Risk Compliance News June 2011

8/6/2019 Risk Compliance News June 2011

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_____________________________________________________________ International Association of Risk and Compliance Professionals (IARCP)

www.risk-compliance-association.com

International Association of Risk and ComplianceProfessionals (IARCP)

1200 G Street NW Suite 800 Washington, DC 20005-6705 USA Tel: 202-449-9750 www.risk-compliance-association.com

Welcome to the June 2011 edition of the International Association of Risk and Compliance Professionals (IARCP)

newsletter

Dear Member,

Today we discuss several interesting subjects:

SUBJECT A. Deutsche Bank analyst Matt OConnor warned that forcingbanks to hold too much capital could backfire, and:

1. Banks could charge more for loans, hurting consumers and smallbusinesses

2. Banks might take even bigger risks in order to generate more return,creating the possibility of an even bigger financial crisis.

Matt is right. But there are two other very important risks:

1. Much reduced lending capacity available - reduction in the supply of credit in order to return equity to shareholders.

Most banks are in the business of attracting shareholders, and mustgenerate return on equity (RoE) that is greater than cost of equity (CoE).

The Basel III changes will cause RoE to fall below CoE. As a result banksneed to change their business models.


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2. Bank customers will look elsewhere for credit: To unregulated entities. This would increase the systemic risk.

Although at the November 2010 Seoul Summit, in view of the completionof the new capital standards for banks (Basel III), the G20 Leadersrecognized the potential for regulatory tightening to increase theincentives for business to migrate to the shadow banking system, we havenot seen any concrete measures yet.

Make no mistake, shadow banking is inherently complex as it mutatesover time and varies across jurisdiction.

SUBJECT B. On May 25, the SEC issued a new Regulation 21F under theExchange Act to implement the whistleblower directive under the

Dodd-Frank Act.Section 922 of Dodd-Frank added Section 21F to the Exchange Act toincentivize individuals that act as whistleblowers regarding violations of the federal securities laws.

Individuals who voluntarily provide the SEC with original information about a possible violation of the federal securities laws that leads to anenforcement action resulting in monetary sanctions exceeding $1 million,can receive between 10% and 30% of the amount recovered (!!!).

Regulation 21F will be effective on August 12, 2011

SUBJECT C. The new European regulatory environment: Theestablishment of the ESRB

The European Systemic Risk Board (ESRB) is an independent EU bodyresponsible for the macro-prudential oversight of the financial system

within the Union.

Its seat is in Frankfurt am Main. Its secretariat is ensured by the ECB.


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The ESRB contributes to the prevention or mitigation of systemic risks tofinancial stability in the Union that arises from developments within thefinancial system.

It takes into account macroeconomic developments, so as to avoid periods of widespread financial distress.

The ESRB also contributes to the smooth functioning of the internalmarket and thereby ensures a sustainable contribution of the financialsector to economic growth.

The ESRB is part of the European System of Financial Supervision(ESFS), the purpose of which is to ensure supervision of the Unionsfinancial system.

Besides the ESRB, the ESFS comprises:

1. The European Banking Authority (EBA)

2. The European Insurance and Occupational Pensions Authority(EIOPA)

3. The European Securities and Markets Authority (ESMA)

4. The Joint Committee of the European Supervisory Authorities (ESAs);

5. The competent or supervisory authorities in the Member States asspecified in the legislation establishing the three ESAs.


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Basel III News, June 2011 We have a (June 2011) Basel III revision

Before we cover the new requirements, we will travel to the European

Unions counterparty credit risk - frequently asked questions. It will helpus understand the Basel III amendment.

The financial crisis highlighted that banks massively underestimated thelevel of counterparty credit risk associated with over-the-counter (OTC)derivatives.

This prompted G20 leaders at the September 2009 Pittsburgh summit tocall for more OTC derivatives to be cleared through a CentralCounterparty (CCP).

