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Proposed Rulemakings for an Integrated Regulatory Capital Framework, Questions and Answers, June 7, 2012

Question 1: What does the package of proposed rulemakings contain and why is it divided into three parts?

The package contains
three notices of proposed rulemaking (NPRs) that, taken together, would restructure the Board’s current regulatory capital rules into a harmonized, comprehensive framework, and would revise the capital requirements to make them consistent with the Basel III capital standards established by the Basel Committee on Banking Supervision (BCBS) and certain provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act).

The proposals are published in
separate NPRs to reflect the distinct objectives of each proposal, to allow interested parties to better understand the various aspects of the overall capital framework, including which aspects of the rule would apply to which banking organizations, and to help interested parties better focus their comments on areas of particular interest.

The BCBS quantitative
liquidity requirements and the BCBS capital surcharge for global systemically important banks are not part of this rulemaking.

The Basel III NPR

1. The first NPR,
Regulatory Capital Rules: Regulatory Capital, Implementation of Basel III, Minimum Regulatory Capital Ratios, Capital Adequacy, Transition Provisions, and Prompt Corrective Action (Basel III NPR), is primarily focused on proposed reforms that would improve the overall quality and quantity of banking organizations’ capital.

The NPR would revise the Board’s risk-based and leverage capital requirements, consistent with the Dodd-Frank Act and with agreements reached by the BCBS in Basel III:
A Global Regulatory Framework for More Resilient Banks and Banking Systems (Basel III).
 
The proposal includes transition provisions designed to provide sufficient time for banking organizations to meet the new capital standards while supporting lending to the economy.

The Standardized Approach NPR

2. The second NPR,
Regulatory Capital Rules: Standardized Approach for Risk-weighted Assets; Market Discipline and Disclosure Requirements (Standardized Approach NPR), would revise and harmonize the Board’s rules for calculating risk-weighted assets to enhance their risk sensitivity and address weaknesses identified over recent years.

It would incorporate aspects of the BCBS’s Basel II standardized framework in the
International Convergence of Capital Measurement and Capital Standards: A Revised Framework (Basel II), Basel III, and alternatives to credit ratings for the treatment of certain exposures, consistent with the Dodd-Frank Act.

The Advanced Approaches and Market Risk NPR

3. The third NPR,
Regulatory Capital Rules: Advanced Approaches Risk-based Capital Rule; Market Risk Capital Rule (Advanced Approaches and Market Risk NPR), would revise the advanced approaches risk-based capital rule (in a manner consistent with the Dodd-Frank Act) and incorporate certain aspects of Basel III that the Board would apply only to advanced approaches banking organizations (generally, the largest, most complex banking organizations).

This NPR would also codify the Board’s market risk capital rule and, in combination with the other components described above, would apply consolidated capital requirements to savings and loan holding companies (SLHCs).

Question 2: Which banking organizations are covered by the proposed rulemakings?

The Basel III NPR and the Standardized Approach NPR would apply to state member banks, bank holding companies domiciled in the United States not subject to the Board’s Small Bank Holding Company Policy Statement (generally, bank holding companies with
less than $500 million in consolidated assets), and SLHCs domiciled in the United States.

Consistent with Section 171 of the Dodd- Frank Act, the proposed rulemakings would apply to all SLHCs regardless of asset size.

The Advanced Approaches and Market Risk NPR would generally apply to banking organizations meeting specified thresholds.

In general, the advanced approaches risk based capital rule applies to those banking organizations with consolidated total assets of
at least $250 billion or consolidated total on-balance sheet foreign exposures of at least $10 billion (excluding insurance underwriting assets) and their depository institution subsidiaries.

The market risk capital rule generally applies to those banking organizations with aggregate trading assets and trading liabilities equal to at least 10 percent of quarter-end total assets or $1 billion.

Question 3: How are these proposed rulemakings related to the Dodd-Frank Act?

The NPRs are consistent with statutory requirements in the Dodd-Frank Act.

For example, pursuant to section 171 of the Act, the NPRs would establish minimum riskbased and leverage capital requirements for SLHCs, phase out certain capital instruments over a three-year period, and establish new minimum generally applicable capital requirements.

In addition, pursuant to section 939A of the act, the NPRs remove references to, or requirements of reliance on, credit ratings in the Board’s capital rules and replace them with alternative standards of creditworthiness.

Question 4: What are the main changes to the minimum capital requirements?

The proposal includes a new common equity tier 1 minimum capital requirement of 4.5 percent of risk-weighted assets and a common equity tier 1 capital conservation buffer of 2.5 percent of risk-weighted assets.

The proposal also increases the minimum tier 1 capital requirement from 4 to 6 percent of risk-weighted assets.

The
minimum total riskbased capital requirement would remain unchanged at 8 percent.

The proposal introduces a supplementary leverage ratio that incorporates a broader set of exposures in the denominator measure of the ratio for banking organizations subject to the advanced approaches capital rule.

This supplementary leverage ratio is based on the international leverage ratio in Basel III.

Question 5: What are the main changes related to the definition of capital being proposed?

Capital instruments issued by banking organizations would be subject to a set of strict eligibility criteria that would prohibit, for example, the inclusion in tier 1 capital of instruments that are not perpetual or that permit the accumulation of unpaid dividends or interest.

Trust preferred securities, for example, would be excluded from tier 1 capital, consistent with both Basel III and the Dodd-Frank Act.

Under the Basel III NPR, banking organizations would be subject to generally stricter regulatory capital deductions (the majority of which would be taken from common equity tier 1 capital).

For example, deductions related to mortgage servicing assets, deferred tax assets, and certain investments in the capital of unconsolidated financial institutions would generally be more stringent than those under the current rules.

Question 6: What is the capital conservation buffer and how would it work?

In order to avoid limitations on capital distributions (including dividend payments, discretionary payments on tier 1 instruments, and share buybacks) and certain discretionary bonus payments, under the proposal banking organizations would need to hold a specific amount of common equity tier 1 capital in excess of their minimum riskbased capital ratios.

The fully phased-in buffer amount would be equal to 2.5 percent of risk-weighted assets.

Question 7: Will the new capital requirements and capital conservation buffer be imposed immediately or will there be a transition period?

The Basel III NPR contains transition provisions designed to give ample time to adjust to the new capital requirements, consistent with the agreement in Basel.

The new minimum regulatory capital ratios and changes to the calculation of riskweighted assets would be fully implemented January 1, 2015.

The capital conservation buffer framework would phase-in between 2016 and 2018, with full implementation January 1, 2019.

Question 8: What is common equity tier 1 capital and why are you proposing a new common equity tier 1 requirement?

Common equity tier 1 capital is a new regulatory capital component that is predominantly made up of retained earnings and common stock instruments (that comply with a series of strict eligibility criteria), net of treasury stock, and net of a series of regulatory capital deductions and adjustments.

Common equity tier 1 capital may also include limited amounts of common stock issued by consolidated subsidiaries to third parties (minority interest).
 
Common equity tier 1 capital is the highest quality form of regulatory capital because of its superior ability to absorb losses in times of market and economic stress.

Question 9: What are the main elements of the Standardized Approach NPR?

It would increase the risk sensitivity of the Board’s general risk-based capital requirements for determining risk-weighted assets (that is, the calculation of the denominator of a banking organization’s risk-based capital ratios) by proposing revised methodologies for determining risk-weighted assets for:

o
Residential mortgage exposures by applying a more risk-sensitive treatment that would risk-weight an exposure based on certain loan characteristics and its loan-tovalue ratio;

o
Certain commercial real estate credit facilities that finance the acquisition, development, or construction of real property by assigning a higher risk weight;

o
Exposures that are more than 90 days past due or on nonaccrual (excluding sovereign and residential mortgage exposures) by assigning a higher risk weight; and

o
Exposures to foreign sovereigns, foreign banks, and foreign public sector entities by basing the risk weight for each exposure type on the country risk classification of the sovereign entity.

The NPR would also replace the use of credit ratings for securitization exposures with a formula-based approach.

Additionally, the NPR would provide greater recognition of collateral and guarantees.

However, for most exposures, no changes are being proposed in the NPR.

More specifically,
the treatment of exposures to the U.S. government, government-sponsored entities, U.S. states and municipalities, most corporations, and most consumer loans would remain unchanged.

It would introduce disclosure requirements that would apply to banking organizations domiciled in the United States with $50 billion or more in total assets, including disclosures related to regulatory capital.

The changes in the Standardized Approach NPR are proposed to take effect January 1, 2015.

Banking organizations may choose to comply with the proposed requirements prior to that date.

Question 10: What are the primary objectives of the Advanced Approaches and Market Risk NPR?

It would revise the advanced approaches risk-based capital rule in a manner consistent with the Dodd-Frank Act by removing references to credit ratings from the securitization framework, requiring an enhanced set of quantitative and qualitative disclosures (especially in regard to definition of capital and securitization exposures), implement a higher counterparty credit risk capital requirement to account for credit valuation adjustments, and propose capital requirements for cleared transactions with central counterparties.

The NPR would incorporate the market risk capital rules into the integrated regulatory capital framework and propose its application to savings and loan holding companies that meet the trading thresholds.

Question 11: How will the Prompt Corrective Action (PCA) framework change as a result of the proposed rulemakings?

Under the proposal, the capital thresholds for the different PCA categories would be updated to reflect the proposed changes to the definition of capital and the regulatory capital minimum ratios.
 
Likewise, the proposal would augment the PCA capital categories by incorporating a common equity tier 1 capital measure.

In addition, the proposal would include in the PCA framework the proposed supplementary leverage ratio for advanced approaches banking organizations.

Note that the new PCA framework
would take effect starting on January 1, 2015, consistent with the full transition of the minimum capital requirements and the Standardized Approach for the calculation of risk weighted assets.
 
 

 
June 16, 2011 - Capital and liquidity standards
Speech by Governor Daniel K. Tarullo, Board of Governors of the Federal Reserve System, before the Committee on Financial Services, U.S. House of Representatives, Washington D.C.
 

The financial stability benefits of the Basel III reforms will be realized only if they are implemented rigorously and consistently across jurisdictions.

 

Incorporating internationally acceptable standards into national legislation or regulations is only the first step in effective implementation.

 

A second, critical step is ensuring that these standards are, in practice, rigorously enforced by national supervisors and observed by firms across all the Basel Committee countries.

 

In the United States, the Federal Reserve, FDIC, and Office of the Comptroller of the Currency (collectively, the banking agencies) are working to update and enhance risk-based capital standards, and introduce liquidity standards through a series of rulemakings.
 
These rulemakings will be used to align U.S. capital and liquidity regulations with Basel III.
 
In accordance with the internationally agreed-upon implementation timeframes, the banking agencies plan to issue a notice of proposed rulemaking in 2011 and a final rule in 2012 that would implement the Basel III reforms.
 
We expect that other jurisdictions will be adopting regulations or, where necessary, legislation in a similar timeframe.
 
The Basel Committee will review progress and identify any potential inconsistencies with the terms of Basel III.
 
Monitoring the incorporation of Basel agreements into national law is a fairly straightforward exercise, though no less important for that. It is also a familiar exercise in the Basel Committee.
 
In this regard, the international leverage ratio the Basel Committee has adopted and is currently monitoring serves as an important backstop to risk-based ratios that rely extensively on banks' models.
 
It is notable that analysts that follow significant global financial institutions use a leverage ratio to gain insights into the credibility of banks' average risk-weighted assets.
 
The Federal Reserve Board is fully committed to ensuring a robust leverage ratio remains in place for internationally active institutions.
 
Despite extensive sharing of information on supervisory practices, the Basel Committee has, over the years, found it difficult to achieve what I have characterized as the second critical step in the implementation of international capital accords--that is, rigorous and consistent application of those rules by supervisors and firms across countries, as reflected in reported capital levels and amounts of risk-weighted assets of individual banks.
 
An international process for monitoring implementation on a bank-by-bank basis has become increasingly necessary as capital standards have relied to a greater extent on internal market-risk or credit-risk models, the parameters and operation of which are not transparent.
 
This tendency has combined with the relatively opaque nature of bank balance sheets to complicate external efforts to assess how banks are meeting their capital requirements.
 
One area that has deservedly received attention of late is the potential for differences in the calculation of risk-weighted assets across banks, both currently and prospectively under the Basel III standards.
 
In particular, market participants have focused on differences in measured risk exposure.
 
