Council of Regulators

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See also European Systemic Risk Board, Financial Stability Oversight Council, Systemic regulator and Trading book risk.


Dodd favors "council of regulators" over systemic regulator

"...The Dodd plan would reduce the stature of the Federal Reserve in several ways. The central bank, which has evolved since its creation nearly a century ago into a powerful banking regulator and has gained even greater power over the last year, would lose authority over banks, as well as its ability to regulate mortgages and credit cards.

Mr. Dodd has also rejected the administration’s proposal to have the Fed play the leading role as a so-called “systemic risk” regulator that examines the connections between regulated and unregulated companies for trouble spots that could disrupt the markets. That role would instead be filled by a council of regulators.

(Bowing to political skepticism about the Fed’s performance before the crisis began, the administration’s plan also would create a council, but it would put the Fed in the decisive role.)

The Federal Reserve chairman, Ben S. Bernanke, leading an agency threatened by the overhaul, has sought to push back by asserting the agency’s authority over subprime lending and executive pay in recent days."

Volcker favors bank regulation carried out by an independent agency

"...Obama’s plan to give the Fed powers to monitor risks to the financial system is aimed at avoiding a repeat of the financial meltdown that led to $1.6 trillion of bank losses and writedowns and triggered a global recession. The Obama plan would label banks including Bank of America Corp. and Citigroup Inc. as “systemically important” and subject them to capital and liquidity requirements and stricter oversight.

Jen Psaki, a White House spokeswoman, declined to comment on Volcker’s remarks.

The plan has drawn criticism from lawmakers including Senate Banking Committee Chairman Christopher Dodd, who has said the central bank failed to use its existing supervisory powers to curb some of the lending practices that contributed to the crisis. Congressional leaders are leaning toward vesting authority over capital, liquidity and risk-management practices of big banks in a council of regulators.

The administration also wants the power to seize financial institutions if they run into trouble. And Obama’s regulatory framework would make it mandatory for large hedge funds, private-equity firms and venture-capital funds to register with the Securities and Exchange Commission.

Volcker said the central bank should instead oversee bank regulation carried out by an independent agency. The chairman of that agency could also be a vice chairman of the Fed, both to keep the central bank in the loop and increase accountability.

Volcker, who was Fed chairman from 1979 to 1987, said the central bank itself needs some reorganization “to more clearly focus responsibility for the regulatory side of the house.”

“There’s no doubt in my mind that the attention the Federal Reserve has paid to regulation has gone up and down over the years, depending upon both the intellectual and market environment, and the personalities involved.”

Treasury proposes council, expanded Fed powers and national supervisor

(1) Promote robust supervision and regulation of financial firms. Financial institutions that are critical to market functioning should be subject to strong oversight. No financial firm that poses a significant risk to the financial system should be unregulated or weakly regulated. We need clear accountability in financial oversight and supervision. We propose:

  • A new Financial Services Oversight Council of financial regulators to identify emerging systemic risks and improve interagency cooperation.
  • New authority for the Federal Reserve to supervise all firms that could pose a threat to financial stability, even those that do not own banks.
  • Stronger capital and other prudential standards for all financial firms, and even higher standards for large, interconnected firms.
  • A new National Bank Supervisor to supervise all federally chartered banks.
  • Elimination of the federal thrift charter and other loopholes that allowed some depository institutions to avoid bank holding company regulation by the Federal Reserve.
  • The registration of advisers of hedge funds and other private pools of capital with the SEC.

"...Treasury Secretary Timothy Geithner signaled he may support the idea of a council of regulators to monitor threats to the financial system, after previously insisting that a single agency do the job.

Geithner’s openness to the change follows public opposition by a growing number of lawmakers to suggestions that the Federal Reserve get the job of overseeing companies deemed too-big-to- fail. Other regulators, including Federal Deposit Insurance Corp. Chairman Sheila Bair and Securities and Exchange Commission Chairman Mary Schapiro, have also criticized the concept of a single systemic-risk regulator.

“I don’t believe it’s necessary or desirable for us to concentrate all authority for dealing with future risks to the system in one” agency, Geithner told a Senate Appropriations subcommittee today in Washington.

Separately, the Treasury chief also indicated that several agencies will have responsibility in changing the way that financial executives are paid, after concluding that compensation practices contributed to the financial crisis. The SEC and federal bank regulators will play key roles, Geithner said at the subcommittee hearing today.

President Barack Obama “will lay out a comprehensive set of proposals next week” on changing financial rules, Geithner said. White House Press Secretary Robert Gibbs told reporters the plan is scheduled for June 17.

In March 26 congressional testimony, Geithner said that “we need to establish a single entity with responsibility for systemic stability over the major institutions and critical payment and settlement systems and activities.”

People familiar with the matter have said the administration favors -- and is likely to propose -- making the Fed the systemic risk regulator. Geithner’s comments today are a signal there may be room to compromise with Congress.

Indeed, Geithner also said at the March 26 House hearing that there was room in the Treasury regulatory overhaul for a council to coordinate oversight among agencies.

Elaborating on that today, he said “a necessary part of the solution for the U.S. financial system will be a more effective body to bring together the responsible supervisory agencies alongside the Fed, to make sure we’re looking across the system as a whole,” and that “a council has a lot of merits in that context.”

Bair has instead proposed a “Systemic Risk Council.”

In a May 7 speech in Chicago, she said that such a group could have “a mandate to monitor developments throughout the financial system, and the authority to take action to mitigate systemic risk.” Schapiro said the next day that she was “inclined” to support Bair’s proposal."

Bernanke sees Fed sharing risk oversight

Federal Reserve Chairman Ben Bernanke and leading congressional lawmakers on Thursday voiced strong support for a new council of federal regulators to monitor broad risks to the financial system.

Bernanke, in testimony before the House Financial Services Committee, urged Congress to empower the central bank to regulate firms posing a systemic financial risk. But he also supported a new oversight council, and said that keeping an eye on the whole financial system "may exceed the capacity of any individual supervisor."

Bernanke emphasized to lawmakers that all of the government’s financial regulators should be directed to watch for risks to the system.

The question of which government agencies should monitor “systemic risks,” such as those that stoked the financial crisis in 2008, has emerged as a major flashpoint in the broader effort to overhaul the nation’s financial laws. The Federal Reserve has come under heavy criticism from Democrats and Republicans for lax supervision in the run-up to the crisis, and many lawmakers are reluctant to grant the central bank additional power to oversee the financial system.

The Obama administration proposed earlier this year that the Fed should oversee large firms for systemic risk, and that a new council should provide advice on the broader system. Critics have said the council proposal does not have enough enforcement power.

Senate Banking Committee Chairman Chris Dodd (D-Conn.) is considering granting most of the new authorities to an oversight council instead of to the Fed. House Financial Services Committee Chairman Barney Frank (D-Mass.) has talked about setting up a system of shared authority over systemic risk.

“There were some, myself included, who earlier this year thought the Federal Reserve would have a larger role than it looks like it will have; that it will be part of a conciliar structure,” Frank said on Thursday.

