Board of Directors News July 2011

8/6/2019 Board of Directors News July 2011

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News for the BoardJuly 2011

SEC Proposes Rules Requiring Listing Standards forCompensation Committees and Compensation Consultants

Washington, D.C., March 30, 2011The Securities and ExchangeCommission today voted unanimously to propose rules directing thenational securities exchanges to adopt certain listing standards related tothe compensation committeeof a companys board of directors as wellas its compensation advisers, as required by the Dodd-Frank Wall StreetReform and Consumer Protection Act.

In 2010, Congress passed the Dodd-Frank Act that among other thingssought to address issues regarding the compensation that companies

pay their executives.

Section 952 of the Act addresses the compensation committees formedby corporate boards as well as the compensation advisers that thesecommittees retain.

In particular, this provision requires the SEC to direct the exchanges toadopt certain listing standards relating to the independence of themembers on a compensation committee, the committees authority toretain compensation advisers, and the committees responsibility for theappointment, compensation and work of any compensation adviser.


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Once an exchanges new listing standards are in effect, a listed companymust meet these standards in order for its shares to continue trading onthat exchange.

In addition, the provision requires each company to disclose in its proxymaterial for an annual meeting of shareholders whether its boardscompensation committee retained or obtained the advice of acompensation consultant.

The provision also requires a company to disclose whether the work ofthe compensation consultant has raised any conflict of interest and, if so,the nature of the conflict and how the conflict is being addressed.Requirements of the Proposed Rules

Independence of Compensation Committee Members

Under the SECs proposal, the exchanges would be required to adoptlisting standards that require each member of a companyscompensation committee to be a member of the board of directors andto be independent.

In developing a definition of independence, the exchanges would berequired to consider such factors as:

The sources of compensation of a director, including any consulting,advisory or compensatory fee paid by the company to such member ofthe board of directors.

Whether a member of the board of directors of a company is affiliatedwith the company, a subsidiary of the company, or an affiliate of asubsidiary of the company.

As with all listing standards, exchanges would need to seek the approvalof the SEC before adopting them.


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Authority and Funding of the Compensation Committee

The proposed rules would require the exchanges to adopt listingstandards providing that the compensation committee of a listedcompany:

May, in its sole discretion, retain or obtain the advice of a compensationadviser.

Is directly responsible for the appointment, payment and oversight ofcompensation advisers.

Must be appropriately funded by the listed company.

Compensation Adviser Selection

The proposed rules also would require the exchanges to adopt listingstandards providing that a compensation committee may select acompensation consultant, legal counsel or other adviser only afterconsidering the following five independence factors:

Whether the compensation consulting company employing thecompensation adviser is providing any other services to the company.

How much the compensation consulting company who employs thecompensation adviser has received in fees from the company, as a

percentage of that persons total revenue.

What policies and procedures have been adopted by the compensationconsulting company employing the compensation adviser to preventconflicts of interest.

Whether the compensation adviser has any business or personal

relationship with a member of the compensation committee.

Whether the compensation adviser owns any stock of the company.


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The exchanges themselves could impose additional considerations.

Exemptions

As directed by the statute, the proposed rules would require theexchanges to exempt the following five categories of companies from thecompensation committee independence requirements:

Controlled companies.Limited partnerships.Companies in bankruptcy proceedings.Open-end management investment companies registered under theInvestment Company Act of 1940.

Any foreign private issuer that discloses in its annual report the reasonsthat the foreign private issuer does not have an independentcompensation committee.

In addition, the proposed rules would authorize the exchanges toexempt a particular relationship from the independence requirementsapplicable to compensation committee members.

The proposed rules also would authorize the exchanges to exempt anycategory of company from all of the requirements of the new

compensation committee listing standards.

The proposed rules would exempt controlled companies from all of therequirements of the new compensation committee listing standards.

As with all listing standards, the exchanges would need to seek theapproval of the SEC before adopting any exemptions.

Compensation Consultant Conflicts of Interest Disclosure

Exchange Act registrants subject to the federal proxy rules are alreadyrequired to disclose information about their use of compensation


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consultants, including specific information about fees paid toconsultants that the SEC added in late 2009.

The proposed rules would modify existing rules to require disclosureabout whether:

The compensation committee has retained or obtained the advice of acompensation consultant.

The work of the compensation consultant has raised any conflict ofinterest and, if so, the nature of the conflict and how the conflict is beingaddressed.

The proposed rules also would eliminate the current disclosure

exception for services that are limited to consulting on broad-basedplans and the provision of non-customized benchmark data, but wouldretain the fee disclosure requirements, including the exemptions fromthose requirements.

Sarbanes Oxley News

Happy Anniversary!

Tuesday, June 28, 2011:We have celebrated the 9th anniversary ofSarbanes-Oxley Act, and we had the opportunity to remember what hashappened during the previous 12 months (June 28, 2010 to June 28, 2011).

The Sarbanes Oxley Act has become much more important during thisyear.

1. The new US financial regulatory reform, the Dodd Frank Act, amendssome sections of the Sarbanes Oxley Act.

SOX is part of the new regulatory reform. They did not delete the SOXprovisions; they have made them more strict and clever.


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For example, whistleblowers now have a monetary incentive to reportmatters to the SEC (they may be entitled to as much as 10 percent to 30

percent of the monetary sanctions imposed).

Management should clearly explain to all employees the importance ofprompt reporting of violations.

Public companies should do much more for complaints submitted toaudit committees or employee hotlines to address areas of potentialconcern.

The Dodd-Frank Act also provides an employee with remedies againstthe employer that has violated the whistleblower provisions of the Dodd-Frank Act.

These remedies include reinstatement with the same seniority status thatthe individual would have had, two times the amount of back payotherwise owed to the individual, with interest, and even compensationfor litigation costs, expert witness fees, and reasonable attorneys fees.

Does it look like the end of Sarbanes Oxley? No, it is Sarbanes Oxley onsteroids.

According to the Dodd Frank Act, no employer may discharge, demote,

suspend, threaten, harass, directly or indirectly, or in any other mannerdiscriminate against, a whistleblower in the terms and conditions ofemployment because of any lawful act done by the whistleblower:

- In providing information to the SEC in accordance with the provisionsof the Dodd-Frank Act;

- In initiating, testifying in, or assisting in any investigation or judicial oradministrative action of the Commission based upon or related to suchinformation; or

- In making disclosures that are required or protected under the


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Sarbanes-Oxley Act, the Securities Exchange Act and any other law, rule,or regulation subject to the jurisdiction of the SEC.

2.The US Supreme Court denied putting the Public CompanyAccounting Oversight Board (PCAOB) out of business, and now thePCAOB, with its role clear and well understood, has decided toannounce new and stricter risk assessment standards.

Sarbanes Oxley becomes more strict and mature.

3. On September 15, 2010, the Public Company Accounting OversightBoard (the Board or the PCAOB) filed with the Securities andExchange Commission (the Commission) a notice (the Notice) of

proposed rules (File No. PCAOB 2010-01) on Auditing Standards Related

to the Auditors Assessment of and Response to Risk and RelatedAmendments to PCAOB Standards.

