers in advance of the conference, which
includes a list of topical areas of interest.
Papers submitted to the conference are reviewed by a program committee
organized by the Center, and those selected for presentation are discussed
in a panel format with one or more discussants, typical of academic
conferences.
Seminars
In addition, the Center invites various academics to present ongoing or
published research to the Board and PCAOB staff at internal seminars. The
Center selects topics and research of interest (and availability) to PCAOB
programs and activities.
These seminars offer various benefits to all participants, primarily the
shared insights and feedback on data sources and limitations, research
techniques, and related policy implications.
The Center has conducted 10 seminars since it began this program,
including eight in calendar year 2015 that covered topics ranging from
behavioral research, including fraud, to corporate governance, auditing
research, and the economic effects of regulation in the capital markets.
PCAOB Advisory Groups and Public Meetings
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The Board continues to engage with academics in other formal venues,
including through its SAG and IAG meetings and periodic public meetings
on a range of topics.
Academics who serve as members of PCAOB advisory groups contribute in
a variety of ways, with all the privileges of full membership in these
collegial bodies.
In addition, the Board often calls on academics to present papers or lead
discussions in more depth on topics of particular interest. For example, in
a November 2014 meeting, the SAG heard two panel discussions of
academics on the topic of fraud.
The Board also often invites academics to participate in public meetings on
particular topics, such as the presentations by academics at the Board's
April 2014 public meeting on the auditor's reporting model and the Board's
October 2014 meeting on auditing accounting estimates and fair value
measurements.
RESEARCH IN SUPPORT OF PCAOB ECONOMIC ANALYSIS
AND POLICY MAKING
High-quality research is essential to inform PCAOB's economic analysis
and policy making, each of which involves discrete processes, tools, and
skills. Both activities benefit from the use of original research (and critical
surveys and syntheses of such research), both published and internal.
For economic analysis in rulemaking, the PCAOB staff developed and
follows guidance modeled on that used by federal agencies.
As the SEC's Chief Economist noted recently, "The economic analysis of a
rule's impact is a specific type of research question — a question to which
we should apply the most current tools available.… We routinely draw on
the academic literature to provide us with deeper understanding of market
issues."
High-quality academic research can provide valuable input to the four
basic elements in standard economic analysis for rulemaking:
(1) understanding the nature, extent, and impact of any problems with
audit practice (or, to frame the question in economic terms, "market
failures");
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(2) defining the existing "baseline" of regulation and market or practice
conditions;
(3) considering reasonable alternatives to solving a stated problem; and
(4) evaluating the potential impacts of alternative policy actions.
PCAOB has a dedicated staff of economists (with PhDs in economics,
finance, or accounting) to conduct economic analysis that involves analyses
of public and nonpublic data and review of the literature on such matters.
In the area of broader policy-making analysis, the PCAOB draws on a range
of approaches to analysis and research, including use of traditional
quantitative and statistical analyses, as well as program performance
evaluations and other operations assessment tools.
The staff continues to develop approaches to analyzing PCAOB's oversight
programs using such techniques, but, as with formal economic analysis in
rulemaking, this also often involves the use of the published research
literature.
PCAOB staff regularly review the significant body of growing literature on
the impact of PCAOB inspections on auditor behavior and the capital
markets more broadly and topics that are relevant to our inspections and
other oversight activities.
When considering published literature in its economic analysis and other
policy making, PCAOB staff generally looks for a consensus in the
literature — a sense that the literature over time, based on various
methodologies, sources of data, researchers, etcetera, supports a given
proposition.
PCAOB staff use their own expertise to determine whether the
methodology is sound, the hypothesis is supported by the methodology, the
data are relevant, and the authors are credible.
As those who follow the PCAOB's rulemaking process have undoubtedly
observed, the Board's public releases that accompany each rulemaking
have increasingly incorporated discussions of economic impacts of the
rulemaking and cite relevant academic literature and other internal
research.
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In addition, the Auditing Standards Committee of the AAA, as well as
individual academic researchers, regularly provide comments on PCAOB's
standard setting and other rulemaking actions.
Often these letters provide references to relevant research and sometimes
include reviews of the literature relevant to particular issues or questions
raised by the proposals. This highlights for us potential relevant inferences
that may be drawn from the literature.
The PCAOB staff advises academics and others interested in pursuing
research topics of interest to PCAOB's standard-setting and other oversight
programs to monitor such public developments and periodically survey the
PCAOB's website for updates.
I support developing a more structured process for providing information
to academic researchers about research questions that would be relevant
and useful for informing our oversight programs over time.
OPPORTUNITIES TO FURTHER ADVANCE PCAOB'S
INITIATIVES
As the PCAOB's vision and strategy for contributing to and consuming
research continue to evolve, there are some additional opportunities to
more efficiently and effectively foster research into areas of direct
relevance to the PCAOB.
I offer five concrete suggestions, and I invite today's conference
participants to offer other feedback and other suggestions as well.
The PCAOB's initiatives should foster relevant research without
supplanting the role of academics in reviewing the literature and
independently developing new and innovative research questions and
methods.
-
With this in mind, I believe that the Board could engage in a more
structured process of reviewing its oversight programs to identify and
publish specific topics and questions that may be suitable for research
that would help inform standard setting and all other PCAOB oversight
programs.
-
Because the viability of a research question, and of potential
methodologies, depends on the availability of reliable data, the PCAOB
should continue to look for ways to share information about the
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inventory of the categories and structure of its proprietary data that
could be used for research purposes.