Bernanke responded to lawmakers who sensed a shift in the Fed’s position on the issue by saying that the central bank never supported “some kind of untrammeled super-regulator over the entire system.”

In recent months, the administration has softened its insistence that the Fed alone play this role. The discussions in Congress now center on the balance of power between the Fed and a new council.

"We should seek to marshal the collective expertise and information of all financial supervisors to identify and respond to developments that threaten the stability of the system as a whole," Bernanke said during his testimony.

Bernanke said that such a council, composed of representatives from agencies that currently monitor varying sectors of the financial system, could help identify regulatory gaps and detect excessive risks that are being taken by financial firms or that are emerging in the markets.

The Fed chairman urged lawmakers, who have been hashing out legislation to revamp the financial regulatory system, to "support a reorientation of individual agency mandates to include not only the responsibility to oversee the individual firms or markets within each agency's scope of authority, but also the responsibility to try to identify and respond to the risks those entities may pose, either individually or through their interactions with other firms or markets, to the financial system more broadly."

In addition, the central bank chairman spoke Thursday about the importance of reducing incentives for firms that are perceived as "too big to fail," saying that implicit government backing for those companies could lead to unrestrained risk-taking and create a "tilted" playing field that puts smaller firms at a disadvantage. He added that such firms "should be subject to extraordinary oversight, including higher capital and liquidity requirements, tough risk-management rules, and basically stronger supervision."

GAO testimony outlines systemic weaknesses

"January 2009, we designated modernizing the outdated U.S. financial regulatory system as a new high-risk area to bring focus to the need for a broad-based systemwide transformation to address major economy, efficiency, and effectiveness challenges.9 We have found that:

  • Having multiple regulators results in inconsistent oversight. Our February 2009 report on the Bank Secrecy Act found that multiple regulators are examining for compliance with the same laws across industries and, for some larger holding companies, within the same institution.10 However, these regulators lack a mechanism for promoting greater consistency, reducing unnecessary regulatory burden, and identifying concerns across industries. In July 2009, we reported many violations by independent mortgage lenders of the fair lending laws intended to prevent lending discrimination could go undetected because of less comprehensive oversight provided by various regulators.11
  • Lack of oversight exists for derivatives products. In March 2009, we reported that the lack of a regulator with authority over all participants in the market for credit default swaps (CDS) has made it difficult to monitor and manage the potential systemic risk that these products can create.12
  • Gaps in the oversight of significant market participants. We reported in May 2009 on the issues and concerns related to hedge funds, which have grown into significant market participants with limited regulatory oversight.13 For example, under the existing regulatory structure, SEC’s ability to directly oversee hedge fund advisers is limited to those that are required to register or voluntarily register with the SEC as an investment advisor. Further, multiple regulators (SEC, CFTC, and federal banking regulators) each oversee certain hedge fund-related activities and advisers.

We concluded that given the recent experience with the financial crisis, regulators should have the information to monitor the activities of market participants that play a prominent role in the financial system, such as hedge funds, to protect investors and manage systemic risk.

  • Lack of appropriate resolution authorities for financial market institutions. We recently reported that one of the reasons that federal authorities provided financial assistance to at least one troubled institution—the insurance conglomerate AIG — in the crisis stemmed from concerns that a disorderly failure by this institution would have contributed to higher borrowing costs and additional failures, further destabilizing fragile financial markets. According to Federal Reserve officials, the lack of a centralized and orderly resolution mechanism presented the Federal Reserve and Treasury with few alternatives in this case. The lack of an appropriate resolution mechanism for non-banking institutions has resulted in the federal government providing assistance and having significant ongoing exposure to AIG.
  • Lack of a focus on systemwide risk. In March 2009 we also reported on the results of work we conducted at some large, complex financial institutions that indicated that no existing U.S. financial regulator systematically looks across institutions to identify factors that could affect the overall financial system.14 While regulators periodically conducted horizontal examinations on stress testing, credit risk practices, and risk management, they did not consistently use the results to identify potential systemic risks and have only a limited view of institutions’ risk management or their responsibilities. Our July 2009 report on approaches regulators used to restrict the use of financial leveraging—the use of debt or other products to purchase assets or create other financial exposures—by financial institutions also found that regulatory capital measures did not always fully capture certain risks and that none of the multiple regulators responsible for individual markets or institutions had clear responsibility to assess the potential effects of the buildup of systemwide leverage.15

CFA Institute proposal on risk council structure and functions

  • Source: [

A summary of the IWG findings about systemic risk include:

  • The interconnectedness of complex institutions, practices and products requires the establishment of mechanisms to track and sound early warnings and address the range of significant threats to the financial system.
  • This oversight, which must keep up with financial innovation and be able to coordinate with regulators outside of the United States, must also suggest corrective steps before particular risks grow big or concentrated enough to threaten entire markets or economic sectors.
  • A macro regulator with the Federal Reserve at the helm would vest far too much authority in an agency whose credibility is already damaged by its shortcomings in its response to the subprime crisis.
  • Vesting the Fed with systemic risk oversight authority would also conflict with its primary responsibility for monetary policy.
  • A “council” of existing regulators charged with systemic oversight also faces drawbacks in that it would only add a layer of regulatory bureaucracy without closing the gaps that regulators currently have in skills, experience and authority needed to track systemic risk in a comprehensive fashion.
  • However, the creation of an independent Systemic Risk Oversight Board to supplement, not supplant the functions of the existing federal financial regulators, would fill an immediate void on systemic issues, and serve a vital role in reporting on risks and systemic vulnerabilities and recommending steps to regulators to reduce those risks.
  • Such an Oversight Board would be more able to recognize emerging threats and identify practices designed to escape current regulatory attention and to make appropriate recommendations to existing regulators on how to address those threats.

The above findings led the IWG to propose the following specific recommendations regarding the creation of a Systemic Risk Oversight Board:

  1. Congress should create an independent governmental Systemic Risk Oversight Board. To function efficiently, the board should consist of a chair and no more than four other members. All should be presidential appointees confirmed by the U.S. Senate. The board would be accountable primarily to Congress.
  2. The board’s budget should ensure its independence from the firms it examines. Funding should be adequate and sustainable to attract and retain highly competent board members and staff. Appropriate funding options include an industry assessment fee similar to that of the Public Company Accounting Oversight Board (PCAOB).
  3. All board members should be full-time and independent of government agencies and financial institutions. Members should possess broad financial market knowledge and expertise. Collectively, the members should have backgrounds in investment practice, risk management and modeling, market operations, financial engineering and structured products, investment analysis, counterparty matters and forensic accounting.
  4. The board should have a dedicated, highly skilled staff. Staffers should have a range of key skills and experiences and work exclusively for the board. They should be experts who understand the components and complexities of systemic risk and how to fully examine critical interconnections between firms and markets. To attract and retain top-notch individuals, staff and board member salaries should be commensurate with those of the PCAOB.
  5. The board should have the authority to gather all information it deems relevant to systemic risk. The IWG believes that federal regulators do not currently have the full scope and depth of information they need to understand systemic risks in the U.S. financial system, much less the behavior of those risks in the context of global markets. For the Systemic Risk Oversight Board to have that capability, it should develop a timely way to identify a broad range of threats emanating from institutions, markets, practices, financial instruments and emerging products. Therefore, the board should have the legal authority to gather all the financial information it deems necessary to assess systemic vulnerabilities. Defining such threats is not a static process. Systemic risks do not lurk only in systemically significant institutions. Highly concentrated market segments or critical financial instruments can threaten the health of the financial system. Risk may be baked into regulation in ways that are not well understood. For example, the financial crisis has revealed the danger to the markets of rules that make credit rating agencies gatekeepers for issuing debt without ensuring that they are independent and accountable for the accuracy of their ratings. The board would need to develop appropriate procedures for determining which entities to examine and what information to review. It would need a degree of flexibility so that its focus and examinations could adjust to shifts in market conditions. The board and staff should be able to use their professional judgment to determine the scope of analysis for financial institutions, products or practices. The board should also have the authority to hire consultants and other experts as needed.
  6. The board should report to regulators any findings that require prompt action to relieve systemic pressures and should make periodic reports to Congress and the public on the status of systemic risks. If appropriate, the board would also report its findings to specific companies and other institutions. The board should take steps to mitigate any severe market reactions or disruptions that could occur as a result of its reports. How the board reports its activities and findings should take into consideration the confidential nature of much of the information it will gather and the potential for market mayhem if information is not dealt with properly. The board should also provide comprehensive, periodic reports on the state of systemic risks to all relevant regulators and Congress or committees designated by Congress as well as the public. As appropriate, the board should consult with systemic risk overseers outside the United States. The board should consult with regulators and Congress about the nature of any information it releases publicly.
  7. The board should strive to offer regulators unbiased, substantive recommendations on appropriate action. As an independent monitor, the board should identify firms and markets that are at risk before significant damage is done. This might entail identifying exposures, modeling potential solutions and communicating those recommendations fully and clearly to regulators. Regulators should determine whether and how to implement the board’s recommendations. Where appropriate, the board should coordinate its recommendations with those of overseas systemic risk overseers.
  8. Regulators should have latitude to implement the oversight board’s recommendations on a “comply or explain” basis. Regulators are generally better positioned to understand the operational and practical implications of a proposed regulatory action, and a regulator may believe that it would be appropriate to refine or modify a recommendation of the board. For this reason, the IWG does not believe that the Systemic Risk Oversight Board should have regulatory authority or other powers to force a regulator to implement a recommendation. Instead, the recommendations would shift the onus of systemic risk mitigation onto regulators, by requiring them either to 1) adopt and implement the recommendation(s) as suggested, 2) refine and modify the recommendations as they deem necessary, or 3) reject them and take no further action or follow another course. In the case of options 2 or 3 above, the regulator would provide the board a detailed explanation of its response. This should include a discussion of any alternative approach to address the systemic risk the board identified. The regulator should also address any concerns or issues that could emerge if its alternative approach is not consistent with the coordinated response of other regulators. If the board is not satisfied with the regulator’s response, it should communicate its concerns to the President and appropriate Congressional authorities.

More details regarding the basis for the IWG’s findings and recommendations regarding the Systemic Risk Oversight Board can be found on pages 24-27 of the IWG Report, available in electronic form.

Global approaches to coordinating risk oversight

OECD recommendations for efficient financial regulation

IMF-FSB monitoring risk in the financial sector

Monitoring Risk in the Financial Sector

  • The IMF to work on increasing the number of countries disseminating Financial Soundness Indicators (FSIs), including expanding country coverage to encompass all G-20 members, and on other improvements to the FSI website, including preferably quarterly reporting. FSI list to be reviewed.
  • In consultation with national authorities, and drawing on the Financial Soundness Indicators Compilation Guide, the IMF to investigate, develop, and encourage implementation of standard measures that can provide information on tail risks, concentrations, variations in distributions, and the volatility of indicators over time.
  • Further investigation of the measures of system-wide macroprudential risk to be undertaken by the international community. As a first step, the BIS and the IMF should complete their work on developing measures of aggregate leverage and maturity mismatches in the financial system, drawing on inputs from the Committee on the Global Financial System (CGFS) and the Basel Committee on Banking Supervision (BCBS).
  • The CGFS and the BIS to undertake further work in close cooperation with central banks and regulators on the coverage of statistics on the credit default swap markets for the purpose of improving understanding of risk transfers within this market.
  • Securities market regulators working through IOSCO to further investigate the disclosure requirements for complex structured products, including public disclosure requirements for financial reporting purposes, and make recommendations for additional improvements if necessary, taking account of work by supervisors and other relevant bodies.
  • Central banks and, where relevant, statistical offices, particularly those of the G-20 economies, to participate in the BIS data collection on securities and contribute to the further development of the BIS-ECB-IMF Handbook on Securities Statistics (Handbook). The Working Group on Securities Databases to develop and implement a communications strategy for the Handbook.

International Network Connections

  • The FSB to investigate the possibility of improved collection and sharing of information on linkages between individual financial institutions, including through supervisory college arrangements and the information exchange being considered for crisis management planning. This work must take due account of the important confidentiality and legal issues that are raised, and existing information sharing arrangements among supervisors.
  • The FSB, in close consultation with the IMF, to convene relevant central banks, national supervisors, and other international financial institutions, to develop by end 2010 a common draft template for systemically important global financial institutions for the purpose of better understanding the exposures of these institutions to different financial sectors and national markets. This work should be undertaken in concert with related work on the systemic importance of financial institutions. Widespread consultation would be needed, and due account taken of confidentiality rules, before any reporting framework can be implemented.
  • All G-20 economies are encouraged to participate in the IMF’s Coordinated Portfolio Investment Survey (CPIS) and in the BIS’s International Banking Statistics (IBS). The IMF and the BIS are encouraged to continue their work to improve the coverage of significant financial centers in the CPIS and IBS, respectively.
  • The BIS and the CGFS to consider, amongst other improvements, the separate identification of nonbank financial institutions in the consolidated banking data, as well as information required to track funding patterns in the international financial system. The IMF, in consultation with the IMF’s Committee on Balance of Payments Statistics, to strive to enhance the frequency and timeliness of the CPIS data, and consider other possible enhancements, such as the institutional sector of the foreign debtor.
  • The IMF to continue to work with countries to increase the number of International Investment Position (IIP) reporting countries, as well as the quarterly reporting of IIP data. The Balance of Payments and International Investment Position Manual, sixth edition(BPM6) enhancements to the IIP should be adopted by G-20 economies as soon as feasible.
  • The Interagency Group on Economic and Financial Statistics (IAG) to investigate the issue of monitoring and measuring cross-border, including foreign exchange derivative, exposures of nonfinancial, and financial, corporations with the intention of promoting reporting guidance and the dissemination of data.
  • The IAG, consulting with the FSB, to revisit the recommendation of the G-22 to examine the feasibility of developing a standardized template covering the international exposures of large nonbank financial institutions, drawing on the experience with the BIS’s IBS data, other existing and prospective data sources, and consulting with relevant stakeholders.