Analysts have pointed out that large U.S. banks generally have markedly higher average risk weights, ratios of risk-weighted assets to total assets, and ratios of common equity to total assets, adjusted for differences in accounting, than some of their foreign competitors.
 
These large disparities cannot be easily explained away through differences in risk profiles, which are largely similar within the business lines of competing banks.
 
Indeed, with regard to capital for trading activities, where a commonly disclosed measure of risk is one-day value-at-risk (VaR) U.S. trading banks appear to hold multiples of the capital non-U.S. trading banks hold per unit of VaR. Precisely because of the opacity of bank balance sheets and their internal risk models, we do not yet fully understand the reasons for these disparities.
 
Some observers have suggested that U.S. stringency in application of the rules and standards may be a factor.
 
Gaining insight into these differences and taking action to more closely align capital requirements for similar risk exposures across countries will take concerted work within the Basel Committee.
 
 The Basel Committee leadership has acknowledged that failing to implement Basel III in a globally consistent manner could lead to a competitive race to the bottom and increase risks to the global financial system.
 
The Committee must take action to avoid this outcome, specifically through the Committee's Standards Implementation Group (SIG).
 
The SIG is initiating this year a peer review process, through which teams of experts will assess the extent to which countries have implemented Basel Committee standards.
 
While these reviews will focus initially on standards other than capital, such as stress testing, the process should nevertheless provide insight into how approaches and outcomes related to the implementation of Basel III can be meaningfully monitored and compared.
 
The SIG has already begun sharing information on the status of Basel III implementation by member countries and is in the early stages of planning comparative work on risk-weighted assets across jurisdictions and banks to promote consistent implementation.
 
 As the Basel Committee moves into this next phase, we will urge the Committee to take a comprehensive approach to monitoring processes that includes three elements.
 
First, the Committee should begin work as soon as possible to develop mechanisms to implement effective cross-country monitoring.
 
Second, this process should go beyond traditional stocktaking exercises to include a careful assessment of the methodologies national regulators use to determine the appropriateness and acceptability of bank practices.
 
Third--and here is where the real work will lie--the Committee must develop a mechanism to validate the actual risk-weighted assets calculated by individual banks under international capital standards.
 
There are several possibilities for conducting this work. One that has been discussed in the Basel Committee would be to use tools such as benchmarks and test portfolios, in order to provide an accurate, quantifiable comparison of standards implementation across jurisdictions.
 
Another, more far-reaching option would be to use validation teams working under the auspices of the Basel Committee itself to verify the methodologies used at individual banks to ensure their compliance with international standards.
 
They could use expertise gained through horizontal reviews of institutions to make assessments of individual banks in different jurisdictions.
 
A less far-reaching variant of this option would entail national supervisors collaboratively participating in examinations of specific institutions.
 
 As a result of these monitoring and validation processes, outliers (i.e., banks whose risk weights for comparable assets differ materially from those of other banks) could be identified so that national supervisors might perform more in-depth analyses of their banks' processes and outcomes.
 
This would lead to a greater understanding of the disparity in results for certain institutions or jurisdictions based on their assumptions, data, or risk profiles.
 
There can be legitimate reasons that banks may have different risk estimates for similar portfolios.
 
Where disparities are identified, however, national supervisors of outlier banks should be called upon to explain the results to their fellow supervisors, as well as steps they are taking to address situations in which differences may arise from systematic underestimation of risk or manipulation of capital ratios to achieve desired outcomes.
 
Any of these options would require the Basel Committee, international supervisors, and banking organizations to work together to address confidentiality concerns, as well as other jurisdictional issues. Some options will surely prove more feasible than others.
 
While we do not prejudge which will prove to be most effective, we do maintain that something of this sort is necessary in order to assure that the benefits for financial stability promised by international capital standards are in fact being realized, as well as to prevent some banks from enjoying competitive advantage through lax application of these standards.

At the same time, any of these options will give banking supervisors from the countries represented on the Basel Committee an opportunity to work together to address the many issues of implementation, interpretation, and evasion that will surely arise under Basel III.
 

 

 
November 17, 2010
BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM
Bank holding companies should consult with Federal Reserve staff before taking any actions that could result in a diminished capital base, including actions such as increasing dividends, implementing common stock repurchase programs, or redeeming or repurchasing capital instruments more broadly (planned capital actions).

The comprehensive capital plan submitted in response to this request should:

- Reflect management’s plans for addressing proposed revisions to the regulatory capital framework agreed by the Basel Committee on Banking Supervision (Basel III).
 
BHCs should provide a transition plan that includes pro forma estimates of regulatory capital ratios consistent with the recently proposed Basel III regulatory framework over the phase-in period, with supporting detail around actions and assumptions to be taken over the entire period necessary for the BHC to meet the fully phased in 7% tier 1 common equity target; and

Management Actions in Anticipation of Basel III:

The Federal Reserve will evaluate whether the proposed capital action(s) are appropriate in light of management’s plans to address the proposed Basel III reform measures.
 
The Federal banking agencies have begun the process for adopting the Basel III framework agreed to by the Basel Committee.
 
In line with this effort, the Federal Reserve expects that BHCs will demonstrate with great assurance that they could achieve the ratios required by the Basel III framework, inclusive of any proposed dividend increases or other capital distributions, as those ratios come into effect in the United States.
 
Accordingly, as part of its comprehensive capital plan submission, management should provide a transition plan that includes pro forma estimates under the baseline scenario of the BHC’s regulatory capital ratios in the recently proposed Basel III regulatory framework, with due regard to the possibility that earnings or losses may be less favorable than anticipated.
 
As stated in the September 2010 Group of Governors and Heads of Supervision agreements, under the Basel III proposal BHCs that meet the minimum ratio requirement during the transition period but remain below the 7% tier 1 common equity target (minimum plus conservation buffer) would be expected to maintain prudent earnings retention policies with a view to meeting the conservation buffer as soon as reasonably possible.

In considering a proposed capital action, the Federal Reserve will also take into account the nature of the proposed capital action, such as whether a proposed redemption of regulatory capital instruments is funded by the issuance of instruments of equal or better quality in terms of loss-absorption capacity, or whether common share repurchases are designed to offset increases in share count related to employee share-based compensation awards.
 
Moreover, notwithstanding the factors described above, the Federal Reserve may determine that a BHC’s proposed capital actions are inappropriate in view of supervisory concerns such as unresolved risk management issues.
 
The Federal Reserve will contact each BHC when the supervisory review of its comprehensive capital plan has been completed. Plans containing the elements specified above that are submitted by the first week of a calendar quarter will generally receive a supervisory response no later than 10 days prior to quarter end.
 

 
 
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September 22, 2010 - Treasury Secretary Timothy F. Geithner, Written Testimony, House Financial Services Committee
"Basel III proposals, must be fully implemented through national regulations by the end of 2012.
The United States is committed to meeting these deadlines."
 
"Chairman Frank, Ranking Member Bachus, and members of the Financial Services Committee, thank you for the opportunity to testify before you today about international regulatory issues relevant to the implementation of the Dodd-Frank Act, particularly reform of global capital standards.

Last week the Federal Reserve, the OCC, and the FDIC
reached agreement with their principal foreign counterparts to substantially increase the levels of capital that major banks will be required to hold.
 
As a result of this agreement, banks will have to hold substantially more capital.
 
The new standards are designed to ensure that major banks hold enough capital to withstand losses as large as what we saw in the depths of this recession and still have the ability to operate without turning to the taxpayer for extraordinary help.

This agreement will make our financial system more stable and more resilient.
 
By forcing financial institutions to hold more capital, we will both constrain excessive risk-taking and strengthen banks' abilities to absorb losses.
 
This agreement is designed to allow banks to meet these more stringent standards gradually over time, so that they can continue to perform their essential function of providing credit to households and businesses.

These standards will help establish a more level playing field around the world.
 
By moving quickly to recapitalize our financial system, we have been in a strong position to insist on tough standards abroad.

The Importance of Capital and Liquidity

Excess leverage, a term that describes the amount of risk firms take relative to the financial reserves they hold against those risks, has played a central role in virtually all financial crises.

Capital requirements determine the amount of losses firms can absorb and the magnitude of the risks they can take without risking failure.
 
They help the market provide discipline by forcing shareholders who enjoy profits in good times to be exposed to losses in bad times.

Capital requirements are the financial equivalent of having speed limits on our highways, antilock brakes and airbags in our cars, and strong building codes in communities prone to earthquakes.

Failures in our system of capital requirements were major contributors to the severity of this crisis.
 
Where we had capital requirements, they were too low and they were not supplemented with complementary liquidity requirements.
 
Furthermore, there were no systematic capital requirements in the rapidly emerging "shadow banking" system.
 
Finally, capital standards were not applied consistently around the world. Banks in many parts of the world were allowed to operate with low levels of capital relative to the risks they took on.

At last year's Pittsburgh Summit, the
G-20 Leaders, led by the Obama Administration, called for financial institutions to raise the quality and quantity of capital, strengthen liquidity standards and implement rules to limit leverage.
 
Strengthening capital requirements for major financial institutions was also an important objective in the legislative debate on reforming U.S. financial regulation.
 
Both the Dodd-Frank Act and the Basel process are designed to ensure that major financial institutions are subject to rigorous and consistent capital requirements.
 
The agreement just reached in Basel is an important step towards realizing that goal and fulfilling the G-20's call, and it will be presented to G-20 Leaders at their November Summit in Seoul.

The New Standards

The work of the Basel Committee over the last year, culminating in the
agreement announced last week, will significantly tighten the system of global capital requirements in a number of important ways.

First, the amount of capital that banks will be required to hold relative to risks they take will increase substantially.

Under the new agreement major banks will be subject to
two tiers of capital requirements.
 
All firms will need to hold a substantial minimum level of capital.
 
Further, they will be required to hold an added buffer of capital above the minimum.
 
If a firm suffers losses that force it to eat into that buffer, it will have to take active steps, such as reducing dividends or limiting share repurchases, to restore the buffer.
 
The buffer is important because it will force banks to move more quickly to strengthen their balance sheets as the risk of potential losses increases.

Capital requirements are set relative to a bank's assets, which are
weighted to reflect the riskiness of those assets.
 
That is, capital requirements are defined as a ratio of so-called "risk-weighted assets" (RWA).
 
The level of the new minimum and buffer – 4.5 percent and 2.5 percent of banks' RWA, respectively – have been set to ensure that major banks hold enough capital so they can withstand losses similar to what we saw in the depths of this recession and still have the ability to operate without turning to the taxpayer for extraordinary help.

Second, banks will be required to hold more capital against more risky products and activities, including derivatives, which caused substantial financial damage during the crisis.
 
These assets and exposures are held predominantly by the very largest firms.
 
Consequently, this aspect of the Basel reforms will generate large increases in capital requirements for risky activities typically undertaken by the biggest banks, but is likely to have only a modest impact on smaller banks.

Third, the Basel agreements will improve the quality of capital that banks hold.
 
In contrast to the current rules, which allow a wide range of forms of capital, the new requirements are set in terms of high quality common equity, tightly defined to mean capital that will truly absorb first losses when firms get into trouble.

Taken together, the new Basel agreements impose a very substantial increase in capital requirements on banks around the globe.
 
The change in the ratios alone represents more than a three-fold increase in high quality capital required in the system.
 
Before the recent crisis, banks were implicitly required to hold common equity equal to 2 percent of their risk weighted assets.
 
Now banks will effectively be required to hold tangible common equity equal to 7 percent – the 4.5 percent minimum plus the 2.5 percent buffer – of their risk-weighted assets.
 
In addition, both the new more restrictive definition of what is allowed to count as capital and the more stringent assessment of the risks associated with derivatives, trading-related assets, and exposures to other financial firms will effectively raise capital requirements even further.
 
Importantly, these additional effects will fall most heavily on the largest, most inter-connected banks.

In addition to new capital requirements, the Basel Committee has agreed to impose new global standards for
liquidity management.
 
During the recent crisis banks were poorly prepared for the funding pressures that occurred, and this was a major factor that intensified stress throughout the financial system.
 
The new liquidity standards are designed to ensure that firms can withstand a severe shock in liquidity without deepening a crisis by, for example, selling assets in a panic, cutting credit lines indiscriminately, or turning to central banks for excessive liquidity support.

The
Basel Committee also agreed that banks should be subject to a U.S.-style cap on leverage as a backstop for the more complex risk-weighted capital requirements.
 