-
As the academic community deliberates over the appropriate
framework for understanding the direction of archival auditing
research — and as the PCAOB enhances its processes for economic
analysis -- PCAOB staff could, like the SEC staff, publish white papers
describing relevant economic and auditing theories and the state of the
literature on particular topics. Such publications could provide a
framework not only for guiding original research, but also could
articulate the relationship between original research and the unique
discipline of PCAOB economic analysis.
-
Likewise, the PCAOB could summarize and synthesize the results of its
conferences, seminars, and other deliberations over ongoing research.
Dissemination of such information could benefit the academic
community, investors, and other regulators around the world as they
address their own needs.
Finally, I'd like to see a regular and predictable mechanism in place for
interacting with the academic community and communicating about
the above issues, so that we can continue to evolve and develop the
productive working relationship between PCAOB and academia to
achieve the goals of advancing research to inform regulation that
advances audit quality, protects investors, and promotes confidence in
the capital markets.
-
Conclusion
The investments and organizational changes undertaken by the PCAOB in
the area of economic analysis and research are substantial. Likewise, the
continued focus by academics on innovation and rigor in research on audit
quality and investor protection continue to be impressive.
It is now time to build on this strong foundation and on previous successes
to form a clear, long-term strategy aimed at meeting our mutual goals of
reliable, relevant, and rigorous research to inform regulation that promotes
reliable auditing and investor protection, while inspiring the future
generations of practitioners and academics in the field of auditing.
By addressing the opportunities I suggested, and possibly others, and by
providing more transparency about PCAOB's research needs and activities
under such a strategy, we can leverage the power of independent academic
research to advance the regulation of auditing in the capital markets.
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I will be happy to personally work
with the Auditing Section of the AAA
and other representatives of
academia to help move forward with
these goals.
Thanks for all that you do to educate future members of the profession
while conducting research to help advance the integrity and reliability of
financial reporting and auditing.
I look forward to continuing to work with the academic community as
PCAOB continues to advance its mission into the future.
Deutsche Bank response to Financial Stability Board
consultation on guidance on
arrangements to support operational continuity in resolution
Deutsche Bank welcomes the Financial Stability Board’s (FSB) proposed
guidance on operational continuity, to ensure that financial institutions
undertaking resolution planning have arrangements in place to ensure
continuity of critical shared services.
Without these, as the guidance notes, the continuation of critical functions
- a core objective of resolution - is unlikely to be possible.
Overall, we support the draft guidance, as it correctly focuses only services
that are critical to continue in resolution and recognises that a central
feature of operational continuity is effective contractual arrangements.
The guidance also rightly does not prescribe a particular service delivery
model and recognises that changes to achieve operational continuity in
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resolution should consider the impact on the effectiveness of firms’
operations on a going concern basis.
As with all aspects of resolution planning, changes to firms’ operating
structures to remove barriers to resolvability should only be considered
where necessary and proportionate to do so.
There are some areas where we suggest that the final guidance could be
clarified – e.g. on the definition of services in scope, on cross-border
arrangements and on how arrangements should be adapted to specific
service delivery models or resolution strategies.
In addition, we request greater recognition that it is not possible to
anticipate what post-resolution restructuring will require, as this will vary
depending on the circumstances that led to the firm’s failure, market
conditions and the shape of the bank at the point of resolution.
Finally, we strongly welcome the commitment to prepare a report - and to
consider guidance - on continuity of access to financial market
infrastructures (FMIs).
This is a key area for operational continuity and one where firms can only
make limited progress without regulatory support.
Our detailed responses to the questions are set out in the attached annex.
Please let us know if you have any questions on the issues raised or if you
would like to discuss any points further.
Annex - DB responses to consultation questions
Q1: Do you agree that the three service delivery models set out in Section
3 of the draft guidance represent, singly or in combination, current
industry practice? Do you have any comments on the analysis of each
model from a perspective of resolvability under different resolution
strategies?
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We agree that the models in 3.1 broadly reflect industry practice. However,
model i) – provision of services within a regulated legal entity – subsumes
two types, where services are provided either:
a) to critical functions performed within the same legal entity; or
b) from one operating entity within the group to another.
The final guidance should either define a) and b) separately, or revise
model i) to clarify different resolvability implications depending on
whether services are provided to the same legal entity or to others in the
group.
In our view, b) poses similar challenges to model ii) – that of providing
services from an intra-group service company – insofar as there is an equal
need for clearly defined intragroup service level agreements and armslength pricing mechanisms.
However, b) also has some similar advantages to model i), as providing
services within a regulated entity makes it more likely that authorities can
enforce continuity (although cross-border / regulatory coordination
challenges may exist, see Q7) and, as the entity is subject to capital and
liquidity requirements, measures will already be in place to ensure
sufficient financial resources in resolution, (e.g. bail-in, funding plans).
More generally, we are concerned that the discussion on the scope of
critical shared services under 2.3-4 is not sufficiently clear on how
authorities and firms should determine which services are subject to the
specific operational continuity arrangements outlined in the draft
guidance.
In particular, while we agree with the intent of 2.4 to make clear that these
types of arrangements are not appropriate for every type of critical shared
service, the introduction of the concept of “transactional” services with
supporting examples creates confusion.
Rather, we strongly suggest that 2.4 does not provide examples but rather
makes clear that it will be part of resolution planning discussions between
firms and authorities to identify for which critical shared services (and in
which circumstances) it is appropriate to apply these arrangements.