European Systemic Risk Board

1. Why do we need a European Systemic Risk Board (ESRB)?

We need a European Union-wide system to be able to assess and prevent potential risks to financial stability in the EU properly and swiftly. The rapid propagation of the financial crisis from the US to Europe in 2007/2008 highlighted the present weaknesses in monitoring and assessing potential threats and risks arising from the interaction between macro-economic developments and the financial system in the EU but also worldwide. This is why the Commission proposes the creation of the ESRB and its close cooperation with the Financial Stability Board and the International Monetary Fund whose powers in terms of international financial stability and economic surveillance are also being reinforced.

2. What kind of risks will the ESRB monitor?

The notion of systemic risk is wide. The ESRB will have to monitor the soundness of the whole financial system. This can cover very different areas, from the financial situation of the banks to the potential existence of asset bubbles or the good functioning of the market infrastructures. The ESRB will have to identify all the potential risks and, as the intention is not to end up with an endless list, it will also have to prioritise them and issue warnings when it thinks that the risks are significant.

3. How will the ESRB deal with the risks it will identify?

If the ESRB identifies risks to stability it shall issue recommendations to the country or group of countries concerned. If the addressee agrees with the recommendation, it must communicate the actions undertaken to deal with the potential problem. If it does not agree and chooses not to act, the reasons for that must also be properly explained. If the ESRB feels that the explanations are not convincing, it shall inform the Council of ministers.

In general, the ESRB recommendations will also be sent to the Council. In some cases, the Council itself will be the addressee. It is notably the case of the warnings or recommendations addressed to the Community as a whole. But in most cases, the warnings and recommendations will be transmitted to the relevant addressee and to the Council. This transmission of warnings and recommendations is not intended as a filter or as a way to water down their content, but aims on the contrary at increasing the moral pressure on the recipient to act or explain.

The quality of the ESRB work will provide a significant moral incentive to follow up on its recommendations or give convincing reasons for not to.

Specific follow-up procedures are also foreseen. For instance, when a national supervisory authority intends to deviate from an ESRB recommendation, it must first discuss and justify it with the competent European authority and will have to take into account its views before answering the ESRB. And if the ESRB feels that the explanations are not convincing, it shall inform the Council.

4. Why is it proposed to give central banks, including the European Central Bank, a prominent role within the ESRB?

Central banks have always played a key role in macro-prudential supervision and in many countries they are responsible fully or in part for the supervision of individual institutions. .The European System of Central Banks (ESCB) includes all 27 national Central Banks of the European Union and the 27 Governors sit in the General Council of the ECB. Being at the heart of the EU monetary system and having wide ranging expertise in the macro-prudential field, the ESCB holds a unique and privileged position for analysing and assessing the linkages between developments in the financial sector and the macroeconomic performance of EU economies. It is therefore appropriate for the ESCB to have a prominent role in the European Systemic Risk Board.

5. The Secretariat of the ESRB will be entrusted to the ECB. Does this mean that non euro area Central Banks will be excluded from the preparation of the ESRB work?

No, the ESRB will include the central bank governors of all 27 Member States. The ECB employs at all levels of its hierarchy citizens of all Member States, including from those who have not adopted the euro. Seconded experts from non euro area Central Banks will participate within the ECB to the work of the ESRB secretariat.

6. Will the warnings and recommendations be made public and if not why?

The issues potentially addressed in the warnings and recommendations will be extremely sensitive and we must be careful about adverse effects, such as the warnings turning into self-fulfilling prophecies by frightening financial markets. The decision whether or not to publish will, therefore, require a case-by-case decision after a careful assessment of the potential consequences.

7. What form do the legislative texts take and when do you expect them to be approved?

The creation of macro-prudential supervision at the EU level and the establishment of the ESRB are foreseen in a draft Regulation based on Article 95 of the EC Treaty, that requires co-decision by the Council and the European Parliament. The Regulation is completed by a draft Council Decision which confers on the ECB the task of ensuring the Secretariat of the ESRB.

Before making the legislative proposals, the Commission conducted extensive consultation of interested parties both after the publication of the report of the Larosière Group and of the May 2009 Communication, which outlined the new supervisory architecture. The June European Council supported the proposals contained in the Communication and welcomed the Commission's intention to adopt the legislative texts early in the autumn for a swift approval in order for the new framework to be in place in the course of 2010. The European Council has announced it would discuss the subject again in October.

8. The latest crisis has shown that systemic risks can be global in nature. Why not leave monitoring of systemic risks to the recently enhanced and renamed Financial Stability Board?

The existence of an internal market in the EU and the increasing political and financial integration of the EU require an EU-level institution to supervise and monitor risks to the financial system. The US has also announced a systemic risk monitoring body, to be created within the Federal Reserve. The ESRB will, of course, liaise closely with the new Financial Stability Board and with the other relevant international bodies, contributing to a stronger global framework for risk monitoring and more stable financial markets. This global network ought to monitor systemic risks more effectively and detect potential crises earlier to be able to defuse them or, in the very least, mitigate their impact. The ESRB will play a key role in this network and fills an important gap in financial supervision in the EU.

9. Will the ESRB lead to a greater administrative burden for financial institutions?

No. Most data needed by the ESRB will be provided to it by the European Supervisory Authorities (ESAs) using information which they already possess. Before asking for information, the ESRB will furthermore check with the ESAs that its request is proportionate.

The ESRB will also not present any extra cost for the Community budget as it will build, to the extent possible, on existing staff and resources of the European System of Central Banks, with a secretariat provided by the ECB

10. The ESRB will potentially deal with very sensitive market information. How will the confidentiality of the data be safeguarded?

There are specific articles in the Regulation and the Decision aimed at guaranteeing effective procedures for handling confidential data. Specific detailed procedures for the transmission of the information will furthermore be agreed between the ESRB and the European Supervisory Authorities. Last but not least, one should keep in mind that all the Members of the ESRB are used to dealing with highly confidential data on a daily basis.

11. Who will be the chair of the ESRB?

The chair will be elected by the members of the General Board, the main decision-making body of the ESRB, for a period of 5 years, renewable. The General Board will be composed of all the Governors of the national Central Banks in the EU, the President and the Vice-President of the ECB, a Member of the European Commission and the Chairpersons of the three European Supervisory Authorities. National supervisors and the President of the Economic and Financial Committee will also form part of the Board, but without voting rights.

12. Why will national supervisors have no voting right in the General Board?

The presence of the national supervisors inside the ESRB improves the flow of information and allows a constant exchange of views between the actors having a macro angle (the ECB, the National Central Banks, the Commission…) and those working with a micro-prudential perspective. But national supervisors are in charge of micro-supervision of individual banks, and not of the stability of the financial system as a whole. This difference in the approach, mission and analytical angle explains the difference in the voting rights.

