samchain/econo-pairs-v1 huggingface dataset:
Jaime Caruana: Risk management trends and the supervisory structure Remarks of Mr Jaime Caruana, Governor of the Bank of Spain and Chairman of the Basel Committee on Banking Supervision, at the 31st General Assembly of the Geneva Association, Madrid, 27-29 May 2004. * I. *  *  Introduction and overview  I would like to thank Mr de Castries, Mr Liedtke, and the members of the Geneva Association for inviting me to participate in your 31st General Assembly. As the chairman of the Basel Committee on Banking Supervision, I am honoured to address another organisation that names itself after a distinguished city in Switzerland. It is a special privilege for me to do so here in Madrid, not far from the Bank of Spain. Our organisations may hail from different Swiss cities and different sectors of the financial services industry, yet both organisations monitor trends in risk management and work to encourage advances in that discipline. This is a difficult but enormously important duty for all of us. Financial organisations whether they are insurance companies, securities firms, or banks - compete on their knowledge of their customers. They seek to tailor products and services to each customer’s ever changing needs. To succeed in an environment where products and services must evolve quickly, financial service providers must understand thoroughly the benefits, costs and risks of their current activities, while watching the horizon carefully for future changes that might alter the balance between risks and rewards.

The effects of exchange rate fluctuations on activity are an important factor in our evaluation of the inflation outlook and in our monetary policy decisions. At the present time, interest rate differentials with developed economies are well below historic averages and the interest rate is still below normal levels. The fourth principle I want to discuss is that stronger countries generally have stronger currencies. In other words, the purchasing power of their wage packets is comparatively greater as these economies outpace the rest of the world. We could discuss many more factors, such as ways to mitigate appreciation, what circumstantial factors spur it, etc. At the end of the day, what we need is to transform the cyclical strength of our economy into greater productivity which will increase our potential for growth. But it is important to note that this principle does not work the other way around. In the past we have been obnubilated equating a strong currency with a strong economy, but we soon had to realize that the strength of the currency was not due to a fundamentally sound economy but rather the outcome of policies inducing currency misalignment. I would like to draw your attention to the fact that I have not included a flexible exchange rate as one of the principles, in order to avoid dogmatism. But in our country, experience overwhelmingly shows that exchange rate flexibility, managed pragmatically, is the most adequate system for us.
Secondly, in order to make it easier for investors to purchase the bonds, all commercial and Islamic banks, as well as Bank Kerjasama Rakyat, have been appointed as agent banks. The public may start applying for the bond beginning 5 January until 30 January 2004. Thirdly, profits will be paid to investors on a quarterly basis. Through the quarterly payment of profits, investors will receive a steady stream of income to support their expenditure needs. For the first issuance, the Merdeka Savings Bond offers a profit margin of 5% per annum. At 5% per annum, the return is higher than interest rates paid for 12-month fixed deposits by the commercial banks. The income earned from the bonds will also be exempted from tax. The Merdeka Savings Bond also provides investors with the benefit of early redemption without any penalty in terms of forgone profits. Investors can redeem the full amount of their initial investments at any time after the first profit payment. Profit payments will then be based on the number of days the bond is held. This feature gives investors the option and flexibility to withdraw their savings at any time to meet unanticipated expenses. There will be a dedicated hotline and website to attend to public queries regarding the bonds. The launch of the Merdeka Savings Bond marks a further step forward in creating new investment instruments for a specific target group of savers who have retired. Moving forward, further savings products should be developed by the financial services industry.