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This is already implicit in the draft guidance, but it should be made explicit
in 2.4 that identifying the appropriate scope of application of these
operational continuity arrangements is part of the resolution planning
process.
Q2: Are the arrangements to support operational continuity set out in
Section 4 comprehensive and likely to be effective? What additional
arrangements, if any, should be considered for inclusion? Should any
elements be modified for specific service delivery models?
We agree that the arrangements set out in 4.4 are comprehensive and likely
to be effective.
However, as recognised in the discussion of resolvability in section 3,
individual arrangements will be more or less relevant, depending on the
service delivery model (and the resolution strategy, see Q3 below).
For example, contractual provisions are essential when shared services are
provided by a legal entity other than the one performing the critical
functions (or by an intra-group service company or third party).
Financial resources are less relevant where the services are provided within
a regulated legal entity, as resolution planning should ensure sufficient
capital and liquidity in resolution.
Governance is obviously less relevant when it comes to a third party service
provider, given firms have no direct control over this (with joint-venture
entities as the exception).
We suggest that the final guidance clarify further under each type of
arrangement in section 4 where the service delivery model requires that
arrangement always be in place, versus where it may be less relevant.
It would also be helpful to specify in 4.1 that, in addition to assessing the
effectiveness of services models on a firm-by-firm basis, the relative
importance of individual arrangements and the scope of critical shared
services covered by them (see Q1) should also be assessed in this way
Q3: Are any of the arrangements particularly important in the context of
either a Single Point of Entry (‘SPE’) or a Multiple Point of Entry (‘MPE’)
resolution strategy, or are they strategy neutral?
We are concerned that the guidance does not sufficiently distinguish
between SPE and MPE strategies, nor does it sufficiently recognise that
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what is needed in restructuring cannot be fully anticipated. For SPE
strategies in particular, the form of restructuring will vary and depend on:
i)
ii)
iii)
iv)
The circumstances that led to resolution – i.e. which were the
businesses or activities that led to the bank’s failure, and will they
need dealt with separately;
ii) The market conditions at the time of resolution – if there is a
systemic crisis it may not be possible to sell or to transfer
functions without destabilising the purchaser;
iii) The shape of the bank at the time of resolution – given that
management will likely have taken actions during the recovery
phase (such as disposals) to restore viability; and
iv) The target operating model under the restructuring plan – as
the FSB draft guidance on funding recognises, this will not have
been formulated at the point of resolution.
As such, while we agree that contractual arrangements for SPE banks
generally need to provide flexibility for “transferability” and allow for
continuity beyond the stabilisation period, this should not require
banks to pre-determine ex-ante which activities will be sold or
transferred or wound down.
The length of time that operational continuity is required following sale
or transfer will also be subject to commercial negotiation, and the level
of ongoing support (including financial or other resources to be
transferred, pricing or access rights) would be reflected in the sale price.
We therefore suggest deleting of the reference in 3.2 to identifying
“scenarios” for poststabilisation restructuring, and revision of 2.6 to
acknowledge that while all arrangements to support operational
continuity are relevant irrespective of the resolution strategy, individual
relevance for the post-stabilisation restructuring period will vary
depending on the preferred strategy.
Both 2.6 and 4.7 should make clear that it is only where MPE strategies
are preferred that separation should be given particular focus in
operational continuity arrangements. For SPE strategies, 4.8 should
clarify the focus is primarily on ensuring sufficient flexibility in
arrangements.
Finally, we disagree that financial resources should be required poststabilisation, as by the end of the stabilisation period firms should have
restored access to private sources of funding.
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The FSB’s draft principles on funding in resolution recognise this, as
they acknowledge one of the core purposes of the restructuring plan is
to help restore market confidence and access to private funding.
It would therefore be disproportionate to require financial resources for
the restructuring period.
The guidance partially acknowledges the need for proportionality, by
recognising that entities may be “right-sized” during restructuring.
We therefore recommend revising 4.4 iii) to state “in all cases, financial
resources should be sufficient to cover the stabilisation period, which
may be a few months.
Transition from stabilisation until the firm returns to private sources of
funding should be taken into account when developing the resolution
funding plan.”
Q4: Do you consider that any of the arrangements identified in Section
4 would be challenging to implement in the context of all or specific
types of the service delivery models identified in Section 3?
As outlined above, we believe that some of the arrangements are more
relevant for certain service delivery models.
For example, where services are provided from a regulated legal entity,
we do not believe that financial resources are necessary to ensure
continuity of services, beyond the general obligation under resolution
planning to ensure operating entities have sufficient capital and
liquidity post-resolution to continue critical functions.
Even for intra-group service companies or third party service providers,
we believe it would be extremely challenging from a “business as usual”
perspective to maintain additional or ex-ante pre-funding of financial
resources for the poststabilisation restructuring period, beyond the
timeframe envisaged in the broader liquidity plan to return to market
funding (as outlined in the FSB’s draft principles on funding in
resolution).
In addition, it is worth being aware that there may be circumstances
where business continuity rules also require ring-fencing of financial
resources.
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Authorities should allow firms to rely on these to avoid duplicating
these arrangements, providing they are satisfied that financial resources
that are depleted for business continuity purposes can be quickly
replenished.
In addition, as mentioned in Q2, firms will often have no influence over
the governance of third party service providers, but other arrangements
may also be challenging in this scenario – e.g. operational resilience and
resourcing, management information systems – as this relies on the
third party service provider having these capabilities in place.