13. The ESRB will have over 60 institutions represented in it. Is this not too cumbersome to be effective?

A broad representation of institutions within the ESRB is necessary to ensure a global macro-prudential perspective in the ESRB’s risk assessments. The ESRB must include all those who have relevant information and expertise to contribute. These include the governors of national central banks, the new European Supervisory Authorities, and national supervisors. However, a steering committee (consisting of the ESRB chairperson and vice-chairperson, five additional central bank members of the ESRB, the chairpersons of the new European Supervisory Authorities, the President of the EFC and the Commission member) will prepare and ensure efficient ESRB operations.

14. What will be the role of the Advisory Technical Committee (ATC)?

The composition of the ESRB will be very high level (Governors, Commissioner, Chairman of the European Authorities…etc). While the secretariat will be able in most cases to prepare all the discussions and provide the necessary analysis, it can happen that the ESRB needs to draw on more specific competences than the ones usually available at the ECB. The ATC will be able to bring this technical expertise on issues for which it might be needed to go beyond the support provided by the secretariat (e.g., problems linked to the supervision of the insurance sector…).

FSA's Turner on a European Systemic Risk Board

"... I expressed the dilemma as ‘more Europe or less Europe’ but the fact is that we always knew and accepted that the choice made would be primarily on the more Europe side and indeed should be. And the FSA therefore proposed a major change in the structure of regulatory and supervisory cooperation in Europe, through the creation of a European Financial Regulatory Authority, with significant rule making powers, and working closely with the European System of Central Banks to address macro-prudential issues. In fact the chosen way forward has been in terms of formal structure slightly different than we proposed – reflecting instead the de Larosière Group’s recommendation that the existing level 3 committees should be turned into formal authorities.

But the essential objectives set out in my review and in the de Larosière report were the same – to introduce greater integration and coordination where that will contribute to financial stability and a more efficient single market, while keeping at national level those supervisory activities which are best delivered close to the markets and to supervised institutions. It is essential that we achieve these objectives. And I would therefore like to set out what the FSA believes will be the crucial determinence of success in meeting them. As so often, what will really matter is not simply the formal definition of the responsibilities of different organisations, but their approach, their skills and their detailed operating procedures.

The reforms will create a European Systemic Risk Board (ESRB), charged with identifying major trends in the financial system and major threats to financial stability. Its focus will be on macro-trends and macro-prudential issues, not the micro-prudential risk assessment or supervision of individual firms. And it could play a very useful role.

One of the most crucial things that went wrong in the run-up to the crisis was that the global central banking and regulatory community, those in different ways responsible for financial stability, failed to see the big picture of emerging financial risks: the regulators too exclusively focused on institution by institution threats, and the central banks too exclusively focused on meeting the sole objective of low and stable inflation over the medium term.

And as a result we failed to identify how the development of complex credit intermediation had created new risks, failed to spot new and dangerous forms of maturity transformation in the banking and parts of the shadow banking sectors, and failed to warn against and take action against out of control housing and commercial real estate booms in several countries. So the idea that in future we should have a body at European level, focused specifically on identifying these big picture risks makes sense. And this body will need input from both central banks and from national supervisors - so it has both a ‘top-down’ and a ‘bottom-up’ perspective. But creating such an institution will be the easy bit; making sure it really adds value will be more challenging:

Because we have to remember that in the years before the crisis, the world already had bodies charged with identifying the big picture risks, but that either we still missed the risks or we didn’t take action on them. The IMF’s Article IV Reports on several countries did point out unsustainable macroeconomic imbalances, too rapid credit growth, but large developed-economy nations, not dependent on IMF lending, found it easy to ignore those warnings. And the IMF’s Global Financial Stability Report in April 2006, far from warning that the world of complex securitised credit had created dangerous risks, included a paean of praise to how complex securitisation had reduced risks and increased the resilience of the system.

Two lessons follow; the success of the ESRB will depend on:

  • The quality of its analysis,
  • the quality of its debates and, in particular,
  • the creation of mechanisms to ensure that conventional wisdoms about the way the world works are continually challenged.

And the willingness of politicians to take its warning seriously and to countenance potentially unpopular responses, such as action through counter-cyclical capital requirements to slow down an unsustainable but, for as long as it lasts, thoroughly enjoyable credit and property price boom.

A second key objective of the reforms will be to ensure a commonly agreed and commonly enforced rule book – covering many key issues of financial regulation, but of particular importance in respect to the core prudential concerns of capital and liquidity. In ensuring that these rules are well designed and well enforced – not only over the next few years as we implement the many changes in the global regulatory regime now being debated and agreed in the Financial Stability Board, the Basel Committee and other key fora – but over time as the financial systems and markets continually evolve, we need to get three balances right:

The balance between political oversight and delegation to technical experts. Much of the detail has to be worked out by technical experts and the success of the European Supervisory Authorities (ESAs) will depend crucially on creating an espirt de corps of technicians devoted to good regulation and supervision as ends in themselves, independent of apparent national interests (such as influencing the location of activities), independent of short-term political concerns, and informed by the economic analysis of markets.

But equally we have to recognise that decisions on the overall balance of regulation are not politically neutral, they embed assumptions about the appropriate balance between innovation and risks, growth and stability, producers and consumers, which need to be considered as best possible at the political level.

The balance between prescriptive rules expressed in detailed rule books, and the definition of required outcomes, leaving discretion to national supervisors on how those outcomes are achieved.

And the appropriate balanced approach to consultation with industry participants, sufficient to gain clear understanding of the difficulties and complexities of implementation, sufficient to gain the insights which industry participants can help provide into the likely impact of regulation, but with the regulatory authorities still making the ultimate decisions in the public good.

A third key element of the reform proposals, is the creation of a robust process of peer review between supervisory authorities, extending not just to whether each of us at national level is implementing EU requirements, but also looking at our resourcing and our detailed supervisory processes. Accepting this openness to challenge and to the exchange of ideas on how to do supervision, will at times be uncomfortable, but it is inevitable if we are to have confidence in one another, and confidence therefore in the firms which, through passporting rights, are allowed to operate in each host country on the grounds that their home country is supervising them effectively."

FSA Financial Risk Outlook 2010

Since the publication of last year’s Financial Risk Outlook, the immediate financial crisis has subsided, equity and credit market prices have recovered, and most major economies came out of recession in the last quarter of 2009. But this stabilisation and recovery was only possible because of the public policy response to the crisis – bank recapitalisations, public debt guarantees, exceptional central bank liquidity support, quantitative easing and the reduction of policy interest rates to historically low levels.

Moreover, despite these measures, most developed economies including the UK suffered a severe recession in 2009; recovery is only gradual, and vulnerabilities created by the build up of leverage in the pre-crisis years still remain.

Fundamental reforms to global financial regulation are now being designed. These will entail significant increases in capital requirements to above pre-crisis levels, with particularly significant increases against risky trading activity, and tighter liquidity requirements which will restrain risky maturity transformation.

Banks will be required to build up counter-cyclical capital buffers in good times so that they are available for drawdown in periods of stress. These reforms will create a sounder financial system for the future.

Their introduction, however, will create challenges for banks and building societies, particularly when combined with the withdrawal of exceptional funding and liquidity support.