Those eight auditing standards(hereinafter referred to as RiskAssessment Standards), which will supersede six of the Boards interimauditing standards, are:

Auditing Standard (AS) No. 8, Audit Risk;

AS No. 9, Audit Planning;

AS No. 10, Supervision of the Audit Engagement;

AS No. 11, Consideration of Materiality in Planning and Performing anAudit;

AS No. 12, Identifying and Assessing Risks of Material Misstatement;

AS No. 13, The Auditors Responses to the Risks of MaterialMisstatement;

AS No. 14, Evaluating Audit Results;


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AS No. 15, Audit Evidence.

December 23, 2010 - The Commission is granting approval of theproposed rules. The rules are effective for audits of fiscal years beginningon or after December 15, 2010.

The suite of risk assessment standards, Auditing Standards No. 8through No. 15, sets forth requirements that enhance the effectiveness ofthe auditor's assessment of, and response to, the risks of materialmisstatement in the financial statements.

The risk assessment standards address audit procedures performedthroughout the audit, from the initial planning stages through the

evaluation of the audit results.

"These new standards are a significant step in promoting sophisticatedrisk assessment in audits and minimizing the risk that the auditor willfail to detect material misstatements," said PCAOB Acting ChairmanDaniel L. Goelzer.

"Identifying risks, and properly planning and performing the audit toaddress those risks, is essential to promoting investor confidence inaudited financial statements."

________________________________________________________

Study and Recommendations on Section 404(b) of the Sarbanes-OxleyAct of 2002 For Issuers With Public Float Between $75 and $250 MillionAs Required by Section 989G(b) of the Dodd-Frank Wall Street Reformand Consumer Protection Act of 2010

Under Section 989G(b) of the Dodd-Frank Wall Street Reform andConsumer Protection Act (the Dodd-Frank Act), the Securities andExchange Commission (SEC or Commission) is required to conduct a

study to determine how the Commission could reduce the burden ofcomplying with Section 404(b) of the Sarbanes-Oxley Act of 2002


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Staff study on Section 404, discussed in Section III of this study),focusing our data analysis on issuers that would be within the rangecalled for by the study;

(2) a review of prior academic and other research, including hundreds ofstudies and research papers with respect to Section 404; and

(3) a request for public comment which included 23 specific areas ofinquiry on how the Commission could reduce the burden of complying

with Section 404(b) for issuers with $75-$250 million in public float, whilemaintaining investor protections for such issuers, and whether anymethods of reducing the compliance burden or a complete exemptionfor such issuers from Section 404(b) would encourage issuers to list onU.S. exchanges in their IPOs.

The purpose of using these sources was to:

(1) learn about the specific characteristics of the issuers in the range ofthe study, how they compare to other issuers reporting as acceleratedfilers and non-accelerated filers, and the benefits and current andhistorical costs of compliance with Section 404(b) and current investor

protections relating to such issuers; and

(2) facilitate the development of potential new ideas for reducing the

compliance burden among such issuers, including the effects of suchcompliance burden reduction or complete exemption from Section404(b) to encourage companies to list IPOs in the United States.

Benefits to Section 404 Compliance

Numerous research papers and studies address the benefits ofcompliance with Section 404.

Considering Sections 302 and 404 of the Sarbanes-Oxley Act broadly, theresearch results suggest that unless the external auditor is involved intesting and reporting on the effectiveness of internal controls, as is the


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case under Section 404(b), the reliability of information about controlsmay be negatively affected.

Auditor testing of accelerated filers controls has generally resulted in thedisclosure ofinternal control deficiencies (ICDs) that were not

previously disclosed by management, and the external auditorattestation appears to have a positive impact on the informativeness ofinternal control disclosures and financial reporting quality.

Studies also document that Section 404(a)-only issuers, comprised ofmostly smaller issuers, have more material weaknesses, restatements,and incidences of fraudulent financial reporting as compared to mostissuers that comply with Section 404(b).

For example: Section 404(a) and (b)-compliant issuers are less likely toissue materially misstated financial statements than issuers not subjectto these requirements.

The rate of restatements surrounding a disclosure of effective ICFR was46% higher among issuers that only filed Section 404(a) reports ascompared to those that also filed auditor attestations under Section404(b) during the cumulative four years of compliance with Section 404.

Specifically, Section 404(b)-compliant issuers that reported effective

ICFR experienced a financial restatement rate of 5.1%, while Section404(a)-only issuers experienced a restatement rate of 7.4%.

From 2003-2009, non-accelerated filers have accounted for approximately65% of the total financial restatements compared to accelerated filers(3,979 restatements out of a total of 6,116).

Section 404(a)-only issuers had a higher adverse management reportpercentage rate (27.8%; 853 out of 3,066 annual reports), indicating thatnon-accelerated filers failed to maintain ICFR that were as reliable as

accelerated filers ICFR.


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A number of investors and stakeholder organizations opposedexempting smaller issuers from Section 404(b).

Behavior of Issuers in an Effort to Avoid Compliance

1. Listing Trends

With respect to the portion of the study addressing the question of animpact on Section 404(b) compliance on listing decisions, the Staffreviewed research on listing trends.

a. Going-Private and Going-Dark Transactions

One aspect of listing trends relates to issuers that determine to exit the

reporting system.

Some academic literature on going-private transactions and going-darktransactions suggests that the enactment of the Sarbanes-Oxley Act,including Section 404(b), has generally had relatively little or no effect ondecisions to engage in these types of transactions.

However, there is reported evidence suggesting Sarbanes-Oxley Actcompliance costs disproportionally burdens smaller issuers, resulting in

delisting activities.

The findings also show that many going-private transactions resulted insurviving companies that remained subject to SEC reportingrequirements or became SEC reporting companies within twelve monthsof the transaction.

Specifically:

There are instances in which the Sarbanes-Oxley Act in general,

increased compliance costs, or Section 404 implementation was cited asa reason for delisting, especially for smaller, low performing (e.g., less


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liquid, slow growth), or high inside ownership issuers.

There was a sharp increase in the rate at which issuers have gone privatesince the enactment of the Sarbanes-Oxley Act.

However, the rate at which such issuers remained Exchange Actreporting companies following a going-private transaction significantlyincreased between 2003 and 2006.

There was an increase in the quarterly frequency of going-privateactivities from 1998 to 2005 and an increase in going-dark transactions in2003 and 2004, which may be due to increased Sarbanes-Oxley costs,although several academic researchers argue that the link between theSarbanes-Oxley Act and going-dark or going-private decisions in the

United States is somewhat doubtful.

There was no relative increase in the rate of acquisitions by privateacquirers (going private) among U.S. issuers, and while there was anincrease in the rate of going private transactions by small U.S. issuers inthe first year after the Sarbanes-Oxley

Act was enacted, there was no effect for acquisitions announced morethan a year after the enactment of the Sarbanes-Oxley Act.

Although an increasing number of foreign issuers exited the U.S.securities markets after the enactment of the Sarbanes-Oxley Act, theresearch suggests that these issuers had greater control by insiders ratherthan outside investors.

b. Listing on Foreign Exchanges

Another aspect of listing trends relates to issuers decisions to list onforeign exchanges.

Some research suggests that the decline in cross-listings may mostly beexplained by changes in characteristics of the issuers, rather than


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changes in the benefits of cross-listing.The AIM market represents a distinct exception, with few delistingsrelative to the high rate of new listings in the period following theenactment of the Sarbanes-Oxley Act.

More recent data on IPO activity on AIM shows that 102 companiesraised 3.4 billion in the first half of 2007, 38 companies raised 829.83million in the first half of 2008, 3 companies raised 223 million in thefirst half of 2009, and 16 companies raised 350.6 million in the first halfof 2010.