There are also barriers to enforcing operational continuity where the
resolution authority has no direct powers over third party providers,
discussed in more detail below under Q5 and Q7.
Q5: Does the legal entity ownership structure for the provision of
critical shared services (for example, wholly owned or partly owned
through joint ventures) give rise to specific challenges in relation to
operational continuity? If so, what are these challenges and how might
they be mitigated?
As mentioned above in Q2 and Q4, where the service provider is a third
party, financial firms and resolution authorities will have limited or no
influence over their internal arrangements. In some circumstances,
continuity would be covered in the contract / service level agreement
(e.g. pricing structure, management information that would be
provided) but in others it would not (e.g. governance, operational
resilience and resourcing).
In these circumstances, authorities should allow firms to rely on the
vendor to ensure they have adequate arrangements in place.
There are also very significant challenges where the resolution authority
has no direct powers in the resolution regime to enforce continuity from
service providers.
This is particularly challenging with third party providers.
In the EU legal framework and the Hong Kong draft resolution bill,
statutory powers exist over service providers based in their jurisdiction,
including non-financial firms. However, as these firms are outside the
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scope of financial regulation, these powers are untested and so how
effective they would be in practice is uncertain (see Q6 below).
In addition, such powers are less likely to be effective if services are
provided by entities based outside the home jurisdiction regardless of
whether they are financially regulated or not (see Q7 below), but
particularly if provided by a third party or joint venture and especially if
these are not financially regulated.
Q6: Are there measures, in addition to those suggested in Section 4 of
the draft guidance, that might reinforce contractual arrangements for
the provision of shared services to support operational continuity in
resolution? Do you foresee any challenges in adopting such measures
in the context of all or specific types of service delivery model?
There are no specific additional measures we would suggest for section
4, beyond more clarity on when the arrangements apply (see Q1), where
each arrangement is most relevant (see Q2) and more recognition of the
different resolution strategies (see Q3).
In terms of challenges, when it comes to services provided by a third
party, the biggest potential obstacle is the dependency on the service
provider's goodwill to accept the insertion of contractual resolution
provisions in existing contracts.
This is a concern to a lesser extent for point i) under 4.6 – requirement
to have robust service level agreements in place – as this is best practice
for all service contracts.
However, points ii)-v) – that the level of service provision should not
alter upon entry into resolution and recognising the possibility of
transfer and / or divestment in resolution – are entirely new concepts
and so it is possible that service providers would push back on such
provisions.
Even if such contractual provisions are agreed, it is difficult to predict
whether the level of service provision will remain unaltered, especially if
the resolution authority does not have powers to enforce this.
As the draft guidance notes, the likelihood of such provisions being
accepted and effective will depend on the level of confidence that third
party providers have that they will continue to be paid.
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The guidance should therefore also mention the importance of statutory
powers in the resolution regime to ensure continuity of critical shared
services, which should also be able to be applied to non-financial firms
providing services (as in the case of the Hong Kong and EU resolution
regimes).
This would be consistent with the FSB’s cross-border effectiveness
principles, which recognise the importance of supplementing
contractual measures with statutory ones.
Q7: Are there any arrangements that might mitigate challenges in
connection with (i) service providers from outside the jurisdiction of
the resolution authority and (ii) non-regulated third party or intragroup service providers that should be covered in this guidance?
We agree with the draft guidance that there are particular challenges to
operational continuity where services are provided by an entity outside
the jurisdiction of the resolution authority.
This is mitigated to an extent where the services are provided within the
group – particularly by a regulated entity – but may still rely on
cooperation with host authorities and is particularly challenging where
third party service providers are involved.
The final guidance should therefore explicitly address cross-border
provision, to commit all FSB member jurisdictions to:
i)
Ensure domestic resolution regimes include powers to enforce
operational continuity of essential services in their jurisdictions,
including from outside the financial sector;
ii)
Explicitly address operational continuity arrangements as part of
cooperation agreements between home and host authorities; and
iii)
Seek to identify specific support and / or recognition measures by
the host authorities that may be necessary to ensure operational
continuity arrangements are enforced.
In addition, authorities should recognise that this potential lack of
enforceability stems from shortcomings in the legal framework, and seek to
address it via regulatory cooperation.
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This option should be pursued before considering whether this presents a
material barrier to resolvability, which may require a firm to take measures
(e.g. legal, structural or operational changes) to overcome it.
Q8: Do you agree with the classes of information set out in the Annex as
necessary to support firms and authorities in their assessment of
operational continuity in resolution? Do you foresee any challenges for
firms in producing and maintaining that information?
We fully agree that the classes of information set out in the Annex, are
what firms eventually should be able to produce in a timely manner to
facilitate operational continuity in resolution.
However, it needs to be recognised that it is not a quick and easy task for
firms to gather this information, or to develop the systems to maintain it
and capability to produce it quickly.
Mapping of critical shared services, supporting contracts and personnel
will take time given “critical functions” are a relatively new concept.
Existing databases and systems will then need to be updated to facilitate
quick access and data aggregation to give a view on either a global or
individual country or legal entity basis; this is particularly challenging
where interdependencies exist.
While particular areas can be prioritised and tactical solutions developed,
it needs to be recognised that meeting these expectations comprehensively
will require significant systems development possibly over several years,
which in turn needs to work with the existing IT investment cycle.
In addition, we would caution against authorities expecting a single
centralised database for operational continuity.
As long as there is a single repository detailing how to access all the
necessary information, and the information itself can be retrieved within a
reasonable timeframe, it is neither necessary nor desirable to duplicate
existing systems.