Sections A and B describe the prudential risk management challenges for banks, building societies and insurance companies created by the combination of the macroeconomic environment, the changing regulatory regime, and the future withdrawal of funding and liquidity support.

Section A sets out the Macroeconomic background and outlook. It focuses in particular on the challenges created by the need for some households and companies (particularly in commercial real estate) to deleverage from high pre-crisis levels of indebtedness. It describes the base case assumption of a gradual low inflation recovery, but also possible alternative scenarios which would pose different challenges for specific consumer segments and firms.

Section B considers the implications of this outlook for Financial stability and prudential risks and issues.

In the banking sector, the FSA’s interim capital regime has already driven a major increase in capital ratios to above pre-crisis levels, but banks and building societies will need to build up capital further to meet future global requirements. Stress tests now play a crucial role in assessing capital adequacy and Section B sets out the new macroeconomic parameters that the FSA will be requiring firms to use in capital stress tests during 2010.

In addition, the transition to more sustainable patterns of funding and liquidity will be particularly challenging. In the insurance sector, meanwhile, immediate crisis-driven challenges (for instance, relating to very high credit spreads) have receded, but some specific recession-induced risks remain.

ECB to lead the Euro risk council

The European Central Bank will combine future tests to check the health of the financial system, its vice president said, outlining his vision for a new watchdog to prevent further crises.

Earlier this month, the European Commission, the EU’s executive arm, unveiled its blueprint for an overhaul of the way banks and financial markets are policed, a central plank in new rules meant to prevent a repeat of the global economic crisis.

It plans to create a pan-European watchdog, staffed and run by the ECB, that would warn of early signs of crisis.

On Wednesday, ECB Vice President Lucas Papademos said the so-called risk board would use a broad range of tools to judge the health of financial markets and the economy.

Many have blamed what they see as the tunnel vision of regulators in focusing on individual banks rather than the overall system for failing to stop the worst financial crisis in a generation.

Papademos said “taking the temperature” of a patient was not enough and this would be complemented by other tests as well as the “judgment of the physician” to choose the right medicine to stop a crisis.

He said the ECB was working on developing the tools and early warning signal models to sound the alarm when the financial system approaches danger.

But he and ECB Governing Council member Axel Weber stressed they would not lose sight of the ECB’s main goal of keeping inflation steady despite the increased focus on financial stability.

“What we have learned in this crisis is that price stability and financial stability go hand in hand,” Weber said.

Their remarks at an industry conference come as Sweden’s financial markets minister, Mats Odell, and Jacques de Larosiere, author of a report that formed the basis for EU laws, pushed for the new watchdogs to be set up soon.

“Will these new institutions be up and running by the end of next year?” Odell said. “My answer is: yes we can. Member states need to be prepared to walk the extra mile to make that happen.”

De Larosiere said: “The risk board is a detector of emerging risks,” adding that single supervision of individual institutions is not enough to create a stable system.

Some, however, are suspicious of the new body. Britain is worried about the extent of powers given to the group, which will be based in Germany and most likely chaired by ECB President Jean-Claude Trichet.

There is widespread scepticism in London about fresh financial rules that many there see as a German-French bid to undermine the City of London, Europe’s largest financial centre.

Nonetheless the law puts Europe ahead of the United States, which is still bogged down in a wrangle over whether to give similar watchdog powers to the Federal Reserve.

“If we start fragmenting the package, we will destroy the image of a united Europe on these matters,” de Larosiere warned.

European "supervisory colleges"

Establishment of Colleges of Supervisors

2.7 The consolidated supervisor for a cross-border banking group must establish a college of supervisors to facilitate its duties in relation to information sharing and the planning of supervisory activities, both in relation to everyday supervision and in emergency situations.

Colleges will, amongst other things: enable better sharing of information; facilitate the allocation of tasks and responsibilities amongst the relevant supervisors; reduce duplication of supervisory activities; and provide for better planning and co-ordination in emergency situations.

CRD 2 sets out those tasks that the consolidated supervisor must undertake in its role of coordinating the college. Members of the college may include third-country supervisors, central banks and host state supervisors in relation to ‘significant branches’ (see below). CEBS will be kept informed of the college’s activities and receive information relevant to its work on supervisory convergence.

Australian view of well designed regulatory regime

  • Source: The Regulatory Environment A Brief Tour John Trowbridge, Executive Member Australian Prudential Regulation Authority at the National Insurance Brokers Association (NIBA) Conference, Sydney, 22 September 2009

"There are also, however, some distinguishing features between regulatory regimes that work well and regulatory regimes that do not work so well. They include:

  1. regulatory agency structure;
  2. powers of the regulator;
  3. scope of regulations; and
  4. quality and depth of supervision or surveillance of institutions.

The first three are enabling, and the fourth is about accountability.

Our system is able to work effectively because:

  1. we have a good structure: we have a single national integrated regulator who is a specialist prudential regulator — our „twin peaks‟ model, where the specialisation is, I believe, a signal virtue;
  2. APRA has, on the whole, adequate legislative powers to do its job, including the power to make its own prudential standards; and
  3. APRA has developed a suite of regulatory requirements (in the form of prudential standards) with which we are largely satisfied because they give us the framework or regulatory underpinning we need to do our supervisory job.

Accountability: the quality and depth of supervision

Our prudential standards are built around capital adequacy, effective risk management and good governance. A fundamental plank of our approach is that we hold the boards of regulated institutions accountable for meeting the standards. We normally work through management but we reserve the right to deal directly with the board and we do so whenever we think we need to. As I see it, our system does work effectively because APRA is a vigilant and effective supervisor. It was not always so, but APRA now has the resources comprising the experience, culture, competence and strategy to operate effectively.

The quality of active supervision of individual institutions is a critical success factor. Prevention is not only better than cure, it is also better than punishment after a failure. Active supervision is a pre-requisite and a sine qua non of an effective prudential regulatory system.

In summary, our agency structure, with its national specialist prudential regulator with suitable powers and suitable regulations along with, above all, active supervision, are all well suited to the task. We believe we will continue to be effective as long as APRA remains competent in supervision and vigilant. And that is our primary response to the GFC.

By comparison, many other governments and regulators have much to do to meet these criteria. And my biggest concern is that, in the debates that are currently occurring around the world on financial regulation, faith in regulation itself is far too often taking precedence over the importance of effective supervision.

Systemic data

US bank statistics


  • Number of institutions 16,512
  • Number of branches or offices 110,068
  • Value of transaction accounts (USD billions) 993.95

Commercial banks

  • Number of institutions 7,021
  • Number of branches or offices 83,767
  • Value of transaction accounts (USD billions) 845.83

Savings institutions

  • Number of institutions 1,281
  • Number of branches or offices 11,405
  • Value of transaction accounts (USD billions) 59.17

Credit unions

  • Number of institutions 7,964
  • Number of branches or offices 21,398
  • Value of transaction accounts (USD billions) 74.90

Branches of foreign banks

  • Number of institutions 246
  • Number of branches or offices nav
  • Value of transaction accounts (USD billions)14.06

Federal Reserve's Micro Data Reference Manual

The Micro Data Reference Manual (MDRM) is a catalog of micro and macro data collected from depository institutions and other respondents. The data are organized into reports, or data series, and consist primarily of financial and structure data. The MDRM documents the labels and values associated with each data item. A web interface is used to access and display the MDRM data. The MDRM is designed to assist end users of the micro data.