Despite a strong post-2002 market growth, the U.S. IPO marketremained cold overall from 2001-2007, posting seven consecutive years

with less than 200 IPOs being completed each year.

Prior to 2001, the last time that less than 200 IPOs were completed in ayear was 1990, and only three times during that 11-year span were lessthan 300 IPOs completed.

If 1999 and 2000 are eliminated as bubble years, the aggregate proceedsraised by IPOs recovered in 2004 and maintained that level through 2007,despite the drop in number of the number IPOs compared to the pre-2001 era.

A number of academics suggest that the net effect of Section 404 onsmaller companies IPOs is difficult to measure and may be due to otherfactors, such as the economic environment.

One researcher found that between 2008-2009, the numbers of IPOsremained low, noting that this does not appear to be a result of theSarbanes-Oxley Act.

In addition, several studies demonstrate that foreign listing activity hasslowed and foreign de-listing and deregistration activity has increased,

but there is no consensus on how much influence the Sarbanes-OxleyAct has had on these decisions.


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Overall, although there is some reported evidence consistent withSarbanes-Oxley Act compliance cost disproportionally burdening smallcompanies, the research on listing trends generally reveals that theenactment of Section 404(b) has not noticeably affected decisions byissuers to exit the reporting requirements of the SEC, including ICFRreporting, and therefore evidence does not indicate that issuers listingbehavior would be significantly altered by reducing the cost ofcompliance or by granting further exemptions under Section 404(b).

2. Managing Public Float

The research evidences that some issuers may attempt to avoid Section404 costs by reducing or managing their public float in order to becomeor remain a non-accelerated filer.

Specifically, academic researchers found that: Issuers with marketcapitalization between $60 and $90 million reduced their market valuesduring the relevant time periods that determined Section 404 complianceby increasing insider purchases to impact the number of sharesoutstanding and using discretionary accruals to achieve stock pricereduction.

Some smaller issuers strived to remain below the $75 million non-accelerated filer threshold by reducing investments in property, plant,

and equipment, intangibles, and acquisitions, increasing cash payouts toshareholders via ordinary and special dividends and share repurchases,reducing the number of shares held by non-affiliates, making more badnews disclosures, and reporting lower earnings.

Cost savings from the avoidance of Section 404 compliance requirementsmotivated some non-accelerated filers to underreport public float whilethe cost efficiency and flexibility of Form S-3 eligibility motivated otherissuers to overreport public float.

Overall, the research suggests that issuers may attempt to manage publicfloat to remain or fall below a threshold for additional reporting;


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therefore, any further exemptions under Section 404(b) could lead tosuch incentives by issuers that are larger (in terms of revenues andassets) than issuers with public float less than $75 million.

Speech by SEC Chairman: Opening Statement at SEC OpenMeeting: Item 2 - Whistleblower Program by Chairman Mary L.Schapiro, U.S. Securities and Exchange Commission,

Washington, D.C., May 25, 2011

Next, we will consider whether to adopt rules to create a whistleblowerprogram that would incentivize those close to a fraud to come forwardand provide information to the Commission.

These rules, originally proposed last November, would implement

Section 922 of the Dodd-Frank Act.

The new whistleblower program is a part of our effort to enhance theagencys capacity to detect and prevent fraud.

Todays proposed final rules build upon our efforts over the past twoyears and our experience with the Sarbanes-Oxley Actan Act thatmade great strides in creating whistleblower protections and requiringinternal reporting systems at public companies.

From that experience, we learned that despite Sarbanes-Oxley, too manypeople remain silent in the face of fraud.

Todays rules are intended to the break the silence of those who see awrong.

For an agency with limited resources like the SEC, I believe it is criticalto be able to leverage the resources of people who may have first-handinformation about potential violations.

And, it is especially important to investors whose savings or retirementfunds may hinge on our ability to stop an ongoing fraud or obtain


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hidden evidence.

Already, the whistleblower provision of the Dodd-Frank Act is having animpact.

While the SEC has a history of receiving a high volume of tips andcomplaints, the quality of the tips we have received has been better sinceSection 922 became law. And we expect this trend to continue.

Todays proposed final rules map out simplified and transparentprocedures for whistleblowers to provide us critical information.

To a great extent, the procedures work in tandem with the new onlinesystem we established to collect tips and complaints across the agency.

Not surprisingly, this rulemaking process brought to light severalchallenging policy issuesissues that were raised in the 240 commentsand more than 1,300 form letters we received.

The recommendation before us today is a result of the careful weighingof the comments which improved upon the earlier rules we proposed.

Categories of Persons: For example, the proposed rules limited theability of lawyers, auditors and internal compliance personnel to

improperly use their positions to claim a reward.

Todays final rule recognizes that we might have initially sought toexclude too many important, potential whistleblowers.

So, the proposal narrows some of those exclusions and, moreimportantly, creates appropriate exceptions to ensure sufficient avenuesfor vital information ultimately to get to the SEC.

Simpler Procedure: Similarly, we agreed with those who advocated for a

simpler, more streamlined procedure for submitting information.As such, the proposed final rule now includes a single form that a


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whistleblower can submit.

Whistleblower Protections: And, further, the final rules make clear thatthe statutes whistleblower protections apply to anyone who provides usinformation, even if that information relates to a possible securities law

violation, and regardless of whether it leads to a successful enforcementaction.

But, perhaps, no issue received more focus during this process than therole of internal compliance programs.

As I have often said, internal compliance programs play an extremelyvaluable role in the fraud prevention arena.

And we have sought to leverage compliance officers who can helpprotect investors by keeping companies on the straight path.

But many commenters vigorously asserted that these programs wouldonly survive if the Commission required whistleblowers to first reportinternally before coming to us.

This view, however, was countered by many other commenters whostrenuously argued that mandating internal compliance reporting isinconsistent with the statute.

They noted that such a mandate would dissuade whistleblowers fromcoming forward.

I believe that the final recommendation strikes the correct balanceabalance between encouraging whistleblowers to pursue the route ofinternal compliance when appropriatewhile providing them theoption of heading directly to the SEC.

This makes sense as well because it is the whistleblower who is in the

best position to know which route is best to pursue.


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Nevertheless, these final rules expand upon the incentives forwhistleblowers to report internally where appropriate to do so.

First, the final rules lengthen the period of time in which a whistleblowercan wait before coming to the SEC, after reporting internally.

Now whistleblowers will be able to get credit for the original date theyreported to their company so long as they notify the SEC within 120 days.

Second, the final rules now make clear that the Commissionwhenconsidering the amount of an awardwill consider how much a

whistleblower has participated in or interfered with the internalcompliance process.

Perhaps most significantly, the final rules would give credit to awhistleblower whose company passes the information along to theCommission, even if the whistleblower does not.

This could create an opportunity for a whistleblower to obtain an awardthrough internal reporting where the whistleblower might not otherwisehave qualified for an award because the information was not sufficientlyspecific and credible.

Offering financial incentives for whistleblowers to report appropriate

concerns to internal compliance is unprecedented.

But, I believe that incentivizingrather than requiringinternalreporting is more likely to encourage a strong internal complianceculture.

Our rules create incentives for people to report misconduct to theiremployers, but only if those companies have created an environment

where employees feel comfortable that management will take themseriouslyand where they are free from possible retaliation.