This may in fact introduce new operational risks, as replicating information
from one database to another may reduce accuracy.
Q9: Are there any other actions that could be taken by firms or
authorities to help ensure operational continuity in resolution?
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Although this will be dealt with in 2016, we
would like to reiterate our strong support for the
FSB commitment to do more to ensure
continuity of access to payment, settlement and
clearing services in resolution.
Financial Market Infrastructure (FMI) continuity
is a key issue, where industry faces similar
challenges and FMIs similar constraints, from their own rulebooks, risk
management standards and regulatory regimes.
Balancing these issues to ensure continuity of access for participants while
also protecting FMIs themselves requires support from regulators.
This should at least take the form of detailed guidance or, preferably, the
development of model language that could be adopted into FMI rulebooks
to facilitate continuity of access.
This would help ensure consistency in arrangements between FMIs and
their participants globally, and help with market confidence during
resolution by providing transparency to other participants.
The British Bankers’ Association’s (‘BBA’) response
Guidance on arrangements to support operational continuity in
resolution
Dear Mr Andresen,
Guidance on arrangements to support operational continuity in
resolution
This is the British Bankers’ Association’s (‘BBA’) response to the above
consultation; we welcome the opportunity to provide our views.
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The BBA is the leading trade association for the UK banking sector with
200 member banks headquartered in over 50 countries with operations in
180 jurisdictions worldwide.
The BBA has firmly supported the role the FSB has played to coordinate
the development of effective resolution regimes and recognises the
contribution this has made to enhance the resolvability of the globally
significant and wider community of banks.
As demonstrated by the FSB Resolvability Assessment Process, inadequate
provision to underpin the operational continuity of critical functions
provided by banks could act as an impediment to resolution.
We therefore support the development of guidelines to assist firms to
enhance their arrangements. In considering the proposals for operational
continuity, however, it should not be forgotten that significant progress has
been made and that many firms have developed a well-advanced
understanding of their critical economic functions which are supported by
robust recovery and resolution planning arrangements.
Great progress has also been made towards the evolution of balance sheets
to account for new loss absorbency requirements and to ensure that
contracts with counterparties are resolution-friendly. It is in this context
that the proposals for operational continuity should be reviewed.
We provide specific comments on the draft guidelines in response to the
questions identified in the consultation in the attached annex.
It is important, however, to highlight the following overarching points:
 the intention to develop guidelines which focus on outcomes to be
achieved and are model neutral is very welcome;
 whilst it is important to ensure that operational continuity arrangements
will be effective, requirements should be considered and assessed
predominately in the context of the preferred resolution strategy;
 the two stages of resolution – stabilisation and restructuring – covered by
the guidelines are different and it should be recognised that the demands
and ability to pre-plan and organise for the two are different. Whilst
planning for stabilisation must understandably be detailed this is not the
case for the post-resolution restructuring phase where planning needs to
be much more flexible and able to support numerous solutions;
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 the need for adequate financial resources to be
available to critical shared service providers is
understood but any requirements should be judged
against the resolution strategy. It should also be
noted that it is most critical to have available
resources during the immediate stabilisation phase of
resolution. The need for financial resources during
the restructuring phase will be dependent on the
strategy pursued and may be partly met by resource
generation during the period; and
 the guidelines could do more to promote
cooperation and coordination through Crisis Management Groups and
colleges of supervisors. We consider that global cooperation will be
essential in the context of requirements for global firms and therefore
encourage further work on this important topic. Please do not hesitate to
contact me if you would like to discuss any of the points in our response.
International banking statistics at end-September 2015
January 2016
The Bank for International Settlements (BIS) released international
banking statistics at end-September 2015.
Cross-border bank lending shrank for the second consecutive quarter, due
mainly to falling claims on emerging market economies (EMEs).
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The global contraction of $151 billion between end-June and endSeptember 2015 was smaller than the previous quarter's and left
outstanding claims at $27 trillion.
Cross-border claims on advanced economies remained virtually unchanged
in Q3 2015, while those on EMEs declined by $142 billion.
The decline was primarily driven by emerging Asia, and China in
particular.
Cross-border bank credit to China fell by $119 billion between end-June
and end-September 2015, or by 17% from a year earlier. Outstanding
claims on China at end-September 2015 totalled $877 billion, the lowest in
two years.
Developments in the latest international banking statistics are summarised
in the Statistical release, together with charts showing historical data.
Additional data are available on the BIS website, where they can be viewed
as tables in PDF, browsed in the BIS Statistics Explorer, or searched in the
BIS Statistics Warehouse.
Data are subject to change. Revised data will be released concurrently with
the forthcoming BIS Quarterly Review on 6 March 2016.
The international banking statistics at end-December 2015 will be released
no later than 22 April 2016.
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To read more:
http://www.bis.org/statistics/rppb1601.pdf
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EIOPA sets out its strategic approach to riskbased and preventive conduct of business
supervision
The European Insurance and Occupational Pensions
Authority (EIOPA) has published its Strategy towards
a comprehensive risk-based and preventive framework
for conduct of business supervision.
The document outlines EIOPA's strategic approach as
well as the tools it proposes to use to implement this
framework.
A key element of the Strategy is "smart regulation", which focuses on
outcomes that are relevant to consumers and moves away from a legalistic,
"tick-box" approach. More specifically, "smart regulation" is based on a two
pronged approach, which is:
Risk-based, i.e. identifying the depth and scale of issues and focuses
priorities and resources where they matter most.