Micro Data Overview

The Federal Reserve System collects various types of data. Individual respondents are provided reporting forms and instructions (either electronically or hard copy) that define the data to be submitted to the Federal Reserve. The forms are each given a number that is preceded by either FR or FFIEC depending on whether they are a Federal Reserve or interagency data collection. Generally speaking, the data are collected by the Federal Reserve Banks and transmitted to the Board via the Federal Reserve’s STAR system. Some data are received from other agencies.

In addition to a reporting form number, each data series is given a four-letter mnemonic, which is used for data transmission and storage. Each variable, within a data series, is assigned a number (usually 4 digits). Combining the series mnemonic and number references a specific data item on a specific series and is known as the MDRM number. For example, SVGL2170 refers to total assets on the Thrift Financial Report of Condition.

Although series mnemonics are unique for each data series, numbers are used across data series to facilitate comparisons between data series. For example, Total Assets is reported on many data series and is always assigned the number 2170. Therefore, RCON2170, SVGL2170, and BHCK2170 all refer to total assets, but on different series.

Some series have sub series and segmented mnemonics. That is, the series itself has one mnemonic for transmission and storage but several mnemonics (prefixes) may be assigned to the various data items. This is done when the same data item is maintained more than one way. For example, on the Bank Call report, RCFD, RCON, and RCFN refer to consolidated data, domestic data, and foreign data, respectively. RCON2170 is domestic total assets and RCFN2170 is total assets of foreign offices. RCFD2170 is total assets of the entire institution, i.e., taking all the domestic and foreign offices as a group. The Report of Deposits (EDDS) is another good example of segmented mnemonics because the same data items are collected as weekly averages and daily values. The weekly average of total deposits (MDRM #2200) is EDD02200 while EDD12200 is the first day of the week's value, EDD22200 is the second day of the week's value, etc. Although segmented mnemonics add some complexity to the data retrieval process, they streamline the numbering methodology and make it easier for end users since the same data item always has the same number.

Description of the MDRM Manual

The MDRM consists of two sections. The Reporting Forms and Mnemonics section which includes links to the reporting forms and a brief description of each reporting series. This section also provides a link between the reporting forms public name and the MDRM mnemonic. The Data Dictionary section defines each data item and shows all of the reporting series on which that item appears.

The Reporting Forms and Mnemonics:

The Reporting Forms and Mnemonics section lists all of the data series defined in the MDRM. Clicking on the ‘Main Series’ or ‘Sub Series’ mnemonic displays a series description as a PDF file, which is read by Acrobat Reader. The series description briefly tells about each series and provides a history of changes and other significant information. Clicking on "reporting forms" will provide a link to the list of Agency's websites for the available forms. This section also provides an excellent way to identify which mnemonic goes with a reporting form or vice versa.

The Data Dictionary:

This is the most heavily used portion of the MDRM. The Data Dictionary defines each data item, i.e., each financial or other item that appears on one or more series, and shows all series on which the item appears. It also provides information regarding when the items were available, item descriptions, and item type (reported, structure, ratio, or derived), and short (45 character) title called the data stub. The Data Dictionary can be searched in any of the following ways:

US clearing and payment statistics

National Securities Clearing Corporation

  • Total number of contracts and transactions cleared in 2008 -- 21,877,000,000
  • Total value of contracts and transactions cleared in 2008 -- $315,500,000,000,000

(Subsidiary of DTCC. Includes equities, corporate and municipal debt, American Depository Receipts, exchange-traded funds, unit investment trusts, mutual funds, insurance products and other securities.)

Fixed Income Clearing Corporation

  • Total number of contracts and transactions cleared in 2008 -- 37,000,000
  • Total value of contracts and transactions cleared in 2008 -- $1,125,800,000,000,000

a) Government Securities Division

  • Total number of contracts and transactions cleared in 2008 -- 34,400,000
  • Total value of contracts and transactions cleared in 2008 -- $1,014,500,000,000,000

(Includes Treasury bills, bonds, notes, zero-coupon securities, government agency securities and inflation-indexed securities.)

b) Mortgage-Backed Securities Division

  • Total number of contracts and transactions cleared in 2008 -- 3,000,000
  • Total value of contracts and transactions cleared in 2008 -- $111,300,000,000,000

Bond market statistics

BIS's Research on global financial stability

One of the lessons of the global financial crisis which started in August 2007 is the crucial importance for policy makers and supervisors of having access to a wide range of reliable, timely and detailed financial statistics. In this regard the BIS has been playing a pioneering role in collecting and providing, since long ago, financial statistics which have been actively used to better understand the crisis and international financial trends and linkages. International financial statistics also may soon play an enhanced role as central banks and supervisors move towards a macroprudential approach to financial stability.

The BIS financial statistics consist of three major groups. The first is represented by the international banking statistics, which provide data on stocks and flows, on the currency denomination and maturity structure of cross-border banking assets and liabilities, both on a locational and a nationality basis. The origins of the BIS international banking statistics go back to the mid-1960s and to the need to monitor the emergence of the so-called eurocurrency markets that had sprung up to circumvent domestic regulations. Throughout the current financial crisis, these data have inter alia been used to analyze cross-border sources of funding for banks, in particular the so called “dollar shortage”, whose role has been prominent in the early stage of the crisis, and channels for international transmission of disturbances. There is currently ongoing work to expand these statistics.

Turning to the second group of statistics, in the mid-1980s, as a result of the increasing role of the international securities markets in global financial intermediation, the BIS was mandated to collect and publish international debt securities statistics on the basis of data from commercial databases and from central banks. In the early 1990s the BIS also started to collect domestic debt securities statistics.

A third group of financial statistics which is collected and published by the BIS are data on derivatives. Data on OTC derivatives have been available, based on an ad hoc semi-annual survey, since 1998; in 2004 they have been supplemented with data on credit default swaps. Data for exchange traded derivatives, which are provided by the exchanges, are also published by the BIS, with a longer time series. Ongoing work is aiming at expanding these statistics with a view to better and more timely understand the transfer and ultimate distribution of credit risk.

The second CGFS workshop on “Research on global financial stability: the use of BIS international financial statistics” was held on 4–5 December 2008 in Basel.2 The aim of the workshop was to take stock of how BIS international financial statistics have helped academic and central bank researchers to improve our understanding of global financial stability issues and, in particular, of the financial crisis which started in August 2007. In addition to BIS staff, the event was attended by economists and statisticians from thirteen central banks and from the IMF, together with eight academics.