Finally, in deciding upon the appropriate amount of an award, the rule


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indicates that the Commission will focus on the timeliness and quality ofa whistleblowers assistance.

Already, I have heard stories from our investigators about howwhistleblowers have saved us weeks of investigation time because of thespecific, credible and timely information they provided.

Before I close, Id like to recognize the hard work of the staff, of which Iam very proud. From the outset, this team has been extremely thoughtfulabout the difficult policy choices created by these rules.

I believe the staffs recommendation strikes an appropriate balancebetween the need to encourage whistleblowers to come forward and therisk of promoting unintended consequences.

From day one, this effort has been a true partnership between theDivision of Enforcement and the Office of General Counsel, and thesupport from the Division of Risk, Strategy and Financial Innovation hasbeen extremely valuable as well.

PCAOB Issues Concept Release on Auditor's Reporting ModelWashington, D.C., June 21, 2011

The Public Company Accounting Oversight Board today issued aconcept release to discuss alternatives for changing the auditor'sreporting model.

The Board also announced that it will convene a public roundtable todiscuss the concept release in the third quarter of 2011.

"The concept release we issue today represents a significant step forinvestor protection in response to the financial crisis, and a first step

toward a holistic consideration of reforms designed to foster therelevance, transparency and reliability of the audit process," said JamesR. Doty, PCAOB chairman.


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The Board is seeking comment on alternatives and other matterspresented in the concept release regarding possible enhancements in theauditor's reporting model.

The auditor's report is the primary means by which the auditorcommunicates to investors and other financial statement users aboutinformation regarding the audit of the financial statements.

"The auditor is in a unique position to provide relevant and usefulinformation, because of the auditor's extensive knowledge of thecompany and as an independent third-party, said Martin F. Baumann,PCAOB Chief Auditor and Director of Professional Standards.

"The concept release explores ways to expand the auditor's

communication in the auditor's report about the audit and thecompany's financial statements."

The concept release presents several alternatives for changing theauditor's reporting model and is seeking specific comment on these orother alternatives that could provide investors with more transparency inthe audit process and more insight into the company's financialstatements or other information outside the financial statements.

These alternatives include:

An auditor's discussion and analysis;

Required and expanded use of emphasis paragraphs;

Auditor assurance on other information outside the financial statements;and,

Clarification of language in the standard auditor's report.

The current release seeks public comment on alternatives foramendments to, or the development of new, auditing standards that


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would supersede the Board's current standards on the auditors' report.

The Board also today released a fact sheet that provides a summary ofthe matters included in the concept release.

Earlier this year, PCAOB staff reached out to investors, auditors,preparers of financial statements, audit committee members, and otherinterested parties to seek their views on potential changes to theauditor's report.

The staff reported its findings to the Board on March 22.

Comments on the concept release are due Sept. 30, 2011.

Additional details about the roundtable discussion on the auditor'sreporting model concept release will be announced at a later date.

Basel III News, July 2011

Is it true that investors will lose money because of Basel III?

It is true. This is the price we pay because the banking system becomesmore resilient. More risks, more profits - do you remember the principle?

You cannot make much money in a "deep, liquid and transparent"market where you take limited risks.

Is it that simple? Less profit because of fewer risks?

There is a second reason.

The objective of the Basel III reforms is to reduce the probability andseverity of future crises. So, we will face fewer risks. But this involves

costs arising from stronger regulatory capital and liquidity requirementsand more intense and intrusive supervision.


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We will do have "benefits to the society that will well exceed the costs toindividual institutions", but investors will pay the cost.

According to the Bank for International Settlements (BIS), banks mayneed to scale back their profit expectations.

According to the annual report of the BIS, we could have lower, morestable returns on equity (ROEs), a key measure of profitability, sincebank balance sheets will be less risky.

There is a third reason also.

Basel III makes regulatory arbitrage harder.

Basel II allowed banks to play more games. Basel II mispriced the riskinherent in securitizations and let banks load up on off-balance-sheetinstruments and collateralized debt obligations. Basel III adds a leverageratio, and capital has to be at least 3% of total assets (TOTAL assets, notrisk weighted assets).

Yes, Basel III introduces a simple leverage ratio that provides a backstopto the risk-based regime.

The supplementary ratio, which is a measure of a banks Tier 1 capital as

a percentage of its assets plus off-balance sheet exposures andderivatives, will serve as an additional safeguard against attempts togame the risk-based requirements, and will mitigate model risk.

The packaging and selling of loans is no longer the great way to avoidcapital requirements.

Banks must consolidate positions from all their trading desks and maketheir trading book compatible with their banking book (a read IT anddata management challenge).


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Another opportunity lost - it will not be that simple for banks to transferassets out of their banking book into the trading book to get bettercapital treatment.

Oh, yes, this is going to be a real challenge for US banks that are notcurrently under the Basel II framework.

The moral of the story: Forget bank returns that are at the range of 20percent.

I was surprised to read that Deutsche Bank AG is targeting a pretaxinvestment bank return of20 to 25 percent after 2013 (down from 28

percent in 2010).

Deutsche Bank AG may have to raise additional capital for anotherreason: Regulators have agreed to make as many as 30 of the worldslargest and systemically important banks hold as much as 2.5 percentmore capital than the 7 percent core Tier 1 capital required.

This adds to the problem that banks cannot use hybrid capitalinstruments that are using now, such as contingent convertible bonds, tomeet the target.

HSBC Holdings Plc (HSBA), Bank of America Corp. (BAC), Citigroup,

Deutsche Bank, BNP Paribas, JPMorgan Chase & Co. (JPM), BarclaysPlc (BARC) and Royal Bank of Scotland Group Plc may be subject to thesurcharge of the 2.5 percent.

UBS AG, Credit Suisse, Goldman Sachs Group Inc. and Societe Generalemay be subject to a lower charge of 2 percent.

The size of the potential market for contingent convertible bonds(CoCos) in the UK has already shrunk by two thirds, as banks cannotcount the instruments as capital cushions, according to an analysis by

Bank of America/Merrill Lynch.


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The U.K.s Financial Services Authority has asked banks to prepare aflight path to put them in compliance with the Basel III capital rules,taking into account dividends, bonuses and stress testing (they musttake into account the possibility of another economic recession).

Paul Tucker, Deputy Governor of the Bank of England, challengesbanks and asks them to build up capital ahead of the Basel IIIrequirements (rather than using strong earnings to make payouts to staffand investors).

In the States, although major banks try to keep a brave face, they havealready challenged Fed Chairman Ben S. Bernanke on whetherregulators have gone too far and are slowing economic growth.

According to Mario Draghi, incoming European Central Bank president,banks already claim that opposing jurisdictions seek to water downBasel, and at the same time these banks have tried to weaken Basel III

within their respective jurisdictions.

Important parts of the 81st Annual Report of the BIS

In the 81st Annual Report of the BIS we read that the Basel III rulesneed to be implemented in a timely and globally consistent manner.

All member countries of the Basel Committee must now translate theBasel III texts into national regulations and legislation in time to meetthe 2013 deadline.

The Committee and its oversight body of Governors and Heads ofSupervision have consistently stated that the new standards will beintroduced in a manner that does not impede the economic recovery.

Thus, they have chosen a staggered timeline for implementation.


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For example, the July 2009 enhancements that strengthen regulatorycapital and disclosure requirements are due to take effect no later thanthe end of 2011.