The new internationally applied leverage ratio requirement will, for the first time, include firms' off balance sheet commitments and exposures.

Finally, the recent agreement, by providing a
more constrained definition of capital and by expanding to include new international standards on liquidity and aggregate leverage, provides a framework for more rigorous and consistent global capital standards.

We cannot know with certainty how the economy and the financial system will evolve, but these heightened capital requirements, along with other important reforms, should substantially reduce the likelihood that we will soon repeat the sort of severe financial crisis that we have just lived through.

The Transition

Capital requirements are going up substantially.
But if we were to raise them too fast we could hurt economic recovery.
 
To limit that possibility, the agreement gives banks a meaningful transition period to meet the new standards.

The new capital requirements will not become effective until the beginning of 2013, and banks will not have to meet the full minimum common equity capital requirement of 4.5 percent of risk-weighted assets until the beginning of 2015.
 
The buffer will be phased in between 2016 and 2019.
 
In addition, the definition of capital becomes progressively more stringent between 2013 and 2018.

It is important to note that because we moved so quickly with the bank stress tests in early 2009 that forced banks to raise more common equity, the U.S. financial system is in a very strong position internationally to adapt to the new global rules.
 
For the most part, banks should be able to meet these new requirements through future earnings, which will help protect the recovery currently underway.

The Road Ahead

The agreement that has just been reached is a major milestone in the process of reforming global capital standards. But we still have more work to do.

The liquidity requirements are a new part of the Basel system. We will need to make sure that they are calibrated correctly before they are fully implemented.

It is also essential that
the Basel agreements are implemented by national authorities in a way that generates a `level playing field' in our increasingly integrated global financial system.
 
We will engage our foreign counterparts to look for ways to ensure that that these agreements are implemented in a transparent and consistent way by supervisors in different countries.

We will also continue to explore innovative ways, such as the use of
counter-cyclical buffers and contingent capital, to expand the capacity for the system to absorb unexpected losses without amplifying shocks to the system.

The new capital standards have to be implemented at the national level.
 
The agreement that was just reached, and other so-called Basel III proposals, must be fully implemented through national regulations by the end of 2012.
 
The United States is committed to meeting these deadlines.

In conclusion,
the agreement reached in Basel last week, working with the Dodd-Frank Act, will significantly lower the probability and severity of future financial crises, and it will help protect taxpayers by limiting excessive risk-taking by financial institutions.
 
The Basel agreement is the result of thoughtful and diligent work by the men and women of key regulatory and supervisory agencies here and around the world. We owe them our thanks. "
 

 
Treasury Assistant Secretary for Financial Institutions Michael S. Barr, Remarks at the Chicago Club on Next Steps on Financial Reform: Implementing the Dodd-Frank Act to End Too Big To Failst month, President Obama signed into law a comprehensive set of reforms to our financial system that will lay a firm foundation for growth and prosperity in the years ahead.

Last week in Charlotte, I focused on getting the balance right on consumer protection while fostering innovation and growth.
 
Today I want to focus on the task of ending "too- big-to-fail."

The
Dodd-Frank reforms will help to make sure that risks taken by banks do not threaten the health of the economy as a whole.
 
These reforms require the largest financial firms to build up their capital and liquidity buffers, constrain their relative size, and place restrictions on their riskiest financial activities.
 
These reforms bring transparency to the shadow banking system and fully regulate our derivatives markets.
 
And these reforms create a mechanism for the government to shut down failing financial firms without putting taxpayers at risk.
 
The import of the Act is clear: in the future, no financial firm will be "too big to fail."

For much of the last century, the American financial system was the envy of the world--surpassing other major developed economies in innovation and productivity growth.
 
It provided investors and consumers with the strongest protections.
 
Its regulatory checks and balances helped create a remarkably long period of relative economic stability. And the financial system was consistently better at directing investment towards the companies and industries where the returns would be the highest.

But over time those great strengths of our financial system were undermined. The careful mix of protections we created eventually eroded.
 
Huge amounts of risk moved outside the banking system to where it was easier to increase leverage. In the period leading up to the recent crisis, we saw the significant growth of large, highly leveraged, and substantially interconnected financial firms.
 
These firms benefited from the perception that they were "too-big-to-fail"-- a presumption that they would receive government assistance in the event of failure.
 
This was an advantage for them in the marketplace.
 
Creditors and investors believed that large firms could grow larger, take on more leverage, engage in riskier activity – and avoid paying the consequences should those risks turn bad.
 
It was a classic problem of moral hazard.

The
adverse effects of "too-big-to-fail" are numerous.
 
Such a presumption reduces market discipline and encourages excessive risk-taking by firms.
 
It provides an artificial incentive for firms to grow. It creates an unlevel playing field with smaller firms.
 
And as we've recently seen, the government had no effective tools to respond to the distress of major non-bank financial firms, whose failures had devastating effects that rippled throughout the economy.

Without meaningful reform, the government's actions in the recent financial crisis, while necessary to prevent the implosion of our financial system, would have likely magnified the market's expectations of government support in times of severe economic stress.
 
Any continuation of this presumption would have been a serious threat to financial stability and free and fair markets. That is why we had to enact reform, and that is why we must move quickly to demonstrate credibly that, with the passage of the Dodd-Frank Act, the conditions that once gave rise to this presumption have been permanently ended.

The new resolution authority, and the constraints on other emergency authorities, have critically undercut any reasonable presumption that a major financial firm can fail without significant pain being inflicted on its shareholders, creditors and management.
 
We will--once and for all--fully end the market's perception of "too-big-to-fail" firms, when we build a system that is capable of absorbing the failure of the next AIG or Lehman Brothers; a system that constrains risk-taking by major financial firms, strengthens the basic shock absorbers and transparency in the financial system, and provides the government with credible tools to manage effectively the failure of major financial firms while at the same time safeguarding the broader economy.

On the foundation provided by the Dodd-Frank Act, we must now build that system--with speed and diligence--and restore the American economy as the world's most reliable engine for economic growth and innovation.

Monitoring and Mitigating Systemic Risk

In the recent crisis, a key enabler of the "too-big-to-fail" presumption was the inability to sufficiently monitor emerging concentrations of risk throughout the financial system. Regulators cannot constrain risk if they cannot see it.

To address these risks, the Dodd-Frank reforms focus on three major tasks:
 
1) providing an effective system for monitoring and responding to systemic risks or threats to financial stability as they arise;
 
2) creating a single point of accountability for tougher and more consistent supervision of the largest and most interconnected institutions; and
 
3) tailoring the system of regulation to cover the full range of risks and actors in the financial system, so that risks can no longer build up without oversight or ability to monitor.

First, these reforms create accountability and provide new authority to identify and manage systemic risk in a way that we could not do before.

The Act establishes the
Financial Stability Oversight Council, with clear responsibility for examining emerging threats to our financial system regardless of where they come from.
 
The Council is chaired by the Secretary of the Treasury and its membership includes the heads of the financial regulatory agencies.
 
The Council has a critical role in the management of systemic risk: to designate firms for heightened supervision by the Federal Reserve and to make recommendations to the Fed and other federal financial regulators concerning the establishment of heightened prudential standards.

The Act also establishes an
Office of Financial Research (OFR) within the Treasury Department – to support the Council through the collection and analysis of data concerning risk in the financial system.
 
The OFR will be able to gather critical financial information not available elsewhere – looking across the whole financial system, and providing insight to the Council and its member agencies, Congress, and the public.

Second, these reforms provide for clear, accountable, strong and consolidated supervision and regulation by the Federal Reserve of any financial firm whose combination of size, leverage, and interconnectedness could pose a threat to financial stability if it failed.

Third, the reforms will shine sunlight on the shadow worlds of derivatives and the parallel banking system, which played such major roles in almost pushing us into a second Great Depression.

The recent crisis has clearly demonstrated that risks to the system can emerge from all corners of the financial markets and from any of our financial institutions.
 
That's why these reforms bring over-the-counter derivatives markets into a comprehensive and rigorous regulatory framework; provide for consistent and tough regulatory oversight for critical clearing, payment, and settlement systems; strengthen the regulation of markets for securitization; and require the registration of all hedge funds and other private pools of capital over a minimum threshold in size.

In the lead-up to the recent crisis, we needed a system that let regulators see risks as they emerged across the financial system. The reforms we've enacted achieve that aim.

Basic Reform of Capital, Supervision, and Resolution Authority

To fully end "too-big-to-fail" we need to make our financial system safer for failure.
 
We cannot rely on the hope of perfect foresight--whether by regulators, or by managers of firms, private sector gatekeepers, or other market participants.
 
Financial activity involves risk, and no one will be able to identify all risks or prevent all future crises.

However, robust capital, leverage, and liquidity requirements can prevent the build-up of risk, ex ante, and insulate the system from unexpected shock events, ex post. Imposing higher prudential standards on the largest, most interconnected firms will require them to internalize the risks they impose on the system by virtue of their size and complexity.
 
The largest and most interconnected firms cause more damage to the system when they fail, so they need to hold more capital against risk. That is based on a principle of fairness and also of economic efficiency. It internalizes their costs of failure and provides incentives for firms to limit their size and reduce their leverage.

Internationally, we are working to raise capital requirements so that financial firms can withstand future crises as severe as the one we have just gone through, and do so without government support.
 
In the Basel III negotiations, we are pushing hard to set minimum capital ratios at a level that will represent a significant increase in firms' requirements.
 
These new requirements include the creation of a capital conservation buffer above the minimums, which if breached will restrict firms' ability to pay dividends or buy back stock. Such restrictions will help shore up a firm's capital base before it reaches a point of no return.

Not only are we
raising the ratios, but just as importantly, we are raising the standards on the quality of capital that underlie them.
 
The new capital requirements will focus on common equity, excluding other liabilities that did not act as a buffer to absorb losses in the crisis.
 
There will be strict limits on minority interests, as well as on the aggregate contribution of investments in other financial institutions, mortgage servicing rights and deferred tax assets.

In addition to increasing the quality of the capital that firms hold, we are
increasing the capital required for banks' riskiest activities, such as their trading positions and their counterparty credit exposures.
 
Capital calculations for trading exposures will now have to be based on stressed market conditions, and the charges for securitization exposures will be increased substantially.
 
In both derivatives and secured lending transactions, firms will now also be subject to a capital charge for losses associated with a deterioration in the credit worthiness of their counterparties.

Under
Basel III we will also be introducing a new, internationally applied, leverage ratio requirement that, for the first time, includes firms' off balance sheet commitments and exposures.

The combination of these changes – higher capital ratios, new capital requirements, tougher and more extensive measurement standards – will help ensure that firms have sufficient capital to weather the next crisis.

In addition to new capital requirements, we will be instituting explicit quantitative liquidity requirements for the first time, to ensure that financial firms are better prepared for liquidity strains.
 
Under the new rules, firms will have to hold enough highly liquid assets to meet potential net cash outflows over a 30 day stress scenario.
 
Through the Basel Committee we are also working on developing a liquidity requirement that will require a minimum amount of stable funding over a one year time period, relative to a firm's assets, commitments and obligations.
 
These liquidity requirements will be crucial in helping to mitigate severe strains like those that we saw on the financial sector at the time of the collapse of Bear Stearns and Lehman Brothers during 2008.

Taken together, these heightened standards will provide positive incentives for major financial firms to reduce their size, leverage, complexity, and interconnectedness.

The financial crisis has shown that a narrow supervisory focus on the safety and soundness of individual firms can result in a failure to detect and thwart emerging threats to financial stability that may cut across many institutions or have other systemic implications.
 
Under these reforms, federal financial regulators will have the responsibility to supervise our major financial firms in a manner that is designed to protect overall financial stability.
 
The federal financial regulators will engage in a searching review of the bank and nonbank subsidiaries of our major financial firms.

Regulators must supplement existing approaches to supervision with
mandatory "stress tests," credit exposure reporting, and "living wills," so that they can adequately assess the potential impact of the activities and risk exposures of these firms on each other, on critical markets, and on the broader financial system.

When, despite reforms,
a major financial firm fails, the government simply must have the necessary tools to wind-down a failing financial firm without exposing taxpayers to losses and without pushing the economy to collapse.
 
While we have long had a tested and effective system for resolving failed banks, there was no effective legal mechanism to resolve a large non-bank financial institution or bank holding company.
 