Preventive, i.e. anticipating consumer detriment early and, thereby,
tackling the problems of the future, rather than of the past.
Strengthening conduct of business supervision is important for consumers
and for the EU economy as a whole.
It aims to protect consumers from unfair and abusive business practices by
identifying tangible risks at an early stage to ensure they are adequately
tackled before fully materialising and it promotes the orderly functioning
of markets resulting in a level playing field, healthy competitive
environment, increased consumer confidence and financial stability.
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FSB announces membership of Task
Force on Climate-related Financial
Disclosures
Financial Stability Board (FSB) Chair Mark Carney announced in Paris on
4 December 2015 the establishment of an industry-led Task Force on
Climate-related Financial Disclosures (TCFD), with Michael R. Bloomberg
as chair, and that the initial membership of the Task Force would be
announced in due course.
Today the FSB announced the initial membership of the Task Force, which
will develop voluntary, consistent climate-related financial disclosures for
use by companies in providing information to lenders, insurers, investors
and other stakeholders.
The Task Force membership includes a balance between preparers and
users of financial disclosures, and comprises members from both financial
and non-financial companies across a range of countries and relevant areas
of expertise.
The four Vice Chairs of the Task Force are: Denise Pavarina, Managing
Officer, Bradesco; Graeme Pitkethly, Chief Financial Officer, Unilever;
Christian Thimann, Group Head of Strategy, Sustainability and Public
Affairs, AXA; and Yeo Lian Sim, Special Adviser, Singapore Exchange.
Members of the Task Force will act in a personal capacity.
The Task Force will consider the physical, liability and transition risks
associated with climate change and what constitutes effective corporate
financial disclosures in this area.
It will seek to develop a set of recommendations for consistent,
comparable, reliable, clear and efficient climate-related disclosures.
The Task Force will conduct outreach with a wide range of stakeholders
and conduct public consultation to ensure that it receives the necessary
input into the development of the final recommendations.
Michael R. Bloomberg said, “The breadth of experience the Task Force
brings to this important work will be essential to our success.
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Managing climate-related risk is increasingly critical to financial stability,
but it can't be done without effective disclosure.
The recommendations from the Task Force will increase transparency and
help to make markets more efficient, and economies more stable and
resilient.”
The Task Force has today launched a website, www.fsb-tcfd.org to provide
ongoing information on its work. The website provides further biographical
information about the Task Force members.
Notes
In April 2015, G20 Finance Ministers and Central Bank Governors asked
the FSB “to convene public- and private- sector participants to review how
the financial sector can take account of climate-related issues”.
In November 2015 the FSB published a proposal for the creation of an
industry-led disclosure task force on climate-related risks.
On 4 December 2015 the FSB announced that it was establishing the Task
Force, with Michael R. Bloomberg, appointed as Chair.
The Task Force will conduct its work in two stages. During the first stage,
the Task Force will determine the scope and high-level objectives for its
work. It is expected that this first stage will be completed by end-March
2016.
During the second stage, the Task Force’s work is likely to focus on
delivering specific recommendations for voluntary disclosure principles
and leading practices, if appropriate, with a view to completing its work,
for public consultation, by end-2016.
Information on the progress of the work of the Task Force will be posted on
its website (www.fsb-tcfd.org). TCFD can be followed on Twitter
@FSB_TCFD.
The FSB has been established to coordinate at the international level the
work of national financial authorities and international standard setting
bodies and to develop and promote the implementation of effective
regulatory, supervisory and other financial sector policies in the interest of
financial stability.
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It brings together national authorities responsible for financial stability in
24 countries and jurisdictions, international financial institutions, sectorspecific international groupings of regulators and supervisors, and
committees of central bank experts. The FSB also conducts outreach with
65 other jurisdictions through its six regional consultative groups.
Developing Climate-related Financial Disclosures
Policymakers have an interest in ensuring that the financial system is
resilient to all forms of risk. Possible climate-related risks fall into three
broad categories; physical risks, liability risks and transition risks.
It is essential these risks are managed.
Appropriate disclosures are a prerequisite for stakeholders not only to
manage and price these risks accordingly but also, if they wish, to take
lending or investment decisions based on their view of transition scenarios.
In December 2015 the FSB launched the industry-led Task Force on
Climate-related Financial Disclosures (TCFD).
The Task Force will develop a set of recommendations for consistent,
comparable, reliable, clear and efficient climate-related disclosures by
companies, as requested in the FSB’s proposal for the Task Force published
in November 2015.
The wide range of existing disclosure schemes relating to climate highlights
the importance of companies and relevant stakeholders reaching a
consensus on the characteristics of effective disclosures and examples of
good practices.
In doing so, the industry-led Task Force will take account of the work of
other groups related to effective disclosures.
As part of its work the Task Force will conduct public outreach to engage a
wide and varied range of stakeholders as it develops its recommendations.
Michael R. Bloomberg is Chair of the Task Force, which includes users and
providers of disclosures from a wide range of backgrounds.
The Task Force will conduct its work in two stages. During the first stage,
the Task Force will determine the scope and high-level objectives for its
work.
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It is expected that this first stage will be completed by end-March 2016.
During the second stage, the Task Force’s work will focus on delivering
specific recommendations for voluntary disclosure principles and leading
practices, if appropriate, with a view to issuing a report for public
consultation by end-2016.