They also require soundly functioning and well-integrated financial markets capable of diversifying risks across borders and correctly pricing concentration risks. This is why, in my view, the most immediate and significant challenge facing EMU is to reinforce the integration of both banking systems and capital markets. Reinforcing the Banking Union When the euro was launched, there was actually an expectation that many banks would become truly European, providing retail services across the whole euro area. The reality is quite different. 6/11  Cross-border consolidation remains very limited and most firms and households in the euro area remain largely dependent on their domestic banking systems to maintain investment and smooth consumption profiles. Although no formal barriers to foreign banks exist, relevant distortions arise from stillsignificant specificities in banking regulations across countries. Some of the existing savings banks, government-owned banks or regional banks in the EU are protected by national legislations hampering incentives to compete or effectively sheltering them from competition. Moreover, regulation fails to fully acknowledge the benefits generally arising from geographical diversification in a single market. We also need to address the current deadlock on the third pillar of the Banking Union, the European Deposit Insurance Scheme (EDIS). Some experts argue that this third element may not be essential once we have in place a stringent resolution framework with homogeneous bail-in requirements; but in my view, it remains crucial to make EDIS a reality.
We make use of the powers conferred on us under the amendments to the law approved by the parliament. I would like to express special gratitude to you for that. We progressively stamp out suspicious transactions from the banking sector. Our current objective is to introduce end-to-end supervision over both credit institutions and non-bank  BIS central bankers’ speeches  3  organisations through implementing our functions of a megaregulator in order to prevent the spillover of suspicious transactions from the banking to the non-banking sector. The last year was important as the first full year in our capacity of megaregulator. We completed the transition period nine months earlier than expected. Along with internal restructuring at the Bank of Russia, we kept working on legislative initiatives. We continue developing financial market infrastructure by creating new and improving existing instruments. High-quality improvements in the system of financial market regulation and supervision are impossible without legislative amendments. Non-governmental pension funds had to be incorporated and join the guarantee system. We inspected non-governmental pension funds before their accession to the guarantee system. As a result, 26 funds joined the system. The supervision obliged many funds to improve the quality of their assets and to make the ownership transparent, so that the guarantee system incorporated only resilient funds capable of ensuring safety of pension savings. We will further monitor and supervise these funds very closely. Some words about insurance. We applied new laws on compulsory motor third party liability insurance (OSAGO) and raised the tariffs.

As the manager of the Exchange Fund, the HKMA has ensured that ESG principles are now an integral part of our investment criteria, investment process and asset allocation decisions. 42. And, once again, Hong Kong’s status as China’s offshore financial centre gives us an edge in sustainable finance. No financial centre is better positioned than Hong Kong to channel global investment into China’s ambitious plans to achieve carbon neutrality by 2060. Opportunity – Technology 43. When it comes to technology, Hong Kong is already at the forefront of the global fintech scene. The HKMA’s Smart Banking initiatives have helped drive the digital transformation of banking services, bringing competition and promoting financial inclusion that directly benefit 4/5  BIS central bankers' speeches  customers. This is just the start of a long journey. The adoption of AI and data analytics in banking operations, the use of Regulatory Technology – or Regtech – in compliance and the need for enhanced cybersecurity are high on our agenda. 44. Looking ahead, apart from the technology itself, it’s clear that data will be central to the future of banking innovation. That’s why we’re building next-generation financial infrastructure. Last November, we announced plans for a pilot to build a Commercial Data Interchange. The project will enable corporates to share with banks their digital footprint kept by their business partners on a common platform.
But before I get into the details, let me say that I believe the LTCM episode and the supervisory response to it is fundamentally about two things: leverage and good judgment. Leverage is a fact of life in our financial world, and is a key part of the risk-taking necessary for the creation of wealth. But sometimes banks go too far in extending credit to their customers and counterparties. That’ s where good judgment comes in. I know - - I’ ve been there. I was a commercial banker for 22 years before becoming President of the New York Fed, and I can tell you that the most important decisions a banker makes are how to lend and to whom. Those decisions are not easy, and often involve many shades of gray. One of our aims as supervisors should be to see that banks are using the right tools to make those judgments. The importance of these issues extends beyond banks and their supervisors. Sound credit policies and procedures are essential not only for the stability of individual banks, but also – and more importantly – for the health of the financial system and the economy as a whole. This is because banks play a pivotal role in our economy as providers of credit. If banks make poor credit decisions with respect to a borrower, including a hedge fund like LTCM, the financial system and our economy will suffer.

But in recent months, the spotlight of the Treasury Select Committee (TSC) has swung onto this area, and we have all been enjoying the debate! Many hours have been spent highlighting the biblical scale of the reporting requirements, the wickedness of the risk margin calculations, the mystical nature of the Ultimate Forward Rate…I could extend this list tenfold. Then we have had a rather more pointed exchange about whether we at the PRA have been over-zealous in our implementation of Solvency II, perhaps damaging competition, or making life too difficult for insurance companies, or denying the nation of vital new infrastructure by being too cautious about insurers’ investment strategies, or all three! All of these are important topics, and in the course of the debate I am as guilty of focusing on them as anyone else. Indeed, I will double-down by talking about some of them again today. So for those of us inside the insurance beltway, this is a very useful and timely debate and I think it is a great thing that the TSC has taken an interest. Can we make our implementation of Solvency II work better? In my opinion, despite some inevitable differences of view, there is in fact a strong degree of agreement between us, the TSC and the industry about the answer to that question. Where is the policyholder? However, in all the blizzard of insurance and regulatory jargon, I think something has been missing from our discussions. Where is the policyholder?
Are these repeated crises the inevitable result of human nature at work in financial markets, with greed and fear alternating as sentiment swings from irrational optimism to irrational pessimism? Or is it the failure over many years to find the right incentive structure for banking markets? Or is it a mixture of both? I don’t pretend to be able to offer a complete answer to those questions. But I do want to focus on the relationship between the Bank of England and the banks because it helps to explain why crises occur and what we can do about them. Let me start by saying that, although I do think the role of the Bank needs to be enhanced, it would not be right for the Bank to take back banking supervision from the FSA, as some have suggested. We should remember that the period before 1997, when FSA and the “tripartite arrangements” were set up, was not seen at the time as a golden age of official oversight of banks. Before 1997 the relationship between the Treasury and the Bank of England in respect of banking supervision was often fraught. Remember too that the experience which shaped the design of the 1997 settlement was that of idiosyncratic problems in Johnson Matthey, BCCI and Barings, not a system-wide crisis affecting the liquidity of the banking system as a whole. As a result, the tripartite Memorandum of Understanding which underpinned that settlement was not so much faulty as incomplete.