The Dodd-Frank Act fills this gap in our legal framework by providing a emergency tool modeled on our existing system under the Federal Deposit Insurance Act--a tool that replaces the untenable choice between taxpayer bailouts and market chaos. Resolution authority is a linchpin of ending "too-big-to-fail."

Both our financial system and this crisis have been
global in scope.
 
So our solutions have been and must continue to be global. International reforms must support our efforts at home, including strengthening the capital and liquidity frameworks; improving oversight of global financial markets; coordinating supervision of internationally active firms; and enhancing crisis management tools.
 
We have not waited for the international community to act before building a new foundation in the Dodd-Frank Act, and we will not accept an international race to the bottom on regulatory standards.

Path Forward on Implementing Financial Reform

These reforms will help us restore market discipline to a financial system distorted by the moral hazard associated with "too-big-to-fail." And that process is already underway.

Let me give you a brief introduction to the steps taking place over the next several months.

We are already hard at work. The agencies involved in implementing financial reform are in the process of establishing timelines for moving forward on the scores of studies, regulations, and other regulatory actions required by the Dodd-Frank Act. In some critical areas, the agencies are already drafting proposed rules for public comment.

In September, when the
Financial Stability Oversight Council first meets, we will establish an integrated road map for the first stages of reform and put that in the public domain.

We are going to move quickly to begin shaping reforms of the derivatives market. In this process, we will work with the Fed, the SEC and the CFTC to develop specific quantitative targets and timelines for moving the standardized part of the over-the-counter derivatives business onto central clearing houses.
 
And we must accelerate the international effort to put in place common global standards for transparency, oversight, and the prevention of manipulation and abuse of these critically important markets.

We're going to stand-up the
Office of Financial Research, which in the coming months will work closely with regulators and market participants to assess the financial data reporting needs and challenges for better monitoring of firm-specific and systemic risk, to streamline current regulatory data reporting requirements imposed on financial firms, to improve data sharing among regulators, and to enhance the utility of existing data sources.

As I mentioned, we are now finalizing an international agreement that will require financial firms to hold both more and higher quality capital than they did before the crisis.
 
Those are some of the key areas regarding prudential reforms where we – the Treasury, the financial regulators – will be focused in the coming months.
 
I'd also like to briefly highlight our work on consumer protection.

We are moving quickly to give consumers simpler disclosures, so that they can make better choices, borrow more responsibly, and compare costs.

For example, in place of the two separate, inconsistent and overly-complicated federal mortgage disclosure forms that borrowers receive today, there should be one clear, simple, user-friendly form.

In addition, we will be inviting public comment on new national underwriting standards for mortgages, so that we can begin to shape the reforms of the mortgage market.

And we are working quickly to get the CFPB up and running, to consolidate rule-making, supervision, and enforcement responsibilities that today are split, inefficiently and ineffectively, among seven different regulatory agencies.

On all fronts, we are committed to moving with speed, with transparency, and with a commitment to ensuring that our financial system remains the most competitive financial system in the world.

But reform is a shared responsibility. And so to those in the financial industry, I encourage you not to wait on Washington before embracing change. As we work together to rebuild our financial system, responsible private sector leadership is every bit as important as responsible regulation and supervision.

Conclusion

The Dodd-Frank reforms represent a comprehensive, coordinated response to the moral hazard challenge posed by our largest, most interconnected financial institutions: strong, accountable supervision; the imposition of higher standards, both to deter excessive risk and to force firms to better protect themselves against failure; a strong, resilient, well-regulated financial system that can better absorb failure; and a strong resolution authority to enable the government to wind down major financial firms in a financial crisis in an orderly manner that protects financial stability.
 
These reforms fully protect taxpayers, and by contrast, enable shareholders and creditors to take their losses when failure occurs.

As we go about the task of implementing these reforms, we will be criticized by some for going too far and by some for not going far enough. This distinction is stuck in a debate that presumes that regulation--and efficient and innovative markets--are at odds.

In fact, the opposite is true. Markets rely on faith and on trust. Markets require transparency. The discipline of the market requires clear rules. The President's reforms lay a new foundation for financial regulation that will once again help to make our markets vital and strong. And for all our sakes and that of our economy, we must implement the Dodd-Frank Act and thereby fully end "too-big-to-fail" once and for all.
 
 

 
 
Statement by Daniel K. Tarullo, Member, Board of Governors of the Federal Reserve System, before the Subcommittee on Security and International Trade and Finance Committee on Banking, Housing, and Urban Affairs. United States Senate, July 20, 2010

Chairman Bayh, Ranking Member Corker, and other members of the Committee, I appreciate the opportunity to testify today on developments in international regulatory reform and
U.S. government priorities for international regulatory cooperation.

When you held a hearing on this topic in the fall, I gave an overview of the Federal Reserve’s role in international cooperative activities and reviewed some pertinent recent developments.
 
In my testimony today, I will begin by enumerating the goals that should inform U.S. participation in international regulatory and supervisory activities.
 
Then I will turn to some of the issues you identified in your invitation letter as being of interest to the Subcommittee in this hearing: the Federal Reserve’s role in the international financial reform efforts--including our work on the Basel III reforms, cross-border crisis management and resolution, and incentive compensation--and a preliminary assessment of the likely effect of the Dodd-Frank Act of 2010 on international financial reform.
 
Finally, I will close with a few thoughts on the future role of the Financial Stability Board (FSB) and other international regulatory bodies as we move from the design of financial regulatory reforms to implementation of the new framework.

Goals for International Cooperation in Financial Regulation and Supervision

Before discussing some of the very important initiatives that are under way, I think it important to specify what I believe should be the U.S. goals for international cooperative efforts.

First, to increase the stability of our financial system through adoption of strong, common regulatory standards for large financial firms and important financial markets.
 
As events of the past few years have shown, financial stresses can quickly spread across national borders.
 
Global financial stability is a critical shared goal.

Second, to prevent major competitive imbalances between U.S. and foreign financial institutions.
 
A core set of good common standards will reduce opportunities for cross-border regulatory arbitrage, even as it promotes financial stability.
 
This goal is particularly noteworthy as the United States tightens its domestic prudential standards.

Third, to make supervision of internationally active financial institutions more effective through a clear understanding of home and host country responsibilities and adequate flows of information and analysis.

Fourth, beyond the supervision of individual institutions, to exchange information and analysis in an effort to identify potential sources of financial instability and to take action to help mitigate the buildup of risks in international financial markets, particularly those potentially posing systemic risks.

Embracing these goals does not, of course, answer the often complex questions raised in specific initiatives, such as the degree to which rules should be standardized and the degree to which national variation or discretion is warranted in pursuing shared regulatory ends.
 
But I do think it is useful to keep all of these goals in mind as we pursue our international agenda.
 
Our task as U.S. regulators is to work to ensure that, together, the various international financial organizations produce reforms and practices that are consistent with U.S. interests and legal requirements.

The Federal Reserve’s Role in International Financial Reform Efforts
 
As a central bank with significant supervisory responsibilities, the Federal Reserve actively participates in both
 
(1) central-bank-focused groups that monitor developments in global financial markets and promote sound and efficient payment systems and
 
(2) supervisory forums, such as the Basel Committee on Banking Supervision (Basel Committee), which promotes high global standards for banking supervision and regulation.
 
We also actively participate in the FSB, which is coordinating many of the initiatives undertaken in response to the financial crisis and is directly communicating with the Group of Twenty (G-20).

Our contributions to these groups take advantage of the synergies between our central banking functions and our supervisory responsibilities.
 
Our contributions combine our economic research, knowledge of financial markets, and regulatory policy experience.
 
Interestingly, in the wake of the financial crisis, we see some other countries, notably the United Kingdom, moving
back toward a more significant involvement of the central bank in supervision, presumably for these same reasons.

Basel III

The Basel Committee is working toward new global standards for minimum bank capital levels and a new liquidity requirement--a project that has become known as Basel III.
 
This undertaking is central to the first and second goals for international cooperation that I noted earlier.
 
The Basel Committee aims to complete this task by the November G-20 leaders meeting in Seoul.
 
The Federal Reserve has devoted considerable resources to this important global initiative, and we note that international bank supervisors continued to make progress at the Basel Committee meeting last week.

We agree with the yardstick set forth last month by the G-20 leaders in Toronto--
that minimum capital requirements should “enable banks to withstand--without extraordinary government support--stresses of a magnitude associated with the recent financial crisis.”
 
Our view is that large institutions should be sufficiently capitalized so that they could sustain the losses associated with a systemic problem and remain sufficiently capitalized to continue functioning effectively as financial intermediaries.
 
Meeting this standard will require a considerable strengthening of existing requirements, both with respect to the amount of capital held and to the quality of that capital.
 
As to the former, it is particularly important that the risk weightings associated with traded instruments be substantially increased.
 
As to the latter, the crisis confirmed what many of us have long believed--that common equity is by far the best
measure of a firm’s loss absorption capacity.
 
During the crisis, regulators, counterparties, and market analysts all looked to levels of common equity as the key measure of a firm’s durability in the face of extraordinary financial stress.
 
We have conducted extensive analysis to inform our judgments on the specific rules needed to implement this standard.
 
In this respect, the stress tests we conducted last year as part of the Supervisory Capital Assessment Program have been very useful in assessing the amount of capital needed to survive a financial crisis without unusual government support.

Since the Basel Committee published its proposals in a number of consultative documents,
the Federal Reserve and the other U.S. federal banking agencies have been working together for a Basel III framework that produces a strong set of globally consistent capital and liquidity requirements that will promote financial stability and a level playing field for internationally active banks.
 
We have assessed how various proposals would, or would not, achieve that aim.
 
We have also considered carefully how to structure the transition to the new requirements so as to minimize their effect on the economy as a whole and to allow adequate time for firms to adjust their capital accounts.

Although adopting a robust, common set of capital and liquidity rules for internationally active banks is critical, it is neither practical nor desirable to negotiate all details of financial regulation internationally.
 
It is important that the United States preserves the flexibility to adopt prudential regulations that work best within the U.S. financial and legal systems.
 
Within a common set of agreed-upon global standards, each jurisdiction will want to tailor some of its rules and supervisory practice to national conditions and preferences.
 
Along these lines, there have been recent discussions within the FSB on the possibility of formalizing consultations
among member countries to examine how each member is using its own mix of instruments to achieve particular safety and soundness ends.

The
Basel Committee has a number of initiatives and work programs related to capital requirements that go beyond the package of measures that we expect to be completed by the fall.

These efforts include, among others, ideas for
countercyclical capital buffers, contingent capital, and development of a metric for capital charges tied to systemic risk.
 
Each of these ideas has considerable conceptual appeal, but some of the difficulties encountered in translating the ideas into practical rules mean that work on them is likely to continue into next year.

Cross-Border Crisis Management and Resolution

Like stronger capital and liquidity requirements,
improved resolution regimes for both banks and systemically important nonbank financial companies are a critical element of the domestic and international agenda to contain systemic risk.
 
Internationally, the FSB is seeking to enhance cross-border cooperation both in making advanced preparations for handling severe stress at specific firms and in dealing with financial crises when they occur.

The FSB is developing concrete policy recommendations for the G-20 Summit in November.
 
Specifically, the FSB is working to identify common principles and key attributes for effective national resolution regimes, including a menu of resolution tools for authorities to draw upon in light of the varying circumstances that may be associated with distress at a particular firm.
 
Among these are restructuring and wind-down measures for firms that will be closed down, such as arrangements for providing temporary funding or the ability to establish a bridge bank to take over essential functions.
 
There is also considerable interest at the FSB in developing a resolution tool that could facilitate a restructuring of a firm’s own capital and liquidity that would allow it to continue operating as a going concern.
 
Specifically, the FSB is exploring whether there could be a viable mechanism for converting debt into equity through
terms set out in the debt instruments.

Another aspect of the FSB’s work focuses on
four technical areas that may affect crossborder recovery or resolution:
 
(1) practices for booking trades in one legal entity and then transferring the market or credit risk of the trade to a different location or legal entity;
 
(2) the use of intra-group guarantees and related cross-border implications;
 
(3) the critical nature of global payments operations, such as cash payments or securities settlement; and
 
(4) the adequacy of a firm’s management information systems and service level agreements.
 
The FSB is exploring ways to mitigate challenges related to these four areas.