The Basel III requirements themselves begin to take effect from thebeginning of 2013 and will be phased in by 2019.

This time frame includes an observation period to review theimplications of the liquidity standards for individual banks, the bankingsector and financial markets, with a view to addressing any unintendedconsequences.

Similarly, the Committee will assess the impact of the leverage ratio onbusiness models during the transition period in order to ensure that it

achieves its objectives.

Like all Basel Committee standards, Basel III sets out minimumrequirements, and the transitional arrangements are the deadlines foradopting the new standards.

Countries should move faster if their banks are profitable and are able toapply the standards without having to restrict credit.

Banks should not be permitted to increase their capital distributions

simply because the deadline for achieving the minimum standards is stillsome way off, particularly if there are signs of growing macroeconomicrisks and imbalances.

Therefore, banks, for their part, must also begin to plan and to prepare.

Basel III is the core regulatory response to problems revealed by thefinancial crisis.

Delay or weakening of the agreements would jeopardise financial

stability and the robustness of the recovery over the long term.


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The full, timely and consistent implementation of all relevant standardsby banks, along with rigorous enforcement by supervisors, is critical.

Ultimately, both the official and the private sector will reap the benefitsof a more stable financial system. The severity of the crisis owed much tothe fact that the banking sector in many countries had taken on toomuch risk without a commensurate increase in capital.Furthermore, this inadequate level of capital was of insufficient quality,as the latter had gradually eroded.

Basel III tightens capital requirements, encompasses a broader array ofrisks, and explicitly addresses macroprudential aspects of bankingsystem stability.

Basel III substantially raises the quality as well as the quantity of capital,with a much greater emphasis on common equity.

During the crisis, losses reduced banks common equity. However, somebanks maintained deceptively high ratios of Tier 1 capital to risk-

weighted assets through the inclusion of other forms of financialinstruments in the capital base.

Moreover, non-common Tier 1 capital instruments often did not share inbanks losses through reduced coupon or principal payments and so did

not contribute to maintaining the institutions as going concerns in anymeaningful way.

The artificially high Tier 1 risk-based ratios also meant that banks werebuilding up high levels of leverage. Basel III therefore also introduces asimple leverage ratio that provides a backstop to the risk-based regime.

The supplementary ratio, which is a measure of a banks Tier 1 capital asa percentage of its assets plus off-balance sheet exposures andderivatives, will serve as an additional safeguard against attempts to

game the risk-based requirements, and will mitigate model risk.


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The Basel Committee has also improved the risk coverage of theregulatory capital framework for capital market activitiesa salientfeature of the recent crisis, where trading exposures accounted for muchof the build-up of leverage and were an important source of losses.

Weak capital, excessive leverage and inadequate risk coverage preventedthe banking system from fully absorbing systemic trading and creditlosses. Nor could it cope with the reintermediation of large off-balancesheet exposures that had built up in the shadow banking system.

Under Basel III, banks will have to hold more capital against their lessliquid, credit-sensitive assets whose holding periods are much longerthan traditional trading positions.

Trading activities will also be The Basel Committee has also improvedthe risk coverage of the regulatory capital framework for capital marketactivitiesa salient feature of the recent crisis, where trading exposuresaccounted for much of the build-up of leverage and were an importantsource of losses.

Weak capital, excessive leverage and inadequate risk coverage preventedthe banking system from fully absorbing systemic trading and creditlosses.

Nor could it cope with the reintermediation of large off-balance sheetexposures that had built up in the shadow banking system.

Under Basel III, banks will have to hold more capital against their lessliquid, credit-sensitive assets whose holding periods are much longerthan traditional trading positions.


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Measures for global systemically important banks agreed by theGroup of Governors and Heads of Supervision - 25 June 2011

At its 25 June 2011 meeting, the Group of Governors and Heads of

Supervision (GHOS), the oversight body of the Basel Committee onBanking Supervision (BCBS), agreed on a consultative document settingout measures for global systemically important banks (G-SIBs).

These measures include the methodology for assessing systemicimportance, the additional required capital and the arrangements by

which they will be phased in. These measures will strengthen theresilience of G-SIBs and create strong incentives for them to reduce theirsystemic importance over time.

This package of measures will be issued for consultation around the endof July 2011.

The assessment methodology for G-SIBs is based on an indicator-basedapproach and comprises five broad categories:

1. Size

2. Interconnectedness

3. Lack of substitutability

4. Global (cross-jurisdictional) activity and

5. Complexity.

The additional loss absorbency requirements are to be met with aprogressive Common Equity Tier 1 (CET1) capital requirement rangingfrom 1% to 2.5%, depending on a bank's systemic importance.


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To provide a disincentive for banks facing the highest charge to increasematerially their global systemic importance in the future, an additional1% surcharge would be applied in such circumstances.

The higher loss absorbency requirements will be introduced in parallelwith the Basel III capital conservation and countercyclical buffers, iebetween 1 January 2016 and year end 2018 becoming fully effective on 1

January 2019.

The GHOS and BCBS will continue to review contingent capital, andsupport the use of contingent capital to meet higher national lossabsorbency requirements than the global minimum, as high-triggercontingent capital could help absorb losses on a going concern basis.

Mr Jean-Claude Trichet, President of the European Central Bank andChairman of the Group of Governors and Heads of Supervision, said that"the agreements reached today will help address the negativeexternalities and moral hazard posed by global systemically importantbanks."

Mr Nout Wellink, Chairman of the Basel Committee on BankingSupervision and President of the Netherlands Bank, added that "the

proposed measures will increase the going-concern loss absorbency ofG-SIBs. This will contribute to enhancing the resiliency of the banking

system and help mitigate the wider spill-over risks of global systemicallyimportant banks".


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More about the G-SIBs and the new Basel III rules from theFSB

From the Report of the Financial Stability Board (FSB) to G20 Finance

Ministers and Central Bank Governors (10 April 2011)

Following the endorsement by the G20 Leaders of the Basel III packageof capital and liquidity reforms at the November Seoul Summit, and theissuance by the Basel Committee of the Basel III rules text in December2010, all members will now put in place the necessary regulations and/orlegislation to implement the Basel III framework on 1 January 2013, suchthat it can be fully phased in by 1 January 2019.

Some issues have been raised pertaining to the new liquidity

requirements. These revolve around the calibration of the ratios, ratherthan the conceptual basis of the liquidity framework.

The Basel Committee will use the observation period to review theimplications of the standards for individual banks, the banking sector,and financial markets, addressing any unintended consequences asnecessary.

The Committee is focused on ensuring that the calibration of theliquidity framework is appropriate.

Certain aspects of the calibration will be examined and this will involveregular data collection from banks.

Adjustments will be based on additional information and rigorousanalyses.

In February 2011, the Basel Committee issued revisions to the Basel IImarket risk framework, updated to reflect the adjustments to the

framework announced by the Basel Committee in its June 2010 pressrelease and the stress testing guidance for the correlation tradingportfolio.


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Addressing systemically important financial institutions (SIFIs)

At the November 2010 Summit, the G20 Leaders endorsed the policyframework, work processes and timelines set out in the October 2010FSB report Reducing the moral hazard posed by systemically importantfinancial institutions.

At their February 2011 meeting, the G20 Finance Ministers and CentralBank Governors asked the FSB to deliver to the November 2011 Summitthe recommendations that had been scheduled for end-2011 in theOctober 2010 report.

The FSB and its members have agreed an accelerated timetable in orderto meet that request.