BIS's credit risk transfer statistics

4.1 Linkages with the BIS consolidated banking statistics

4.1.1 Credit derivatives in the consolidated banking statistics

Under the current BIS consolidated banking statistics reporting framework, exposures to credit derivatives are captured in three different categories: net risk transfers, guarantees extended and derivatives contracts (see Table 11 for a summary).10

  • Net risk transfers. This item was designed to help track down the ultimate responsibility for repaying a claim should the original borrower default. There are in general six general categories of risk transfers:
    • (i) guarantees (legally binding commitments by a third party to repay a debt if the direct obligor fails to do so);
    • (ii) insurance policies;
    • (iii) claims on a branch when the parent is based in another country;
    • (iv) collateralised claims;
    • (v) risk participations (eg, loans and acceptances, where the accepting bank has sold a risk participation, are considered to be guaranteed by the purchaser of the participation); and
    • (vi) credit derivatives that have been used as cover for counterparty risk in the banking book.

Credit derivatives reported under net risk transfers are the notional value of credit protection purchased by a reporting bank, as this involves the credit risk being shifted from the immediate counterparty to the protection seller.

  • Guarantees extended. Guarantees are contingent liabilities arising from an irrevocable obligation to pay a third-party beneficiary when a client fails to perform some contractual obligation. The notional value of credit protection sold by a reporting bank, which represents the maximum possible value of the associated contingent liability, is thus reported under guarantees.
  • Derivatives contracts. Data reported under this category cover all cross-border financial claims (ie positive market values) arising from all derivatives contracts.11 These include forwards, foreign exchange swaps and options, interest rate, equity, commodity and credit derivatives contracts. However, for credit derivatives contracts (such as CDS and total return swaps), only those claims that belong to the trading book of the protection-buying reporting bank are included in this category.12

Forms of asset risk

"A similar idea, of “alternative risk budgeting”, comes from Wells Fargo, a company that was in the forefront of developing modern portfolio theory a generation ago.

All look at the risk of outright loss, rather than the volatility of returns.

This requires asset allocators to look at nine different kinds of risk:

  • concentration risk (the risk that many investors have crowded into the same strategy, making it more prone to sudden busts);
  • leverage risk (which multiplies both gains and losses);
  • liquidity risk (the chance that an asset cannot be sold quickly at the prevailing price);
  • transparency risk (if the investment structure is too complex to understand, Wells Fargo suggests, it is too risky);
  • sensitivity to the overall equity market, and bond market;
  • event risk (the danger an unforeseen event could pose);
  • volatility risk (the extent to which returns vary); and
  • operational risk, which includes various risks of businesses failing to perform.

Regulating markets and systemic risk

Markets Matter.

One of the major lessons of the crisis is that the effective regulation of systemically important institutions matters.

It is essential that the regulatory framework relating to them produces the right capital structures and drivers for behaviour. Our friends at the Basel Committee and Central Bankers are addressing this as we speak.

Equally important, but less recognized is the vital and complimentary need for effective regulation of markets. Market conduct and market infrastructure are the areas where the underlying behaviors that led to the crisis actually arose and the transmission mechanism for the risks, was of course, the market.

The conflicts of interest , the profligate lending, excessive leveraging, inappropriate valuations, overvalued securitisations, off balance sheet vehicles, extravagant compensation, all occurred in the area of market regulation, or the lack of it. These activities can lead to behaviors and mechanisms which have systemic implications. In other words institutions matter and markets matter for systemic stability.

The most perfect prudentially regulated institution will founder if the markets it operates in are excessively volatile and unruly.

Regulation of markets and regulation of systemically important institutions both matter. They are the virtuous twins of financial stability and both must be in place if we are to avoid the problems that led to the crisis.

The Financial Stability Board has been set up to operate at a global level, and similar Boards are being set up regionally. As at the FSB, these Boards need the voices of both the virtuous twins to operate successfully. Both voices need to be heard.

Research is essential.

The identification of emerging risks that are systemically important is essential if we are to have any chance of avoiding the mistakes of the past. To quote Andrew Lo, Professor at the Sloan School, MIT, recently in the Financial Times:

“Markets are neither always efficient nor always irrational, but are adaptive. During normal times prices can be trusted to reflect the wisdom of crowds. During times of distress investors act instinctively and emotionally and the wisdom of crowds becomes the madness of mob”. We also need to be adaptive. We need to be aware of the tipping points emerging and to look to interventions to prevent the madness of mob.

At our meeting yesterday IOSCO`s governing board, the Executive Committee made a very important, historic decision. It was decided to formulate a new stand alone, assessable principle on systemic risk.

While the mitigation of systemic risk has been traditionally seen as one of the three objectives of securities regulation along with promotion of orderly effective and fair markets and the protection of Investors and some individual principles have reflected elements of this; it was felt the time was now right to make it a clearly identified separate principle.

The financial crisis has focused us all on the importance of addressing systemic risk and the important role markets and market regulators can play in addressing this issue. The new IOSCO principle will focus on the need for market regulators to identify, assess and mitigate risks and threats within and potentially even beyond the current perimeter of regulation. It will also address the consideration of entities, regulated by market regulators whose failure may have systemic implications for the wider economy.

It is perhaps fitting that this important decision was made here in Basel, the home of our fellow international regulatory bodies, the Basel Committee, the International Association of Insurance Supervisors and the Financial Stability Board itself.

Political will is key

The recent meeting in Pittsburgh of the G20 Leaders also recognized the role securities markets regulators will need to play in developing new global approaches to identify and manage new market structures and products and identify areas of the markets which may harbour systemic risks.

The causes of the crisis were many and varied and the blame has been spread widely around.

Howard Davies gave a wonderful exposition of the causes of the crisis in New Zealand recently. It was called “The financial crisis…who dunnit”. In this exposition he said:

“Now the initial shock is fading, so the Wall St Journal editorial pages have concluded that they were right all along, and that the problem was excessive government interference in the markets. Politicians on the left have decided that they were right all along, in believing that unbridled capitalism carried within it the seeds of its own destruction. The French have decided that it is the fault of the Anglo Saxons in New York, and especially London. The English have decided, with some justification, that the real villains of the piece were Scottish bankers. The Tories think the only villain is a Scottish Prime Minister. No doubt in New Zealand, there are those who blame all your economic ills on your Trans Tasman cousins. The Australians themselves, as is there wont, blame the Umpires. What do ordinary people think? Well, they seem to have a fairly balanced view. A British financial website shows a good distribution of responsibility, with all the main suspects named. Bankers take pride of place, and I would not wish to deny them that accolade”

Regulators have also taken their share of blame as well. I would like to suggest another culprit, lack of political will to regulate, even when it was suspected the entities and behaviors had systemic implications.

Just as the origin of the crisis lay in flawed assumptions about the self regulatory power of markets, it also lay in the lack of political will to regulate market conduct.

Now is the time for the G20 Leaders and others to demonstrate the necessary political will to ensure the global securities market standards, set by IOSCO are implemented in every jurisdiction in the world. They not only need to be implemented, but they should be audited or assessed for compliance and those assessments publicized.

This would ensure that each jurisdiction is totally transparent about the extent to which it complies with the global norms and it would enable investors to better gauge the risk of their investments in various countries.


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