Firm-specific crisis management working groups composed of home and host supervisory authorities are working to identify specific issues and barriers to coordinated action that may arise in handling severe stress at identified firms.
 
This process should culminate in recovery plans--developed by the individual firms--that outline options for an institution to recover from a severe distress without extraordinary official sector actions, and resolution plans--developed by the official sector--intended to identify options that would result in an orderly wind-down.

Domestically,
we have formed crisis management groups to cover the key internationally active U.S. banking organizations.
 
In addition to the Federal Reserve, the groups include representatives from the Office of the Comptroller of the Currency, Federal Deposit Insurance Corporation, Securities and Exchange Commission, and relevant foreign supervisors and central banks.
 
The firms are each internally identifying and assessing their options and strategies to lower risk in the event of stress, including selling portfolios or business lines, restructuring liabilities and implementing contingency funding plans.
 
The objective is to ensure that each firm has a concrete and viable plan to reduce riskiness, ensure the continuity of critical financial services, preserve liquidity, and make up cash flow shortages under severely adverse conditions.

They are individually working with their own crisis management group to isolate key impediments to recovery and are focusing on work that should be undertaken in the near term to enhance recovery options.
 
These plans will have to be dynamic to ensure they remain relevant and appropriate in light of changing business and economic conditions.

Despite the progress that is being made through the FSB work and domestic efforts, comprehensive solutions to cross-border crisis management difficulties will not be easy to achieve.
 
Enhancing cross-jurisdictional synchronization of resolution options and recovery processes would be a meaningful step in the right direction.
 
At least for the foreseeable future, a focus on regulatory coordination and supervisory cooperation and planning before a large firm’s failure becomes a real possibility is likely to yield the greatest benefit.

Incentive Compensation

In the last two years,
compensation has been a regular topic of discussion at meetings of international regulatory groups, culminating in the FSB’s agreement last year on principles to guide incentive compensation.
 
The principles specify that compensation practices at major financial institutions should properly account for risk, that boards of directors and risk managers at such firms should ensure they do so, that supervisors should provide effective oversight, and that firms’ disclosures should be sufficient to inform stakeholders about compensation and risk.
 
In addition to these principles, a number of specific projects are in progress or have recently been completed by international regulatory working groups.
 
The FSB conducted a peer review of G-20 nations’ progress toward implementing the principles, which found that progress is being made but more work is needed.
 
Other projects include work by the Basel Committee, expected by end-2010, on practices that would improve the soundness of risk-taking incentives, and a proposal for disclosure of compensation information under Pillar 3 of Basel 2.

While the views of national supervisory authorities have in many respects converged on such matters as the sources and effects of incentive problems and some methods for better aligning the risk-taking incentives of employees at major financial institutions with the interests of shareholders and the financial system, different nations have taken different approaches in implementing the FSB principles.

We have adopted an approach that
requires large financial organizations to establish and maintain internal governance and management systems to implement principles for assuring that incentive compensation arrangements are risk-appropriate.
 
These principles, and the process by which we proposed that they be implemented, were issued by the Federal Reserve for public comment in October.
 
The final supervisory guidance, which was jointly issued with the other banking agencies, was released last month.
 
We chose a principles-based approach because of the substantial variation in the actual incentives and risks associated with the thousands of executives and other employees within and among banking organizations.
 
Our view continues to be that a uniform or formulaic approach to all such employees would be neither efficient in
motivating and compensating employees nor effective in preventing excessively risky activity, particularly among non-executives such as traders.

In contrast,
this month the European Parliament approved a directive that has the potential to lead to a number of formula-based restrictions on employee compensation at financial services firms operating in the European Union (EU).
 
This approach is consonant with views expressed by some EU members to the effect that formula setting--for example, putting a floor on the portion of an employee’s salary that must be deferred--is the surest way to produce
changes in bank practice.
 
However, many of the details are left to be set by the European Commission, the Committee of European Bank Supervisors, and other entities.
 
While both approaches have merit, we believe the option we have chosen is likely to be more successful in promoting risk-appropriate compensation practices.
 
As already noted, we fear that a formula-based approach applicable to all covered employees may spawn efforts to circumvent the rules through creative new compensation practices, whereas our requirement that the banks internalize sound principles for incentive compensation and apply them to all such arrangements places a continuing responsibility on the firms themselves.
 
Of course, considerable oversight is needed to ensure that a principles-based approach is implemented rigorously.
 
We have already conducted an extensive horizontal review of compensation practices at 25 large U.S. financial holding companies and have sent detailed assessments to each firm commenting on their proposals for implementing the principles.
 
It may well be that over time the two approaches will converge somewhat.
 
For example, we may determine on the basis of experience with many firms that there are certain best practices that should at least presumptively be applicable to certain classes of employees.
 
Similarly, the EU may find that more attention to internalization of the principles and customization of appropriate practices is necessary, particularly as applied to non-executive employees.
 
We intend to continue information sharing and discussions through the FSB and the Basel Committee.
 
For now, though, there is indeed a difference in approach, one that illustrates the point I made earlier that there need not be complete harmonization in all prudential regulation and supervision, even where there is agreement on basic goals.

Effect of the Dodd-Frank Act

Of course, concurrent with the efforts of the Federal Reserve and other U.S. agencies to advance the goals of international regulatory reform,
the U.S. Congress has debated and passed the Dodd-Frank Act, creating a comprehensive package of domestic financial reforms.
 
Many elements of the Dodd-Frank Act align closely with the efforts of the G-20 leaders, the FSB, and the Basel Committee.
 
For example, the act provides the federal government with the authority to subject all financial firms that present outsized systemic risks--regardless of whether they own an insured depository institution--to a common framework of supervision and regulation by the Federal Reserve.
 
In addition, the act creates a special resolution regime that gives the government the capacity to unwind or break apart major non-bank financial firms in an orderly fashion with less collateral damage to the system.
 
Moreover, the act strengthens the resiliency of the financial market infrastructure by mandating increased central clearing and transparency for over-the-counter derivative transactions and stronger prudential regulation of bank and nonbank derivatives dealers.
 
The act also provides for the registration of advisers to hedge funds and other private investment funds, improved regulation of credit rating agencies, and more-consistent oversight of systemically important financial market utilities.
 
At the same time, there are aspects of the Dodd-Frank Act that are unlikely to become part of the international financial regulatory framework.
 
For example, the act generally prohibits U.S. banking firms (and the U.S. operations of foreign banking firms) from engaging in proprietary trading and from investing in or sponsoring private investment funds.
 
The act also prohibits U.S. depository institutions from entering into certain types of derivatives transactions.
 
In the United States, activity restrictions have long been a part of the bank regulatory regime, serving to constrain risk-taking by banking firms, prevent the spread of the market distortions caused by the federal bank safety net to other parts of the economy, and mitigate potential conflicts of interest generated by the combination of banking and certain other businesses within a single firm.
 
Many other countries follow a universal banking model and are unlikely to adopt the sorts of activity restrictions contained in the act.
 
Similarly, the Dodd-Frank Act expands the existing 10 percent deposit cap in U.S. law by preventing the Federal Reserve from approving a material acquisition by a financial firm if the resulting firm would have liabilities that exceed 10 percent of the total liabilities of the broader U.S. banking system.
 
Other countries with more concentrated banking systems are unlikely to impose this type of concentration limit on financial firms in their jurisdiction.
 
Again, not all elements of financial reform can be designed on a national level in a way that is perfectly consistent across countries.
 
The characteristics of each country’s financial system differ, sometimes significantly.
 
Our challenge is to strike the right balance between achieving global consistency on the core reforms necessary to protect financial stability and provide a workably level playing field, and at the same time providing the flexibility necessary to supplement the common standards with elements tailored to national financial systems, legal structures, and policy preferences.
 
Current and Future Focus of International Regulatory Groups

As my testimony makes clear, the international regulatory groups remain focused on responding to the crisis.
 
The FSB is pursuing financial reform and working with the relevant standard-setting bodies to ensure that detailed proposals are developed in a timely manner.
 
In some cases, the importance of the issues and the drive to respond quickly to the crisis have led to a proliferation of international working groups whose mandates may overlap.
 
While this reaction is natural in the wake of a crisis, we will need to rationalize the activities of these groups as our focus shifts from policy development to implementation.
 
So, too, we will need to ensure that the relatively new members of these groups are fully and effectively integrated into their activities, including in leadership positions.
 
It is also important that we not lose sight of the third and fourth goals I suggested for our international cooperative efforts.
 
While much of the effort in the international groups has recently been focused on negotiating rules and principles to reform financial regulation, it would be unfortunate going forward if negotiations were to become the dominant mode of international financial cooperation.
 
We would not want to crowd out the other valuable aspects of international regulatory cooperation, including sharing supervisory perspectives on internationally active financial institutions and analyzing latent risks to financial stability.

The FSB itself has a valuable role to play by bringing together the international standard setting bodies and key national authorities responsible for financial stability in the G-20 member jurisdictions.
 
Its role might usefully be conceived as roughly paralleling the role to be played by the Financial Stability Oversight Council in the United States under the Dodd-Frank Act.
 
The FSB can facilitate discussion and analysis of emerging risks to financial stability that cut across sectors or across the jurisdiction of more than one regulator.
 
Because it consists of senior officials from finance ministries, regulatory agencies, and central banks, it is well positioned not only to identify cross-cutting risks or regulatory gaps, but also to take action to address those risks.
 
Finally, I believe that it will be important for standard-setting bodies such as the Basel Committee to enhance monitoring of the implementation of the sometimes complex agreements reached internationally.
 
Where it is difficult for market analysts and other outside observers to determine if, for example, Basel III capital rules are being vigorously implemented and enforced, the international standard setters must themselves develop appropriate monitoring mechanisms.
 
These mechanisms must go beyond examining whether international standards have been duly incorporated into domestic law to consider whether financial institutions are complying with those standards.

Thank you for again giving me the opportunity to share our thoughts on the evolving issues in international financial cooperation. I would be pleased to answer any questions you may have.
 

 
Breaking News - 12 September 2010
The Group of Governors and Heads of Supervision announces higher global minimum capital standards

At its 12 September 2010 meeting, the Group of Governors and Heads of Supervision, the oversight body of the Basel Committee on Banking Supervision,
announced a substantial strengthening of existing capital requirements and fully endorsed the agreements it reached on 26 July 2010.
 
These capital reforms, together with the introduction of a global liquidity standard, deliver on the core of the global financial reform agenda and will be presented to the Seoul G20 Leaders summit in November.

The Committee’s package of reforms will increase the minimum common equity requirement from 2% to 4.5%.
 
In addition, banks will be required to hold a capital conservation buffer of 2.5% to withstand future periods of stress bringing the total common equity requirements to 7%.
 
This reinforces the stronger definition of capital agreed by Governors and Heads of Supervision in July and the higher capital requirements for trading, derivative and securitisation activities to be introduced at the end of 2011.

Increased capital requirements

Under the agreements reached, the minimum requirement for common equity, the highest form of loss absorbing capital, will be raised from the current 2% level, before the application of regulatory adjustments, to 4.5% after the application of stricter adjustments.
 
This will be phased in by 1 January 2015.
 
The Tier 1 capital requirement, which includes common equity and other qualifying financial instruments based on stricter criteria, will increase from 4% to 6% over the same period.

The Group of Governors and Heads of Supervision also agreed that the capital conservation buffer above the regulatory minimum requirement be calibrated at 2.5% and be met with common equity, after the application of deductions.
 
The purpose of the conservation buffer is to ensure that banks maintain a buffer of capital that can be used to absorb losses during periods of financial and economic stress.
 
While banks are allowed to draw on the buffer during such periods of stress, the closer their regulatory capital ratios approach the minimum requirement, the greater the constraints on earnings distributions.
 
This framework will reinforce the objective of sound supervision and bank governance and address the collective action problem that has prevented some banks from curtailing distributions such as discretionary bonuses and high dividends, even in the face of deteriorating capital positions.

A countercyclical buffer within a range of 0% – 2.5% of common equity or other fully loss absorbing capital will be implemented according to national circumstances.
 
The purpose of the countercyclical buffer is to achieve the broader macroprudential goal of protecting the banking sector from periods of excess aggregate credit growth.
 
For any given country, this buffer will only be in effect when there is excess credit growth that is resulting in a system wide build up of risk.
 
The countercyclical buffer, when in effect, would be introduced as an extension of the conservation buffer range.