More details about the Task Force are available on the TCFD website:
http://www.fsb-tcfd.org/
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Managing Norway's oil wealth
Speech by Mr Øystein Olsen, Governor of Norges Bank (Central Bank of
Norway), at the "Desemberkonferansen" oil and gas conference,
Kristiansund
In 1969, on the day before Christmas Eve, Norway as a nation received the
gift of the century: we struck oil!
The Ekofisk oil field was the largest subsea oil field ever discovered. The
discovery of oil was the start of an extraordinary era for the Norwegian
economy.
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Chart: OECD countries' per capita GDP in 1971
When the first oil was brought to the surface in 1971, income levels in
Norway were low compared with other western countries.
The picture has reversed since then. We have gradually caught up with the
wealthiest nations. Measured by GDP per capita, Norway now ranks at the
very top.
Chart: OECD countries' per capita GDP in 2014
It was established at an early stage that Norway's oil and gas resources
belong to the Norwegian people. The tax system and framework conditions
for the petroleum industry were designed so that the large revenues from
this sector would accrue to the state.
The stage was set for greater prosperity, with prospects for growth in both
public and private consumption.
The discovery of oil in the North Sea generated a wealth of opportunity for
Norwegian business and industry.
The extraction of oil at great sea depths would require the development of
new technologies.
This entailed the building up of expertise in our own country, which would
secure a full order book for many years ahead - and not only off our own
shore.
The activities on the Norwegian continental shelf would also provide a
boost to other industries in Norway.
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And the timing was perfect: economic stagnation and competition from
Asian countries had brought the Norwegian shipping industry to the brink
of a crisis.
With the discovery of oil, an adaptable shipbuilding industry and the oil
companies were soon on good terms.
Chart: A new market for the shipbuilding industry
Building up a new industry and spending the revenues generated also
brought a new set of challenges, and in 1974 these challenges were the
subject of a government white paper, Report no. 25 to the Storting, entitled
"The role of the petroleum industry in Norwegian society".
To provide room for the oil sector and higher consumption of goods and
services, other industries had to give way. The mechanisms described in
the white paper are familiar:
"A transfer of production and jobs between firms and industries can occur
via increased domestic cost pressures."
So, the nation was prepared for restructuring and for the costs this would
involve. But the white paper also made it clear that, in order to reap the
benefits of economic growth, restructuring would be necessary.
We now know, more than 40 years later, that structural changes were
indeed made. The industry structure of our economy has changed. A
growing number of firms, and not only in the engineering industry, have
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targeted the oil industry. Labour shedding in some sectors has freed up
labour for other uses.
Chart: High wages in the oil industry
Oil companies have had the capacity and the willingness to pay. Tax rules
have favoured investment spending and earnings have been solid. Oil
company employees have been wage winners here in Norway.
A state-of-the-art oil service industry has emerged. New products and
technological solutions have been developed.
For many firms, the contracts on the Norwegian continental shelf have
been a springboard to new export markets.
High oil prices and a profitable petroleum production industry have led to
record-high oil investment in recent years.
The level of investment in 2014 was equivalent to that of all the domestic
non-oil industries combined.
The positive spillovers to the oil service industry and other firms have been
substantial. Employment has remained high and unemployment low, even
when the financial crisis hit in 2008.
A large share of the business sector and the labour market is now linked to
the oil industry.
A relatively small number of jobs are directly involved in oil and gas
production.
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Chart: Growth in oil investment
But if account is taken of all the suppliers to the petroleum sector, about 1
in 9 jobs in Norway, a total of about 300 000, were linked to the oil
industry in 2014.
A growing number of these jobs are related to exports of oil extraction
equipment.
The oil and gas industry has played a decisive role in the strong growth of
the Norwegian economy over the past 40 years.
The past 15 years stand out in particular.
But this dependence on oil has also made the Norwegian economy
vulnerable to changes in oil prices or a decline in petroleum revenues.
High domestic labour costs have also increased the Norwegian economy's
vulnerability.
The cost level in the Norwegian business sector has increased sharply in
comparison with our trading partners.
A rise is followed by a fall, and oil prices have fallen by more than half since
last summer.
Chart: High wage growth (not incl. the krone depreciation over the past
two years)
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As activity and earnings from the petroleum sector decline, oil service
companies must seek entry into other markets.
With a high domestic cost level, that task may prove demanding.
A decline in activity on the Norwegian continental shelf has long been
anticipated.
The fall in oil prices has accelerated and amplified an announced decline in
activity. Norwegian exports to other oil-producing nations are also in
decline.
Chart: Fall in petroleum investment
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This does not mean that the oil age is now nearing an end. Nearly half of
known oil and gas reserves on the Norwegian continental shelf have not yet
been extracted.
Large new discoveries have been made over the past few years and the
Norwegian oil service industry is still receiving new orders.
Nevertheless, the Norwegian economy must now adapt to considerably
lower demand from the oil sector.
After many years of relatively high wage growth in Norway, the domestic
cost level must again be brought more closely into line with that of our
trading partners.
A necessary adjustment of the cost level can occur in two ways: through
lower wage growth than in other countries or through a depreciation of the
krone exchange rate.
Over time, monetary policy can only influence inflation. Monetary policy
cannot assume a primary responsibility for delivering the necessary
structural changes in the Norwegian economy.
But via the exchange rate channel, monetary policy can help facilitate the
necessary restructuring process.
Chart: High wage growth (incl. the depreciation of the krone)
Without our own national currency the situation would have been more
challenging.
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The social partners would have had to go it alone.