G-SIFI determination and loss absorbency

The Basel Committee (BCBS) has broadly agreed a methodology toassist the FSB and national authorities in assessing the systemicimportance of financial institutions at a global level.

This methodology incorporates revisions based on feedback from theGroup ofGovernors and Heads of Supervision (the Committeesoversight body) and from the FSB.

The revised methodology is based on quantitative indicators for fivecategories: global activity, size, interconnectedness, substitutability, andcomplexity.

The BCBSs methodology will be used as input to the determination bythe FSB and national authorities, in consultation with standard-setters,of the banking institutions to which the FSB global SIFI (G-SIFI)recommendations will initially apply.

The International Association of Insurance Supervisors (IAIS) isdeveloping a provisional methodology and set of indicators for assessing


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the global systemic importance of insurers as input to the initialdetermination by the FSB and national authorities of G-SIFIs.

A status report on the development of the methodology was provided tothe FSB in March and the IAIS expects to finalise its methodology inSeptember 2011.

In Seoul, the G20 Leaders endorsed a requirement that SIFIs andinitially in particular GSIFIs should have higher loss absorbencycapacity to reflect the greater risks that these firms pose to the globalfinancial system.

Depending on national circumstances, this greater capacity could bedrawn from a menu of viable alternatives and could be achieved by a

combination of a capital surcharge, a quantitative requirement forcontingent capital instruments and a share of debt instruments or otherliabilities.

As requested by the FSB, the BCBS expects to complete by June 2011 itsstudy of the magnitude of additional loss absorbency along with anassessment of the extent of going concern loss absorbency which couldbe provided by the various proposed instruments.

As noted in the next section, the FSB Bail-in Working Group, working

on contractual and statutory bail-in, also expects to finalise its proposalsby mid-2011.

Drawing on these analyses, the FSB, in consultation with the BCBS, willrecommend by the G20 Summit an additional degree of loss absorbencyfor globally systemic banks and the instruments by which this can bemet.

Public consultations will take place during the second half of 2011 on theidentification methodology, amounts and instruments of added loss

absorbency and implementation horizon, before the recommendationsare finalised and delivered to the November Summit.


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Resolution tools and regimes

Work towards the implementation of the recommendations on resolutionset out in the FSBs October 2010 SIFI report is progressing.

The FSB has established a Steering Group responsible for delivering theoverall work programme on resolution and for developing the Key

Attributes of Effective Resolution Regimes which will identify theessential features that national resolution regimes for financialinstitutions, including non-bank financial institutions, should have.

To make resolution possible in a cross-border context, the SteeringGroup is also considering the essential elements for institution-specificcooperation agreements.

These should serve as a benchmark and point of reference to nationalauthorities as they negotiate these agreements (which are to be drawn upby end-2011).

The FSB will discuss the set of draft proposals at its Plenary meeting inJuly.

The FSB Cross-border Crisis Management Group (CBCM) is monitoringthe development of G-SIFIs recovery and resolution plans in close

cooperation with the institution-specific Crisis Management Groups.

To assist this process the CBCM is developing Essential Elements ofEffective Recovery and Resolution Plans as well as a framework for theassessment of resolvability of individual SIFIs, including by drawing onthe groups technical analysis of obstacles to effective resolution arisingfrom internal interconnectedness, global payments operations andinformation systems.

The FSB also has work underway on the technical aspects and financialstability implications of both contractual and statutory bail-in


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instruments and mechanisms to provide for higher loss absorbency andimprove resolvability of SIFIs.

The FSB Bail-in Working Group will report in mid-2011 on thecharacteristics that contractual and statutory bail-in should have to beeffective.

The BCBS Cross-border Bank Resolution Group (CBRG) conducted acomprehensive survey in the first quarter of 2011 to take stock of existingnational resolution regimes and tools.

The CBRG will be reporting on its findings from the survey around mid-2011.

The FSB will drawon the CBRGs findings as one of the inputs for theelaboration of the Key Attributes.

A public consultation will take place during the second half of 2011 onthe measures that the FSB will propose to improve resolution tools andregimes, before the recommendations are finalised and delivered to theNovember Summit.

Supervisory intensity and effectiveness

National supervisors and standard setters continue to address therecommendations set out in the FSBs November 2010 report onIntensity and Effectiveness of SIFI Supervision.

National supervisors are to submit in June their self-assessments againstthe Basel Core Principles (BCPs) covering mandates, powers, resourcesand independence, which create the foundation for effective supervision.

IAIS members will submit their self assessments against the revisedInsurance Core Principles (ICPs) covering mandates, powers, resources,independence and group wide and consolidated supervision by March2012.


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In addition, based on a survey of its members, the BCBS will provide adraft report to the FSB Supervisory Intensity and Effectiveness (SIE)group in June on the changes national supervisors are making toimprove their methods and techniques.

Standard setters are tightening their core principles, implementationstandards and assessment methodologies and criteria.

The IAISs proposed changes to its ICPs are currently out for publicconsultation and are expected to be finalised in October 2011.

The BCBS intends to issue a consultative paper on revised BCPs inDecember 2011.

The IMF and World Bank, in conjunction with the BCBS and IAIS, areconsidering the FSB recommendation that more weight be given to theBCP additional criteria and the IAIS advanced criteria whenassessing against core principles and expect to provide draft revisions tothe assessment methodologies to the FSB in September 2011.

The FSB will review by November 2011 a status report on whetherfurther steps should be taken to implement or complement therecommendations set out in the November 2010 report.

Shadow Banking

At the November 2010 Summit, the G20 Leaders requested that the FSB,in collaboration with international standard-setting bodies, developrecommendations to strengthen the regulation and oversight of theshadow banking system by mid-2011.

The FSB has formed a task force to develop initial recommendations fordiscussion that would:

1. Clarify what is meant by the shadow banking system;


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2. Set out potential approaches for monitoring the shadow bankingsystem; and

3. Explore possible regulatory measures to address the systemic risk andregulatory arbitrage concerns posed by the shadow banking system.

The FSB will consider initial draft recommendations at its July Plenarymeeting and thereafter further develop the recommendations to besubmitted to the G20 in the autumn.

The FSB this month is publishing a short background note on thisproject, setting out current thinking and inviting public comments ontaking the work forward.

The note proposes that monitoring and responses be guided by a two-stage approach:

Firstly, casting the net wide, looking at all nonbank creditintermediation to ensure that data gathering and surveillance cover allthe activities within which shadow banking-related risks might arise;and

Second, then narrowing the focus, concentrating on the subset of non-bank credit intermediation where maturity/liquidity transformation

and/or flawed credit risk transfer and/or leverage create important risks.

Improving the OTC and commodity derivatives markets

In its October 2010 report on Implementing OTC Derivatives MarketReforms, the FSB made 21 recommendations addressing practical issuesthat authorities may encounter in implementing the G-20 Leaderscommitments concerning standardisation, central clearing, exchange orelectronic platform trading, and reporting of transactions to traderepositories by end-2012.


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The FSB has surveyed the actions being taken to implement therecommendations and is publishing a separate, more detailed report on

progress, based on the analysis of its OTC derivatives working group.

The following paragraphs give a brief summary.