These capital requirements are supplemented by a non-risk-based leverage ratio that will serve as a backstop to the risk-based measures described above.
 
In July, Governors and Heads of Supervision agreed to test a minimum Tier 1 leverage ratio of 3% during the parallel run period.
 
Based on the results of the parallel run period, any final adjustments would be carried out in the first half of 2017 with a view to migrating to a Pillar 1 treatment on 1 January 2018 based on appropriate review and calibration.

Systemically important banks should have loss absorbing capacity beyond the standards announced today and work continues on this issue in the Financial Stability Board and relevant Basel Committee work streams.
 
The Basel Committee and the FSB are developing a well integrated approach to systemically important financial institutions which could include combinations of capital surcharges, contingent capital and bail-in debt.
 
In addition, work is continuing to strengthen resolution regimes.
 
The Basel Committee also recently issued a consultative document Proposal to ensure the loss absorbency of regulatory capital at the point of non-viability.
 
Governors and Heads of Supervision endorse the aim to strengthen the loss absorbency of non-common Tier 1 and Tier 2 capital instruments.

Transition arrangements

Since the onset of the crisis, banks have already undertaken substantial efforts to raise their capital levels.
 
However, preliminary results of the Committee’s comprehensive quantitative impact study show that as of the end of 2009, large banks will need, in the aggregate, a significant amount of additional capital to meet these new requirements.
 
Smaller banks, which are particularly important for lending to the SME sector, for the most part already meet these higher standards.
 
The Governors and Heads of Supervision also agreed on transitional arrangements for implementing the new standards.
 
These will help ensure that the banking sector can meet the higher capital standards through reasonable earnings retention and capital raising, while still supporting lending to the economy.
 
The transitional arrangements include:

1. National implementation by member countries will begin on 1 January 2013.
 
Member countries must translate the rules into national laws and regulations before this date.
 
As of 1 January 2013, banks will be required to meet the following new minimum requirements in relation to risk-weighted assets (RWAs):

– 3.5% common equity/RWAs;

– 4.5% Tier 1 capital/RWAs, and

– 8.0% total capital/RWAs.

The minimum common equity and Tier 1 requirements will be phased in between 1 January 2013 and 1 January 2015.
 
On 1 January 2013, the minimum common equity requirement will rise from the current 2% level to 3.5%.
 
The Tier 1 capital requirement will rise from 4% to 4.5%.
 
On 1 January 2014, banks will have to meet a 4% minimum common equity requirement and a Tier 1 requirement of 5.5%.
 
On 1 January 2015, banks will have to meet the 4.5% common equity and the 6% Tier 1 requirements.
 
The total capital requirement remains at the existing level of 8.0% and so does not need to be phased in.
 
The difference between the total capital requirement of 8.0% and the Tier 1 requirement can be met with Tier 2 and higher forms of capital.
 
2. The regulatory adjustments (ie deductions and prudential filters), including amounts above the aggregate 15% limit for investments in financial institutions, mortgage servicing rights, and deferred tax assets from timing differences, would be fully deducted from common equity by 1 January 2018.
 
3. In particular, the regulatory adjustments will begin at 20% of the required deductions from common equity on 1 January 2014, 40% on 1 January 2015, 60% on 1 January 2016, 80% on 1 January 2017, and reach 100% on 1 January 2018.
 
During this transition period, the remainder not deducted from common equity will continue to be subject to existing national treatments.
 
4. The capital conservation buffer will be phased in between 1 January 2016 and year end 2018 becoming fully effective on 1 January 2019.
 
It will begin at 0.625% of RWAs on 1 January 2016 and increase each subsequent year by an additional 0.625 percentage points, to reach its final level of 2.5% of RWAs on 1 January 2019.
 
Countries that experience excessive credit growth should consider accelerating the build up of the capital conservation buffer and the countercyclical buffer.
 
National authorities have the discretion to impose shorter transition periods and should do so where appropriate.
 
5. Banks that already meet the minimum ratio requirement during the transition period but remain below the 7% common equity target (minimum plus conservation buffer) should maintain prudent earnings retention policies with a view to meeting the conservation buffer as soon as reasonably possible.
 
6. Existing public sector capital injections will be grandfathered until 1 January 2018.
 
Capital instruments that no longer qualify as non-common equity Tier 1 capital or Tier 2 capital will be phased out over a 10 year horizon beginning 1 January 2013.
 
Fixing the base at the nominal amount of such instruments outstanding on 1 January 2013, their recognition will be capped at 90% from 1 January 2013, with the cap reducing by 10 percentage points in each subsequent year.
 
In addition, instruments with an incentive to be redeemed will be phased out at their effective maturity date.
 
7. Capital instruments that do not meet the criteria for inclusion in common equity Tier 1 will be excluded from common equity Tier 1 as of 1 January 2013.
 
However, instruments meeting the following three conditions will be phased out over the same horizon described in the previous bullet point:
 
(1) they are issued by a non-joint stock company;
 
(2) they are treated as equity under the prevailing accounting standards; and
 
(3) they receive unlimited recognition as part of Tier 1 capital under current national banking law.
 
8. Only those instruments issued before the date of this press release should qualify for the above transition arrangements.
 
Phase-in arrangements for the leverage ratio were announced in the 26 July 2010 press release of the Group of Governors and Heads of Supervision.
 
That is, the supervisory monitoring period will commence 1 January 2011; the parallel run period will commence 1 January 2013 and run until 1 January 2017; and disclosure of the leverage ratio and its components will start 1 January 2015.
 
Based on the results of the parallel run period, any final adjustments will be carried out in the first half of 2017 with a view to migrating to a Pillar 1 treatment on 1 January 2018 based on appropriate review and calibration.

After an observation period beginning in 2011, the liquidity coverage ratio (LCR) will be introduced on 1 January 2015. The revised net stable funding ratio (NSFR) will move to a minimum standard by 1 January 2018.
 
The Committee will put in place rigorous reporting processes to monitor the ratios during the transition period and will continue to review the implications of these standards for financial markets, credit extension and economic growth, addressing unintended consequences as necessary.
 
The Basel Committee on Banking Supervision provides a forum for regular cooperation on banking supervisory matters. It seeks to promote and strengthen supervisory and risk management practices globally.
 
The Committee comprises representatives from Argentina, Australia, Belgium, Brazil, Canada, China, France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, the United Kingdom and the United States.
 
The Group of Central Bank Governors and Heads of Supervision is the governing body of the Basel Committee and is comprised of central bank governors and (non-central bank) heads of supervision from member countries. The Committee’s Secretariat is based at the Bank for International Settlements in Basel, Switzerland.
 
 
 
 

 
G20 - Meeting of Finance Ministers and Central Bank Governors, Busan, Republic of Korea
June 5, 2010
 
"We, the G20 Finance Ministers and Central Bank Governors, met at a critical juncture to firmly secure the global recovery and address the economic challenges and risks.
 
Building on progress to date, we affirmed our commitment to intensify our efforts and to accelerate financial repair and reform.
 
Therefore, we:
 
Committed to reach agreement expeditiously on stronger capital and liquidity standards as the core of our reform agenda and in that regard fully support the work of the Basel Committee on Banking Supervision and call on them to propose internationally agreed rules to improve both the quantity and quality of bank capital and to discourage excessive leverage and risk taking by the November 2010 Seoul Summit.
 
It is critical that our banking regulators develop capital and liquidity rules of sufficient rigor to allow our financial firms to withstand future downturns in the global financial system.
 
As we agreed, these rules will be phased in as financial conditions improve and economic recovery is assured, with the aim of implementation by end-2012.
 
We welcome the progress on the quantitative and macroeconomic impact studies which will inform the calibration and phasing in, respectively.
 
We are committed to move together in a transparent and coordinated way on national implementation of the agreed rules. Implementation of these new rules should be complemented by strong supervision."
 

 
G20 at the London Summit in April 2009

DECLARATION ON STRENGTHENING THE FINANCIAL SYSTEM – LONDON, 2 APRIL 2009
"We, the Leaders of the G20, have taken, and will continue to take, action to strengthen regulation and supervision in line with the commitments we made in Washington to reform the regulation of the financial sector."

"All G20 countries should progressively adopt the Basel II capital framework; and the BCBS and national authorities should develop and agree by 2010 a global framework for promoting stronger liquidity buffers at financial institutions, including cross-border institutions. "

G20 at the Pittsburgh Summit in September 2009

PROGRESS REPORT ON THE ACTIONS TO PROMOTE FINANCIAL REGULATORY REFORM ISSUED BY THE U.S. CHAIR OF THE PITTSBURGH G-20 SUMMIT – 25 SEPTEMBER 2009

"We are committed to
take action at the national and international level to raise standards together so that our national authorities implement global standards consistently in a way that ensures a level playing field and avoids fragmentation of markets, protectionism, and regulatory arbitrage."

"
Progress is being made in the two major international initiatives now underway on bank resolution frameworks, namely the Cross-Border Bank Resolution Group (CBRG) of the Basel Committee on Banking Supervision (BCBS) and the initiative by the IMF and the World Bank on the legal, institutional and regulatory framework for national bank insolvency regimes.
 
In September, the CBRG published for consultation a report, which includes recommendations for authorities on effective crisis management and resolution processes for large cross-border institutions. "

" The Group of Central Bank Governors and Heads of Supervision, the oversight body of the BCBS, reached agreement in September to introduce a framework for countercyclical capital buffers above the minimum requirement.
 
The framework will include capital conservation measures such as constraints on capital distributions.
 
The Basel Committee will review an appropriate set of indicators, such as earnings and credit-based variables, as a way to condition the build up and release of capital buffers.

The BCBS is also actively engaged with accounting standard setters to promote more forward-looking provisions based on expected losses.

The IASB is working to enhance its provisioning standards and guidance on an accelerated basis, including by considering a proposed impairment standard based on an expected loss (called an “expected cash flow”) approach to loan loss provisioning for issuance in October 2009.
 
The IASB published initial proposals on its website in June to seek input regarding the feasibility of this expected loss approach before it issues an exposure draft in October 2009.

Finally, the BCBS continues to work on approaches to address any excessive cyclicality of minimum capital requirements.

The BCBS will issue concrete proposals on these measures by end-2009.
 
It will carry out an impact assessment at the beginning of 2010, with calibration of the new requirements to be completed by end-2010. Appropriate implementation standards will be developed to ensure a phase-in of these new measures that does not impede the recovery of the real economy. "

" We commit to developing by end-2010 internationally agreed rules to improve both the quantity and quality of bank capital and to discourage excessive leverage and these rules will be phased in as financial conditions improve and economic recovery is assured, with the aim of implementation by end-2012.
 
The national implementation of higher level and better quality capital requirements, counter-cyclical capital buffers, higher capital requirements for risky products and off balance sheet activities, and as elements of the Basel II capital framework, together with strengthened liquidity risk requirements and forward-looking provisioning, will reduce incentives for banks to take excessive risks and create a financial system better prepared to withstand adverse shocks.
 
We welcome the key measures recently agreed by the oversight body of Basel Committee on Banking Supervision to strengthen the supervision and regulation of the banking sector.

The BCBS should review minimum levels of capital and develop recommendations in 2010.

Our efforts to deal with impaired assets and to encourage the raising of additional capital must continue, where needed.

We commit to conduct robust, transparent stress tests as needed.

We call on banks to retain a greater proportion of current profits to build capital, where needed, to support lending. "

" The BCBS has stated that the level of capital in the banking system, both the minimum capital requirement and the buffers above it, will be raised relative to pre-crisis levels to improve resilience to future episodes of stress.
 
This will be done through a combination of measures such as strengthening the risk coverage of the Basel II capital framework, improving the quality of capital, and raising the overall minimum requirement.
 
The BCBS will carry out an impact assessment at the beginning of 2010 and calibrate the new requirements by end-2010. Appropriate implementation standards will be developed to ensure a phase-in that does not impede the recovery of the real economy. "  
 

 
Regulatory Arbitrage and Basel iii
 
Deutsche Bank is concerned about the regulatory arbitrage possibilities. Andrew Procter, the bank’s head of government and regulatory affairs, has expressed concern that the United States may not adopt Basel III.

“The United States continues to influence the Basel process but, in effect, treats the guidelines as optional” .
“Deutsche Bank believes that no other Basel committee members should move ahead with implementation until there is a clear timetable from the U.S.” Andrew believes

Our view is that Basel III will be implemented in the United States.
When?
We are not sure. Perhaps, after the end of 2012. It is true that the United States delayed Basel II, and we consider that something similar is likely under Basel III. But, Basel III is going to be implemented in the United States. 
 