The existing tripartite framework needs to develop so that the authorities are able to reduce systemic risk not just by effective management of crises but by creating incentives for financial institutions to avoid excessive risks. Some of the elements of such a framework I described in my evidence to the Treasury Committee on 20 September last year. In line with international experience, they included a special resolution regime for failing banks, changes to deposit insurance to reduce the incentives for bank runs, and a proper regime for the regulation of bank liquidity. At the heart of the case for a special resolution regime is the need to find a way to allow banks to fail in an orderly manner. As the Treasury Committee said in its report The Run on the Rock, “Banks should be allowed to ‘fail’ so as to preserve market discipline on financial institutions”. It is clear from the responses to the Consultation Document that there is widespread acceptance of the basic case for a resolution regime. But that is tempered by concerns about the details of its design. I want to highlight three key features that will be central to the success of the new regime. First, responsibility for resolving a failing bank should be delegated to a resolution authority which should have a wide range of instruments available to help resolve a failing bank. Which body assumes the role of the resolution authority is less important than the granting of those powers to some body.
Undue exuberance on the part of investors, when price-earning ratios grow beyond fundamentals, or on the part of bankers who failed to assess the impact of high interest rates on collateral or cash flows, would expose both the investor and the lender to asset losses. 17. Specifically, banks in Asia, having easier access to funds as a result of high global liquidity, were able to expand lending much more quickly and, thereby, incurred higher risks in their portfolios that they need to manage more soundly. Ironically, domestic banks may have been induced to move into more risky lending due to increased competition in the form of new entrants and financial intermediation. There is no question that they need to manage these new risks better. 18. There is also one distinguishing feature of the Asian turmoil. The debt problems have not been those of the public sector. On the contrary, the fiscal positions of Asian governments have by and large been quite sound. East Asia, excluding Japan, ran a fiscal surplus of $ billion BIS Review 109/1997  -4-  or 0.1% of GDP in 1996. The debt burden, in fact, has been largely one of private sector overborrowing. The resolution of the debt of the private sector makes the Asian problems quite different from the experience of the sovereign debt issues of the 1980s. 19. In essence, the Asian problem is the age-old question of efficient resource allocation.

•  Sound fundamentals include a high domestic savings rate, sustainable fiscal and balance of payments positions, high foreign exchange reserves and prudent debt management. •  Good supervision involves the maintenance of solid capital adequacy and liquidity requirements for the financial sector, as well as regular examination and monitoring of financial institutions and markets. The banking system must have the capacity to avoid excessive credit concentrations and risks, and to manage market risks well. •  A robust financial infrastructure would encompass an efficient payments and settlements system for domestic and international transactions. In essence, the world is moving towards Real Time Gross Settlement (RTGS) system, which support Delivery vs. Payment (DvP) and Payment vs. Payment (PvP). RTGS reduces payment risks and allows central banks to monitor flows in domestic currency as well as exposure of banks on a real time basis. •  A non-distortive incentive structure, such as taxation or regulatory restrictions that would not encourage risk concentrations or excessive leverage in any economic sectors. 22. Put simply, managing national risks is equivalent to achieving three objectives. First, lower national gearing, because leveraging adds risks, especially if this is leveraged from external borrowing. The more you borrow abroad, the more you become vulnerable to external shocks. Second, the higher the level of domestic savings, which should be reflected in higher bank capital, lower credit/GDP ratio, and higher fiscal surpluses, the greater the resilience to the pain of adjustment to external or internal shocks.
The level of capital was therefore wrong – too little capital was required, and the appearance of strong economic conditions before the crisis appears to have provided a justification for even lower capital, under Basel II. What I have described was the application of the Pillar I element of the Basel regime, namely the minimum capital requirements on the common approach. As I noted earlier, Basel II introduced the three pillar approach, with the second pillar enabling supervisors to set additional capital requirements on a firm specific basis. The second pillar was however not consistently or rigorously applied prior to the response to the financial crisis. In 2008, the major UK banks had a Pillar II capital requirement £ (equivalent to 10% of then Pillar I capital requirement). In summary, the system was flawed both in terms of the definition of capital – the quality – and the quantity required to be held. The first step in response to the financial crisis was agreement in July 2009 to significantly increase capital requirements against market risk via the so-called Basel II.5 package – addressing the widely recognised undercapitalisation of risk in banks’ trading operations. Building on that improvement the next step, was the agreement on, and now introduction of,  2  http://www.bis.org/press/p060524.htm. 3  Data Source: The Banker and Bank of England calculations. Sample comprises: Deutsche Bank, HSBC, BNP Paribas, Barclays, Citigroup, UBS, BAML, BONY, Commerzbank, ING, JPM, LBG, RBS, Santander, State Street, UniCredit, Wells Fargo. 4  BIS central bankers’ speeches  Basel III.