Major implementation projects are underway in the largest OTCderivatives markets, and international policy development is proceedingaccording to the timetable set out in the October report, including thefollowing steps:

1. The Committee on Payment and Settlement Systems (CPSS) and theInternational Organization of Securities Commissions (IOSCO)

published in March a consultative report on harmonised principles for

financial market infrastructures, covering payment systems, centralsecurities depositories, securities settlement systems, and centralcounterparties (CCPs), and including guidance on trade repositories.

2. IOSCOpublished in February a study evaluating the benefits andchallenges associated with the implementation of measures aimed atincreasing exchange and electronic trading. It will conduct furtheranalysis on the current market use of multi or single-dealer platforms.

3. The largest derivatives dealers and other major market participants

delivered in March a letter to the OTC Derivatives Supervisors Group,setting out broad objectives, specific initiatives and supportingcommitments in this letter as the foundation of a roadmap forimplementation of G20 objectives.

4.The CGFS, CPSS, and IOSCO held a forum in January 2011 and areorganizing follow-up work to promote expanding access to centralclearing to a broader set of participants, and links between CCPs,

without sacrificing the rigour of CCP risk controls.

Nevertheless, although implementation is still in its early stages, theFSB is concerned that many jurisdictions may not meet the end-2012


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deadline, and believes that in order for this target to be achieved,jurisdictions need to take substantial, concrete steps towardimplementation immediately.

Differences in approaches are emerging that could weaken theeffectiveness of reforms in these markets, create potential opportunitiesfor regulatory arbitrage, or subject market participants andinfrastructures to conflicting regulatory requirements.

Divergent approaches to requirements for the reporting of transactiondata to trade repositories may lead to difficulties in cross-border sharingof data or aggregating data on a global basis unless steps are taken toensure consistency.

Potential emerging inconsistencies may also be seen in the developmentand future application of clearing requirements and strengthenedmargining/collateralisation practices across asset classes, products andmarket participants, and requirements for trading on multi-dealer versussingle dealer platforms.

In this context, the FSB has requested that IOSCO undertake furtheranalysis on market use of multi- or single-dealer platforms.

More generally, the FSB will continue to monitor developments as

implementation progresses and flag emerging inconsistencies that itidentifies.

The FSBs next report on progress in implementing OTC derivativesreforms will be delivered by October 2011.

The FSB expects that this later report will provide greater insight as towhether progress is on track and greater detail on implementation byasset class (covering interest rate, credit, equity, commodity, and foreignexchange).


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With respect to the commodity derivatives markets, steps are beingtaken to improve transparency, mitigate systemic risk, and protectagainst market abuse. In the first place, all these objectives should befurthered through implementation of the recommendations in the FSBsOctober 2010 report on OTC derivatives market reforms, which applyequally to commodity derivatives as to other asset classes.

In addition, the March 2011 report of the IOSCO Task Force onCommodity Futures Markets proposes future work to address thesegoals, including, by October 2011, updating standards of best practice setout in the 1997 Tokyo Communiqu and producing a joint report withthe International Energy Agency, International Energy Forum andOPEC on the impact of price reporting agencies, and working towardsthe creation of a trade repository for the financial oil market by the first

quarter of 2012.

The FSB will consider next steps following the Task Forces report to itin September 2011


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Breaking NewsBIS invites new members, 26 June 2011

The Board of Directors of the Bank for International Settlements (BIS)

announced its decision to invite 4 central banks to become BISmembers:

1. Colombia2. Luxembourg3. Peru and4. The United Arab Emirates to become BIS members.

These central banks were selected in accordance with Article 8.3 of theBIS Statutes.

The invitations to membership constitute a further step in a process thatbegan in 1996 with invitations to nine central banks:

1. Central Bank of Brazil2. People's Bank of China3. Hong Kong Monetary Authority4. Reserve Bank of India5. Bank of Korea6. Bank of Mexico

7. Central Bank of the Russian Federation8. Saudi Arabian Monetary Agency and9. Monetary Authority of Singapore

The invitations to membership continued in 1999 with four newmembers:

1. Central Bank of Argentina2. European Central Bank

3. Central Bank of Malaysia and4. Bank of Thailand.


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The invitations to membership continued in 2003 with six new members:

1. Bank of Algeria2. Central Bank of Chile3. Bank Indonesia4. Bank of Israel5. Reserve Bank of New Zealand and6. Bangko Sentral Pilipinas.


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General Manager's speech: Building a lasting foundation forsustainable growthSpeech delivered by Mr Jaime Caruana, General Manager of the BIS, onthe occasion of the Bank's Annual General Meeting, Basel, 26 June 2011.

Good afternoon, ladies and gentlemen.

In a number of crucial respects, the picture today is better than it was ayear ago, and much better than it was in June 2009.

While serious vulnerabilities remain and hard work lies ahead, it isimportant that we don't lose sight of how far we have come. Taking theglobal economy as a whole, the gap between world demand and

productive capacity is closing. And the world economy is growing at a

historically respectable rate of around 4 per cent.

The recovery, although slow and uneven, has raised output to its pre-crisis levels in some of the countries hardest hit.

The resurgence of demand has put concerns about deflation behind us.Accordingly, the need for continued extraordinary monetaryaccommodation has faded.The financial reform agenda has movedforward rapidly with the agreement reached on Basel III.

Banks have already increased their capital base significantly. Amacroprudential approach that focuses on systemic risk forms afundamental part of the new framework and internationally agreedstandards.

These are no small achievements, and not one of them was assured ayear ago.

After four years, however, the financial crisis and the ensuing policy

responses continue to cast long shadows.


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perspective - paying modest costs today to avoid larger costs tomorrow -and with attention to the global repercussions of their policies.

In the end, cooperation will make everyone better off.

Challenges and policies for stable and sustainable growth

As we leave the crisis behind us, it is important to understand theunderlying source of the challenges it has left.

We experienced the bust of a global financial cycle.

During the preceding boom, there was a tendency not only tounderestimate financial risk, but to overestimate the economy's potential

growth rate and its capacity to generate sustainable tax revenue.

And associated with this was a failure to recognise emerging structuralimbalances that would ultimately damage the foundations of sustainablelong-run growth.

I will highlight four challenges that were left by the crisis: fiscalreckoning; inflation; excess capacity together with the unfinishedadjustment of private sector balance sheets; and financial vulnerabilities.

Fiscal reckoning

The economic downturn, the tax cuts and expenditure increases inresponse to the crisis, and the cost of recapitalising the financial sectorhave all brought forward the fiscal reckoning.

In countries that experienced credit booms, policymakers have come torecognise the significant hole left by the collapse in tax revenues thathad been only temporarily boosted by the boom.

The aftermath is a sovereign debt crisis. In many cases, recent eventssimply brought forward an approaching problem. Without corrective


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measures, the fiscal trajectories of some of the world's largest advancedeconomies are unsustainable.

This is not news. Rising dependency ratios, expensive publicly fundedprogrammes for retirement and health care and the like put futurecommitments well in excess of future revenues.

Financial market participants can ignore such looming problems for along time until, suddenly, they enforce changes that are swift and painful.

Thus, the need for fiscal consolidation is even more urgent than when Ispoke a year ago. According to the OECD, the average OECD countrymust improve its primary balance by nearly 7 per cent of GDP just tostabilise its debt-to-GDP ratio by 2026.

We will not have lasting macroeconomic and financial stability until wehave taken decisive measures to put public finances on a sound andcredible path.

The creditworthiness of the sovereign is a prerequisite for a well-functioning economy.