 
A report from Rabobank’s Economic Research Department argues that proposed capital and liquidity requirements for internationally operating banks will have a major impact on the banking sector, could restrict the credit supply and hamper economic growth.

Under the Basel III requirements, banks will have to hold more and higher quality liquid assets as a buffer for the short-term. They will also have to finance these assets with more stable and long-term funding. The Rabobank economists claim that the new requirements
will affect the traditional role of the banks, that is transforming customer’s savings into loans.
 


 
Improving Financial Regulation
Report of the Financial Stability Board to G20 Leaders
25 September 2009


1. Since the London Summit, the Financial Stability Board (FSB) and its members have advanced a major program of financial reforms based on clear principles and timetables for implementation that are designed to ensure that a crisis on this scale never happens again.

2. Much has already been achieved, and much is underway that when implemented will result in a very different financial system than the one that brought us this crisis.

However,
policy development is not completed, and detailed implementation of the full set of needed reforms will take time and perseverance.

3. In a globally integrated market economy, where concerns about a level playing field and protectionist pressures are real, it is vital that G20 Leaders strongly support the international policy development underway and signal their determination to implement fully and consistently the reforms at national levels.

4. In recent months, expectations have taken hold in some parts of the private financial sector that the financial and regulatory system will remain little changed from its pre-crisis contours.

These expectations – that business will be able to go on just as before – need to be dispelled.


5. Our objective is to create a more disciplined and less procyclical financial system that better supports balanced sustainable economic growth.

This system will
not allow leverage to increase to the extent that it did.
 
Nor will we allow risks to be taken where profits accrue to individual actors but ultimate losses are borne by governments and the wider public.

6. To these ends,
our program includes substantially higher requirements for the quantity and quality of capital and liquidity at financial institutions.

It also includes
reforms to accounting standards and compensation regimes that improve transparency and limit incentives to excessive risk taking.

We will constrain risks in trading-related activity by improving market infrastructure and by significantly raising capital charges for trading books.

7. Our reform plans set reasonable implementation windows to avoid aggravating the present crisis.

While the financial system will continue to face challenges for some time, the faster our financial systems and economies recover, the faster we should implement finalised reforms.

8. This crisis has highlighted the moral hazard risks posed by institutions that have become too big to fail or that, by their interconnected nature, are too complex to resolve.

We need to address the
deeper-seated challenges that these institutions pose.

We are committed to developing the solutions to these problems over the next twelve months.

9. In recent quarters, many financial institutions have returned to profitability.

These profits owe much to the extraordinary official measures taken to stabilise the system, many of which remain in place.

It is imperative that these profits be retained in financial institutions to rebuild capital necessary to support lending, allow official support measures to be removed and prepare institutions to meet future higher capital requirements.

10. The international supervisory and regulatory community is agreed that restricting dividend payments, share buybacks and compensation rates are appropriate means to these ends.

11. The
support of G20 Leaders
will be vital for the major decisions that will need to be made in these important areas, and we ask that you support us in these endeavours.


Achievements to date

12. Bolstering the resilience of the international financial system is a broad project encompassing a considerable number of related measures.
 
Substantial progress has been made on the many measures recommended in the Financial Stability Forum (FSF)’s April 2008 and 2009 Reports, the G20 Washington Action Plan and the London Summit Statement, especially at the level of international policy development.

Significant actions have been taken since the London Summit:

• The shortcomings in the Basel capital framework that generated incentives for off-balance sheet securitisation activity have been removed;

• The weaknesses in accounting practices and national standards that generated similar incentives for off-balance sheet activities have been addressed.

New standards have been set out that enhance the consolidation of special purpose vehicles and the transparency of banks’ relationships with such entities;

• The risks that banks assume in their trading activities have been brought under better control.

Substantially higher capital requirements against risks in banks’ trading activities have been issued;

• Strong new risk management standards for financial institutions have been issued and are being implemented, covering bank governance, the management of liquidity risk, underwriting and concentration risks, stress testing, valuation practices and exposures to off-balance sheet activities;

• Banks’ disclosures of their on- and off-balance sheet risk exposures have been materially improved.

New disclosure standards for banks have been issued covering valuation and liquidity risk, securitisation and off-balance sheet activities;


• The FSB Principles for Sound Compensation Practices have been integrated into the Basel capital framework, a
nd international guidance is under development to reinforce their implementation;

• Central counterparties have been introduced to clear credit default swaps, reducing the systemic risks from this market.
 
Transparency and standardisation in this market have been increased and dealers have reduced their cross exposures through trade compression;

• Stronger oversight regimes for credit rating agencies have been developed.


New legislation creating oversight regimes has been approved in Japan and is close to final approval in the EU; in the US, amendments to the existing oversight regime have been proposed or already made;

• Internationally agreed principles for the oversight of hedge funds have been issued, and national and regional legislation has been or is in the process of being introduced to implement them;

• Good practices for due diligence by asset managers when investing in structured finance products have been issued, which will reduce their reliance on credit rating agencies;


• Abusive short selling has been addressed. Internationally agreed principles have been issued to counteract the abusive use of short selling while maintaining the benefits of short selling for the functioning of the markets, and their implementation will be monitored;

• Supervisory coordination and cooperation in the oversight of the most important global financial firms have improved. Supervisory colleges have now been established for all the large complex financial groups that the FSB has identified as needing colleges;

• Strengthened arrangements for system-wide oversight have been developed in many jurisdictions, bringing together the relevant authorities to better assess risks to financial stability and identify mitigating actions;

• Firm-by-firm contingency planning is underway to implement the FSB Principles for Cross-border Cooperation on Crisis Management.

Relevant authorities will hold contingency planning meetings for major cross-border banks within the first half of 2010 and assess the barriers to coordinated action that may arise in handling severe stress at these firms;

• Depositors will be protected in a more consistent way around the world.

Core Principles for Effective Deposit Insurance Systems have been developed and an assessment methodology is under preparation.
 


Critical work underway

13. Beyond the areas above, a large body of critical work is underway to take forward other parts of the London Summit Statement. In some areas, policy development is reaching a phase in which difficult decisions will need to be made.

Strengthening the global capital framework

14. The Basel Committee on Banking Supervision is working urgently to build stronger buffers into the financial system, covering capital, liquidity and provisioning, that will raise defenses and constrain the procyclical build-up of leverage in the system.

15.
New rules will be set out by end-2009, calibrated in 2010 and phased in as financial conditions improve and economic recovery is assured.

Government capital injections will be grandfathered.

Banks should be retaining profits now to prepare to meet these future additional capital requirements.

Restricting dividends, share buybacks and compensation rates is a necessary part of that process.

16. The new rules will require a clear step up in the amount and quality of capital that the system as a whole will need to carry, so that banks holding the minimum required capital levels will be clearly viable in a crisis and confidence in the system as a whole will be maintained.

17. To these ends, the Basel II capital framework is being revised.
 
We are agreed that:

• the level and quality of minimum capital requirements will increase substantially over time;

capital requirements will operate countercyclically, so that financial institutions will be required to build capital buffers above the minimum requirements during good times that can be drawn down during more difficult periods;

• significantly higher capital requirements for risks in banks’ trading books will be implemented, with average capital requirements for the largest banks’ trading books at least doubling by end-2010;

• the quality, consistency and transparency of the Tier 1 capital base will be raised.


The predominant form of Tier 1 capital must be common shares and retained earnings.

Appropriate principles will be developed for non-joint stock companies to ensure they hold comparable levels of high quality Tier 1 capital.

Moreover, deductions and prudential filters will be harmonised internationally and generally applied at the level of common equity or its equivalent in the case of non-joint stock companies;


• the definition of capital will be harmonised across jurisdictions and all components of the capital base will be fully disclosed so as to allow comparisons across institutions to be easily made;

• a leverage ratio will be introduced as a supplement to the Basel II risk-based framework with a view to migrating to a Pillar 1 treatment based on appropriate review and calibration.

To ensure comparability, the details of the leverage ratio will be harmonised internationally, fully adjusting for differences in accounting.

18. We will also examine the use of “contingent capital” and comparable instruments as a potentially cost-efficient tool to meet a portion of the capital buffer in a form that acts as debt during normal times but converts to loss-absorbing capital during financial stress, thus acting as a shock-absorber for the capital position.

19. We will also assess the need for a capital surcharge to mitigate the risk of systemic banks.


Making global liquidity more robust

20. The crisis vividly demonstrated that adequate liquidity is a prerequisite for financial stability.

The drying up of liquidity at the level of financial institutions, countries and ultimately the global system caused the seizing up of credit provision and of financial flows.


Cross-border flows are often the most vulnerable during financial crisis, and emerging markets can face damaging volatility in foreign exchange and liquidity flows.

21. Just as strong capital is a necessary condition for banking system soundness, so too is a strong liquidity base.
 
Many banks that had adequate capital levels still experienced difficulties during the crisis because they did not manage their liquidity in a prudent manner.

The lesson is that banks’ resilience to system-wide liquidity shocks – affecting both market and funding liquidity – must be significantly increased and their management of this risk strengthened.

22. To this end, we are substantially raising the bar for global liquidity risk regulation:

The Basel Committee will issue by the end of 2009 a new minimum global liquidity standard.

This new regulatory framework introduces a liquidity coverage ratio that can be applied in a cross-border setting.

It establishes a harmonised framework to ensure that global banks have sufficient high-quality liquid assets to withstand a stressed funding scenario specified by supervisors.

• The Basel Committee will also formulate a structural ratio to address liquidity mismatches and promote a strong funding profile over longer-term horizons.

• This new standard complements the supervisory guidance for banks’ liquidity risk management practices, the implementation of which is being assessed in supervisory reviews.

23. Shortages of cross-border liquidity caused problems at the national level for many countries.

Ex ante measures to reduce the risk of instability are needed, as well as ex post mechanisms to provide a coordinated official response if shortages arise:


• Regulators and supervisors in emerging markets will enhance their supervision of banks’ operations in foreign currency funding markets.

• The Committee on the Global Financial System will investigate policy options to reduce system-wide cross-border liquidity risk, including through strengthening the infrastructure of the foreign exchange swaps market and other aspects of funding liquidity markets.

• National and regional authorities and the international financial institutions will use the results of this investigation to review together the scope for improved cooperation over liquidity provision when liquidity shortages arise.


Reducing the moral hazard posed by systemically important institutions

24. Notwithstanding the actions above to strengthen capital and liquidity, additional steps are needed to reduce the moral hazard risks and economic damage associated with institutions that are “too big to fail” (or, more accurately, too big and too complex to fail).

25. Action in this area is essential to contain the costs to governments and economies of future crises.
 
We will develop over the next 12 months measures that can be taken to reduce the systemic risks these institutions pose.
 
Possible measures include specific additional capital, liquidity and other prudential requirements as well as other measures to reduce the complexity of group structures and, where appropriate, encourage stand-alone subsidiaries.

More intense and internationally coordinated regulation and supervision of firms presenting greater risks can help to reduce the probability of their failure.


26. For all major cross-border firms we will require the development of specific contingency plans that aim at preserving the firm as a going concern, promoting the resiliency of key functions and facilitating rapid resolution or wind-down, should that prove necessary.

The Basel Committee’s consultation document on cross border bank resolution proposes specific actions to achieve an effective, rapid and orderly wind-down of large cross-border financial firms.

27. We will assess the implications of different responses for systemic cross-border institutions with different group structures, and the impact of these different measures for the stability and efficiency of cross-border capital flows.

We ask you to support us in this important future work.
 


Strengthening accounting standards

28. In April 2009, the G20 Leaders stated that standard setters should “make significant progress towards a single set of high quality global accounting standards.”

There is significant progress in this area and nearly all FSB member jurisdictions have programmes underway to converge with or adopt the standards of the International Accounting Standards Board (IASB) by 2012.

29. In addition, the G20 Leaders welcomed the FSF’s procyclicality recommendations relating to accounting and called on “accounting standard setters to work urgently with supervisors and regulators to improve standards on valuation and provisioning and achieve a single set of high-quality global accounting standards.”

Important steps have been taken to improve existing standards and to enhance dialogue with prudential authorities.
 