Quite simply, there will in my view be more of it in the future. When I started in supervision in the late 1980s, we prohibited banks from disclosing their Basel I capital ratios, and we got exercised when they did nonetheless  BIS central bankers’ speeches  7  declare their ratios. That was a relatively simple regime. The Basel III regime is undoubtedly more complex and it is not about the single capital ratio. Capital requirements and buffers will vary between firms and over time, for good reasons. Banks and investors do complain about the lack of clarity about their future requirements in this regime. But that precision is not realistic. Within defined parameters the regime is designed so that buffers adjust in relation to risk and the impact of firm failure. Counter cyclical buffers can be varied over time depending on conditions, and banks can move between GSIB buffers as they change size and structure. Likewise, supervisory work, including stress testing, can lead our judgement about appropriate buffers to change. The regime is built this way deliberately to include a greater element of judgement by supervisors. My view is that this will inevitably lead to more transparency and disclosure, which is fine and to be encouraged providing it can deliver useful guidance. That means we have to work hard to deliver as much clarity as is possible in an uncertain world.
Either new capital must be put into the bank before the transfer of assets or it must be injected into the AMC when the real value of its assets becomes obvious to everyone. Putting the money straight into the bank speeds up the restructuring process. 5  BIS Review 66/2000  Consolidated supervisory authorities I mentioned that supervision should be conducted on a consolidated basis, covering activities in different financial and non-financial sectors. Should also the organisation of the supervisory authority be “consolidated”? Several countries, including the UK, Korea, Australia and others have recently moved in the direction of creating an “FSA” which is responsible for the supervision of banks, securities markets and insurance. In Sweden, we have had an FSA since 1990. Is such a consolidation necessary and useful in all countries? In my view, the optimal structure of the supervisory authority depends on the structure of the individual country. In many countries, banks conduct the most important financial activities while securities markets are less important. Here at least bank supervision must be independent, have adequate resources and skilled staff. This is crucial. In many countries, bank supervision is a part of the central bank. This has benefited bank supervision because the central bank usually has legal independence, adequate resources and can attract qualified staff. Combining bank supervision with securities and insurance supervision will probably imply that supervision will move outside the central bank, since securities and insurance supervision is not normally a task of central banks. In this sense, bank supervision may become weaker.

This illustrates the first question, which is how to solve time inconsistency in fiscal policy. It is easier to follow the prescriptions of Keynes in bad times than in good times. This asymmetry may lead to an increase in budget deficits and sovereign debt over time, also referred to as the fiscal bias. As a result, many countries (PIIGS, UK,) have to tighten policy in a period when the real economy would certainly benefit from further stimulus. The crisis caused fiscal balances to deteriorate by 8–10 percentage points. There is an immense difference between encountering a shock of this magnitude from a positive fiscal balance of 4 per cent and encountering it from a negative fiscal balance of 4 per cent. From a negative balance of 4 per cent, fiscal balances end up at a 12 per cent deficit! Then it is imperative to tighten policy. A similar time inconsistency problem, the inflation bias, has been a much debated issue in monetary policy. The solution has been central bank independence. So the question is, is there something to be learnt from monetary policy? Ragnar Frisch  The fiscal bias is not a new phenomenon. And a number of possible solutions have been tried. As far back as in the early 1930s, the Norwegian economist and Nobel Prize winner Ragnar Frisch had the following suggestion: “It might be an idea to establish a cyclical council to make such decisions, a council that could operate with an independent status similar to that of the Supreme Court.