The default of the sovereign breaks the social contract and underminesthe trust that is essential to the smooth running of both the state and theeconomy.

No economy - no matter how large, rich and powerful - is immune tothe risks posed by fiscal incoherence.

Nowhere is the link between fiscal sustainability and financial healthmore apparent than in parts of Europe today.

In some European countries, vulnerabilities in the financial sectorweakened the state; in others, public sector weakness has infected thebanks; in all, the resulting fragilities now jeopardise the benefits of

economic and financial integration.


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There is no easy way out, no shortcut, no painless solution - that is, noalternative to the rigorous implementation of comprehensive country

packages including strict fiscal consolidation and structural reforms.

The design of the euro area's fiscal and competitiveness arrangementsmust lead to predictable, reliable and less discretionary early correctiveaction in good times.

Unfortunately, Europe does not have a monopoly on urgent fiscalchallenges.

The big economies also need to manage their situations carefully andmake efforts to consolidate fiscal positions quickly, not least becausethey have a big impact on global financial conditions.

Inflation, side-effects and low interest rates

The welcome recovery and absorption of spare resources have broughtwith them the less welcome spectre of inflation.

As they did in the early 1970s, booming commodity prices may point to amore serious problem.

Prices of food, energy, metals and the like are more sensitive to shifts insupply and demand than are the prices of either manufactured goods or

services.

And, unlike in the past two decades, prices of internationally tradedmanufactured goods look to provide little inflation offset, as wages and

prices are rising in emerging markets.

Despite the apparent persistence of slack in some parts of the world,there are risks of second-round effects and of rising inflationexpectations.

Very accommodative monetary policy conditions in the economicregions most affected by the turmoil have been transmitted globallythrough bond and equity markets and bank credit.


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Double-digit growth in US dollar loans to non-US residents is just oneexample of how borrowing in major currencies is providing cheap crediteven where central banks have tightened.

Extraordinarily loose financial conditions may have undesirable side-effects.

We are all familiar with the list.

Low interest rates can delay balance-sheet repair, encourage dangerousrisk-taking in segments of financial markets and, in the process, makethe eventual exit from official support more hazardous.

They can intensify investors' eagerness to place funds in booming

emerging market economies, encouraging the build-up of financialimbalances there.

The more active deployment of macroprudential tools in emergingmarket economies is welcome, but cannot substitute for monetarytightening.

The longer that interest rates are low, the more severe these side-effectsand the greater the risk of a disruption when yields inevitably rise.

There is a need to normalise monetary policy.

The prevailing, extraordinarily accommodative policy rates will notdeliver lasting monetary and financial stability.

Real short-term interest rates have actually fallen in the past year, fromminus 0.6 per cent to minus 1.3 per cent globally.

History teaches us that recoveries from financial crises are slower andless robust than those after ordinary recessions.


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After a financial crisis, it takes longer for debt burdens to fall, balancesheets to be repaired, unproductive capital to be scrapped, and labour tobe reallocated.

Policymakers should not hinder this inevitable adjustment.

Normalising policy too late and too slowly may undermine inflation-fighting credibility as well as risk further damage from the delay ofstructural and balance-sheet adjustments.

More normal interest rates lessen the temptation to muddle through, andthey place the focus squarely on the needed adjustments.

Monetary policy tightening can also aid the adjustment in current

account imbalances.

By encouraging currency appreciation in countries that are growingmore quickly, it will contribute to correcting imbalances there.

It can also complement the structural policies needed to rebalancegrowth patterns globally, moving us away from the unsustainablecombination of leverage-led and export-led growth.

Excess capacity and unfinished balance-sheet adjustments

Excess capacity in finance and real estate points to unfinishedadjustments in the crisis-stricken economies.

The financial industry has built capital buffers, but overall leverage inthe economy - private and public - remains too high.

The simple mean of household debt-to-GDP for the US, the UK andSpain declined by only 2 percentage points from 2007 to the end of 2010,

while over the same period for the same countries, government debt-to-GDP rose 30 percentage points.


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Until losses are revealed and balance sheets repaired, funding problemsand distortions will persist.

This is an important feature of economies after the bust of a credit boom.

In particular, the post-crisis financial system remains large relative to theeconomy as a whole: excess leverage and excess capacity have not beenshed. Policymakers must intensify their efforts to promote the repair offinancial sector balance sheets and to set the conditions for banks' long-term profitability.

The macroeconomic road is likely to be at least as bumpy next year as ithas been this year. This means making sure that banks are ready whenthe next shock inevitably comes.

Tough stress tests, supported by recapitalisation measures, are essential.

Moreover, without a stronger and leaner financial system, it will beimpossible to withdraw the extensive public support that is still in place.

No financial system can operate safely and effectively under conditionsthat are creating both moral hazard and the resource misallocations thatcome with it.

Financial vulnerabilities

Despite efforts to date, sovereign and financial sector risks continue tofeed on each other. Short-term bank funding needs remain high, and therisks of interest rate surprises continue to be elevated.

Elements of global finance are prolonging financial fragilities: theseinclude not only low policy rates and expectations of continued officialsupport, but also high expectations of returns on bank equity.

Investors need to lower their expectations of such returns in accord withlower bank leverage.


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The question is not whether to consolidate fiscal policy.

It is not whether to normalise monetary policy. And it is not whether toaccelerate structural adjustment.

It is when and how each of these will happen.

Fiscal trajectories must be put on sustainable paths, monetaryconditions should be normalised, and adjustments in the real economyand balance sheets should be accelerated.

Early action will reduce vulnerabilities, lower repair costs and strengthenresistance to unexpected events.

This is particularly true for the resilience of financial firms.

Where possible, we should build strength now. Instead of taking themaximum time to reach the minimum standards, there is a good case forgoing faster and going further.

Perhaps this time we will see a virtuous race to the top.

Policy frameworks

The more enduring lessons of the crisis, however, are not just aboutpolicy actions, but about policy frameworks.

A lasting foundation for monetary and financial stability requiresregulation and supervision with a strong macroprudential orientation;monetary policy that plays an active role in supporting financial stability;and fiscal policy that amasses the buffers required for effective crisismanagement.

These policies share two features.

One rejects short-termism in favour of a long-term view.


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The other frees us from home bias in policymaking, allowing us to domore than just "keep our own house in order".

The first feature requires policymakers to keep an eye on the long-termhorizon if they are to pre-empt the slow build-up of financial imbalancesthat can derail growth, cripple monetary policy and trigger sovereigncrises. The governance of macroprudential policy must encouragedecision-makers to take a long view based on the principles ofindependence, clarity and accountability.

This suggests that central banks should play a key role.

Fiscal policy also needs to take a long-term view. Governments, like

financial firms, must build up buffers.

Fiscal policy should aim at maintaining a very low level of debt duringnormal times so that governments are ready for the next, inevitableshocks. And policymakers should recognise that the level of revenuecollected in the midst of a credit boom is unsustainable.

The second feature tells policymakers that, in an integrated globaleconomy, keeping their own house in order is not enough. No individualeconomy is safe unless the global economy is safe.

The fortunes of individual countries and the adequacy of their policiescan be accurately assessed only as part of the global conditions that,collectively, they help to shape.

For instance, if every central bank views commodity price movements asoutside its control, then global monetary policy can be too loose.

Just as each big private bank generates systemic effects that it mustinternalise, so too each country's policies create international spillovers

that it must take on board.


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Documents

Board of Directors News July 2011