But in some instances, achieving improved valuation and provisioning standards alongside the goal of convergence need further attention by standard setters.

30. At present, the IASB and the US Financial Accounting Standards Board (FASB) are considering a variety of approaches which could possibly lead to divergences between IASB and FASB standards with respect to:

• improving and simplifying financial instruments accounting, where FASB is considering an approach that is based on fair value measurement for most financial instruments, which would be proposed by early 2010, while the IASB has proposed a mixed model of historical cost and fair value, to be available for use in 2009 year-end financial statements;

• provisioning and impairment, where the IASB plans to propose a standard using an expected loss or expected cash flow approach to loan loss provisioning in October 2009, which would generally recognise credit losses earlier and mitigate procyclicality,1 whereas the FASB continues to consider changes toimpairment recognition, including an approach based on fair value with plans to issue its proposal by early 2010;


off-balance sheet standards, where the IASB’s proposal on derecognition, which is now subject to consultation, would require repurchase agreements to be treated as sales and forward contracts in certain situations (thus leading to off-balance sheet treatment), instead of as financing transactions on the balance sheet as under current IASB and FASB standards.

31. Moreover, continuing differences in accounting requirements of the IASB and FASB for netting/offsetting of assets and liabilities also result in significant differences in banks’ total assets, posing problems for framing an international leverage ratio.

32. Therefore, additional work in the areas above is urgently needed in order to meet the important objectives of convergence, transparency and the mitigation of procyclicality, as standard setters continue their efforts to improve the quality of their standards and reduce the complexity of their standards on financial instruments.

33. We strongly encourage the IASB and FASB to agree on improved converged standards that will:

• incorporate a broader range of available credit information than existing provisioning requirements, so as to recognise credit losses in loan portfolios at an earlier stage as part of an effort to mitigate procyclicality.

We are particularly supportive of continued work on impairment standards based on an expected loss model; and


• simplify and improve the accounting principles for financial instruments and their valuation.
 
We are particularly supportive of continued work in a manner that does not expand the use of fair value in relation to the lending activities (involving loans and investments in debt instruments) of financial intermediaries.

34. While respecting the independence of accounting standard setters, the FSB is urging renewed efforts by the IASB and FASB to achieve these objectives, working with supervisors, regulators and other constituents.

The Basel Committee has issued for consideration by accounting standard setters principles for the revision of accounting standards for financial instruments, agreed by all G20 banking supervisors, that address issues related to provisioning, fair value measurement and related disclosures.

35. We welcome the IASB’s recent initiatives with respect to provisioning and its enhanced technical dialogue with prudential supervisors and other stakeholders, and encourage the IASB to continue its dialogue with stakeholders as it moves forward.

We request G20 Leaders to support the call for action set forth in this section.
 


Improving compensation practices

36. National regulatory and supervisory initiatives are being taken to implement the FSB Principles for Sound Compensation Practices.
 
The Principles call for wide ranging private and official sector action to ensure that governance of compensation is effective; that financial firms align their compensation practices with prudent risk taking; and that compensation policies are subject to
effective supervisory oversight and engagement by stakeholders.


37. Given competitiveness concerns, speedy and determined coordinated action in all major financial centres is needed to achieve effective global implementation of the Principles.

We must ensure that the Principles are rigorously and consistently implemented and applied to significant financial institutions and especially large, systemically relevant firms across the financial services sector.

38. To this end, we have set out in a separate report2 to the Summit specific implementation standards for the Principles, focusing on areas in which especially rapid progress is needed.

These cover:

• independent and effective board oversight of compensation policies and practices;

• linkages of the total variable compensation pool to the overall performance of the firm and the need
to maintain a sound capital base;

• compensation structure and risk alignment, including deferral, vesting and clawback arrangements;

• limitations on guaranteed bonuses;

• enhanced public disclosure and transparency of compensation; and

• enhanced supervisory oversight of compensation, including sanctions if necessary.


39. The Basel Committee, the International Association of Insurance Supervisors (IAIS) and the International Organization of Securities Commissions (IOSCO) will undertake measures to support implementation.

40. We will undertake a FSB thematic peer review of actions taken by national authorities to implement our Principles and implementation standards.

We will assess whether these actions have had their intended effect and propose additional measures as required.
This review will be completed in March 2010.

41. These actions are in addition to our call for banks to conserve capital by limiting bonus payments today and so be in a better position to meet future additional capital requirements.
 


Expanding oversight of the financial system

42. In addition to strengthening the buffers in the banking system, work is progressing to ensure that, throughout the broader financial system, all systemically important activity is subjected to appropriate oversight and regulation.
 
In particular:

• Regarding hedge funds, regulators are working, including through IOSCO, to set out for consideration by legislatures a consistent framework for oversight and regulation of hedge funds and/or hedge fund managers, including requirements for mandatory registration, ongoing regulation, provision of information for systemic risk purposes, disclosure and exchange of information between regulators.
 
Regulators are coordinating their respective work in order to ensure the best possible consistency with regard to implementation of hedge fund regulation in different jurisdictions.

By March 2010, IOSCO will report on the level of implementation in these areas and on proposed industry standards.


• On credit rating agencies, regulators are working, including through IOSCO, to evaluate whether national and regional regulatory initiatives are consistent with the IOSCO Principles and Code of Conduct Fundamentals and to identify whether divergences between initiatives might cause conflicting compliance obligations for credit rating agencies.
 
Regulators should work together towards appropriate, globally compatible solutions as early as possible in 2010.

• Regarding the perimeter of regulation more generally, supervisors and regulators working through the Joint Forum will identify by end-2009 other key areas where the perimeter needs to be expanded.

• By the November 2009 meeting of G20 Finance Ministers and Central Bank Governors, the International Monetary Fund (IMF), Bank for International Settlements and FSB will have developed preliminary guidance for national authorities to assess the systemic importance of financial institutions, markets or instruments.

43. To guard against regulatory arbitrage, it is imperative that initiatives to expand the perimeter of regulation are effectively and consistently implemented across key jurisdictions.

The FSB will benchmark the regulations implemented in these jurisdictions to assess whether they are well aligned with each other.
 


Strengthening the robustness of the OTC derivatives market

44. Global regulatory efforts to reduce systemic risks in the over-the-counter (OTC) derivatives market have intensified since the London Summit.

Given the global nature of the market, international standards must be established and consistently applied to address these risks, and regulators must coordinate their efforts.

45. To these ends, the official sector will:

• strengthen capital requirements to reflect the risks of OTC derivatives and further incentivise the move to central counterparties and, where appropriate, organised exchanges.


The Basel Committee will issue new standards by mid-2010 to take full account of counterparty credit risks, the benefits of centrally cleared contracts and collateralisation.

Regulators need to ensure that equivalent rules are applied outside the banking sector;

• strengthen standards for central counterparties by mid-2010 to address the issues specific to clearing OTC derivatives, and develop international recommendations for OTC derivatives trade repositories, working through the Committee on Payment and Settlement Systems and IOSCO;

• coordinate efforts to oversee and apply international standards to OTC derivatives central counterparties and trade repositories. We strongly support the ongoing work of the OTC Derivatives Regulators’ Forum to develop international cooperative oversight frameworks by end-2009, including for sharing information among regulators and developing common expectations for data reporting; and

• identify legal or other impediments to implementing the OTC derivatives market reforms, which regulators or legislative authorities will then take action to resolve.

46. The private sector needs to meet its commitments to supervisors to expand central clearing of OTC derivatives trades; improve risk management for trades that are not cleared, meet increasingly stringent targets for operational improvements and report data on their performance to their regulators; and report all non-cleared trades to regulated trade repositories.

If they do not meet these and future commitments, supervisors will develop alternative approaches to ensure the improvements are made.
 


Re-launching securitisation on a sound basis

47. The revival of securitisation markets is needed in many countries to support the provision of credit to the real economy.
 
Although industry initiatives are underway to standardise terms and structures, reduce complexity and enhance transparency, the official sector must provide the framework that ensures discipline in the securitisation market as it revives.

48. To this end, during 2010, supervisors and regulators will


• implement the measures decided by the Basel Committee to strengthen the capital treatment of securitisation and establish clear rules for banks’ management and disclosure, including:

o higher risk weights for securitisations and re-securitisations;

o requirements on banks to conduct more rigorous due diligence of externally rated securitisations, with higher capital requirements imposed where this does not take place;

o tighter prudential guidance for bank management of off-balance sheet exposures arising from securitisation vehicles; and

o improved disclosures of securitisation exposures in the trading book, sponsorship of off-balance sheet vehicles, re-securitisation exposures, valuation assumptions and pipeline risks;


• implement IOSCO’s proposals to strengthen practices in securitisation markets, including by:

o reviewing the due diligence practices and associated disclosures of participants in the securitisation chain;

o better informing and protecting investors by requiring greater disclosure by issuers, including initial and ongoing information about underlying asset pool performance;

o reviewing and, as appropriate, strengthening investor suitability requirements;

o considering what enhancements are needed to regulatory powers to allow authorities to implement the recommendations in a manner promoting international coordination of regulation;


• examine other ways to align incentives of issuers with investors, including considering requirements on issuers of securitisations to retain a part of the economic exposure of the underlying assets;

• encourage greater use of the contractual form used in covered bonds, which tie issuers to the instruments by obliging them to act as the de facto guarantor in the event of underperformance by the underlying assets, provided that depositors are not disadvantaged;

• support implementation of industry initiatives to standardise terms and structures, reduce complexity and enhance transparency and, as securitisation markets restart, adjust measures as appropriate.
 

 
Adherence to international standards

49. The FSB will put in place by the end of 2009 a framework to strengthen adherence to international regulatory and prudential standards. The framework, which will build upon IMF and World Bank assessments, is envisaged to provide comprehensive and updated compliance information.

FSB member countries have agreed to lead by example in
disclosing their degree of compliance.

The FSB will report on the development of this framework at the November 2009 meeting of G20 Finance Ministers and Central Bank Governors.

50. We will apply this framework to identify non-cooperative jurisdictions with reference to cooperation, information exchange and other prudential standards, focusing on jurisdictions of concern due to weaknesses in compliance and systemic importance.

The FSB will work as quickly as possible to develop:


• a global compliance “snapshot” for the relevant standards building on Financial Sector Assessment Program (FSAP) assessments where available and other relevant information, by November 2009;

• criteria for identifying jurisdictions of concern by November 2009;

• procedures for an evaluation process to build on and complement FSAP assessments, to be launched by February 2010 at the latest; and

• a toolbox of measures to promote adherence and cooperation among jurisdictions, by February 2010 at the latest.


51. Within this framework, we are also developing a system of peer reviews among FSB members, based among other evidence on the findings of IMF and World Bank assessments, and will report on their outcome.

These will comprise both single-country and thematic reviews to assess our implementation of international financial standards and of policies agreed in the FSB and determine whether additional steps are needed to reach the intended results.
 
Both modalities will be developed in parallel. Actual reviews will start by end-2009 with the thematic peer review on the implementation of the FSB compensation principles.
 


The need for perseverance and consistent national implementation

52. While reforms are well underway, as we detail in a separate report, they are far from complete.

Effective work to strengthen the global financial system requires policies that are well designed and will be robust over the long run.

This necessarily takes time.

It is important, therefore, that Leaders send a strong message that they are determined to see these reforms through.

Where international policy development is ongoing, we need Leaders’ continued support; where such policy work has concluded, we need Leaders’ commitment to consistent national implementation.

53.
Achieving our objectives of a well regulated open financial system requires the maintenance of a level playing field.
 
Delivering this is one of the reasons why the FSB exists.

However, the speed with which jurisdictions develop and change financial regulation differs, and consistency in what comes into place should not be taken for granted.
 
While the FSB can develop coherent policy proposals, only national authorities can assure implementation that is effective and
is consistent across borders.

Given the commitment we have all made to coherent approaches as we improve the regulation of the system, we must strive to overcome differences in our final rule making.
 
We will continue to take actions to ensure achievement of this end.

54. To maintain ongoing attention to this issue and foster the pace and consistency of implementation, we will launch a project to compare national implementation measures and identify cross-country differences and any need for policy actions to address them.

55.
As our economies recover, it is crucial that national momentum for significant reforms be maintained.
 
The FSB will continue to work to ensure that the goals remain ambitious, that clear targets are set to move us forward towards those goals, and that their importance is not lost even if markets seem to be calmer for the time being.
 

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