The experience of some European countries shows that this can be
demanding.
With a floating exchange rate, the necessary adjustment of the cost level
can take place faster and be less painful.
The krone exchange rate functions as a stabiliser.
The depreciation of the krone through the past year indicates that this
mechanism is functioning.
As long as there is confidence that inflation will remain low and stable over
time, the krone can depreciate markedly even if the key policy rate is low.
The benefit of a national currency is lost if the temporary rise in inflation
due to the depreciation is countered by higher pay increases.
The result could then be a higher key policy rate and a stronger exchange
rate than would otherwise be the case, and higher unemployment.
The social partners have a particular responsibility in this regard.
Oil companies had already given notice of lower investment, workforce
reductions and cost cuts in winter 2014. This tendency has been reinforced
by the sharp fall in oil prices, resulting in spillover effects on the mainland
economy and rising unemployment.
Chart: Key policy rate reduced
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As long as inflation expectations are firmly anchored, monetary policy can
serve as a first line of defence when the economy turns down.
Since December 2014, Norges Bank has reduced the key policy rate by a
total of 0.75 percentage point, to 0.75 percent.
The weaker outlook for the Norwegian economy has been given weight in
our assessments.
From the end of the 1990s, the price of North Sea oil rose from about USD
10 per barrel to over USD 100 per barrel. Large shares of the sizeable
revenues from the petroleum sector over the past 20 years have been
transferred to the oil fund.
Norway's sound public finances have been a great advantage to the
economy, particularly through the financial crisis.
But the management of the government's large petroleum revenues
through our 40 year-long oil history has not always been equally well
planned.
In the mid970s, the budget deficit - including petroleum revenues reached a high level.
And we could not know then that oil prices would more than double a few
years later - with the second oil shock in 1979, known as OPEC II.
But we learned from our mistakes.
The oil fund mechanism in 1990 and the fiscal rule in 2001 were
introduced to discipline fiscal policy in such a way that Norway's petroleum
wealth would also benefit future generations.
Oil fund assets are now equivalent to more than twice the GDP of Norway's
mainland economy, and the oil fund, or the Government Pension Fund
Global (GPFG), is today one of the world's largest sovereign wealth funds.
The GPFG represents the nation's savings, to be managed for the benefit of
both current and future generations.
As an investor, the GPFG makes capital available to other countries for
economic activity, and the return on that capital will depend on the
economic performance of those countries.
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The GPFG is a long-term, responsible investor. The objective of investment
management is to achieve the highest possible return at an acceptable level
of risk.
Chart: Change in market value since January 1998
So far, our nation has earned a solid return on its financial assets. The
cumulative return on the GPFG since its inception amounts to over NOK 2
600 billion, equivalent to about a third of total GPFG capital at the end of
2014.
Chart: Lower yields
Over a third of the GPFG is invested in bonds. Real yields on high-grade
government bonds provide a basis for the rate of return that can be
expected ahead. In recent years, those yields have been close to zero.
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Low bond yields reflect global economic conditions: Governments,
businesses and households are seeking to save more, while demand for safe
investments has increased.
Central banks' substantial asset purchases are pushing in the same
direction. However, low yields may also reflect modest expectations of
economic growth further ahead.
There is no return without risk. The GPFG features a very long investment
horizon and a sizeable capacity to bear short-term risk.
This is why the chosen allocation to equities is relatively high. It is also the
reason why the GPFG has moved into real estate.
The authorities have asked Norges Bank to assess whether the allocation to
real assets should be increased.
Any increase in the allocation to real assets will probably be at the expense
of bonds.
Chart: Spending of petroleum revenues almost level with revenues
Petroleum revenue spending over the fiscal budget has increased since the
turn of the millennium.
The revenue stream from the continental shelf is now declining.
We are approaching the point where government spending of petroleum
revenues will exceed the revenues deriving from the petroleum sector.
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Chart: Transfers to GPFG at an end
At today's oil prices, transfers to the GPFG will soon fall towards zero. We
will then be in a situation where the GPFG's current income is limited to
interest and dividend income.
According to the 2016 government budget, some of the return on the GPFG
will be used to cover the non-oil budget deficit.
Oil prices have fallen sharply over the past six months. Even if prices edge
up again, we have been reminded of the uncertainty associated with future
revenues.
The oil fund mechanism shields fiscal policy from such revenue
fluctuations in the short term.
We have the fiscal space to stimulate overall demand if this should prove
necessary again. But we must also remember that, with lower oil prices, the
government will over time have less money to spend.
Fiscal tightening may become necessary further ahead.
Refraining from increasing petroleum revenue spending further from
today's level is a sensible risk adjustment. The era of rising petroleum
revenue spending should for the most part be behind us.
The more than 40-year old white paper about the role of the petroleum
industry in Norwegian society was both far-sighted and accurate. The
restructuring it described has occurred, although the growth in prosperity
that followed in its wake was more difficult to predict.
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The emergence of an advanced oil service industry is an industrial success
story. We have extracted large quantities of oil and gas in a period of very
high prices. And we have set aside a large proportion of the revenues - for
the benefit of future generations.
In spite of some mistakes and a fair share of luck along the way, we would
have to say that Norway's petroleum wealth has so far been managed well.
Norway's oil age is far from over. But activity in the petroleum sector has
passed the peak.
We must also be prepared for lower returns in the oil industry. In the
period ahead, we should keep an important insight in mind: the key to
economic progress is the ability to restructure.
Thank you for your attention.
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