They also asked that OTC derivatives that could not be cleared centrallybe subjected to higher capital requirements in order to properly reflect thehigher risks associated with them.

Following the G20 leaders' call, the Basel Committee on BankingSupervision (BCBS) started to review the regulatory capital treatment forcounterparty credit risk.

The BCBS identified insufficiencies and that CCPs were not widely usedto clear derivatives trades.

As part of the Basel III reforms, the BCBS has changed the counterpartycredit risk regime substantially.

The new regime will strengthen the capital requirements for counterpartycredit exposures arising from institutions derivatives, repo and securitiesfinancing activities.


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It will create the right incentives for banks to use CCPs wherever practicable, thus helping reduce systemic risk across the financial system.

Specifically, the objective of these amendments will be:

1. Raise the amount of capital backing these exposures,

2. Reduce procyclicality, i.e. dampen the impact of economic fluctuationthroughout the cycle and provide additional incentives to move OTCderivative contracts to central counterparties;

In effect helping to reduce systemic risk across the financial system.

What are OTC derivatives?

A derivative is a financial contract linked to the future value or status of the underlying to which it refers (e.g. the development of interest rates orof a currency value, or the possible bankruptcy of a debtor).

Over-the-Counter (OTC) derivative contracts are not traded on anexchange (for example the London Stock Exchange) but instead privatelynegotiated between two counterparts (for example a bank and amanufacturer).

OTC derivatives account for almost 90% of the derivatives markets.

In mid 2010, the notional value of outstanding OTC derivatives wasaround $583 trillion or 476 trillion.

At the same point in time, the notional value of derivatives traded onexchanges was roughly $66 trillion or 54 trillion.

The OTC derivatives market comprises a wide variety of product typesacross several asset classes (interest rates, credit, equity, foreign


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exchange (FX) and commodities) with widely differing characteristicsand levels of standardisation.

OTC derivatives are used in a variety of ways, including for purposes of hedging, investing, and speculating.

What are Central Counterparties (CCPs)?

A CCP is an entity that interposes itself between the two counterparties toa transaction, becoming the buyer to every seller and the seller to everybuyer.

A CCP's main purpose is to manage the risk that could arise if onecounterparty is not able to make the required payments when they are

due, i.e. defaults on the deal.

CCPs are commercial firms. There are currently about a dozen CCPs, allbut one located in Europe or the USA, clearing interest rates, credit,equity and commodities OTC derivatives.

What is capitalisation of bank exposures to centralcounterparties (CCPs)?

It is the amount of capital that banks will be required to hold against theirexposures to central counterparties.

According to the existing regulatory framework, banks do not have tohold capital for these exposures provided that certain conditions are met.

This will change with the upcoming legislative proposal in order to reflectthe fact that exposures to central counterparties are not risk free.

The proposal will suggest applying different risk weights depending on

the type of the exposure the bank has vis--vis the central counterparty.


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What is credit valuation adjustment?

Credit valuation adjustment (CVA) is an adjustment made by a bank tothe market value of an OTC derivative contract to take into account creditrisk of the counterparty, i.e. the risk that the credit quality of thecounterparty deteriorates or that the counterparty in question defaults.

Specifically, it can be defined as the difference between the 'hypothetical' value of the derivative transaction assuming a risk-free counterparty andthe true value of the derivative transaction that takes into account the

possibility of changes in creditworthiness of the counterparty (includingthe possibility of the counterparty's default).

As such, in accounting terms, CVA is the "market value" of credit risk.

Why is CVA important?

The Basel Committee decided to introduce an explicit capitalrequirement for the CVA risk (i.e. a requirement for extra capital) after it

was revealed that nearly two-thirds of the losses stemming fromderivatives during the crisis were a direct consequence of thedeterioration of the credit quality of the counterparty, and not necessarilytriggered by the default of the counterparty, already covered by theexisting regulatory framework.

The calibration of the capital charge for CVA risk was published by Baselin December 2010.

The one outstanding issue is what to do in the event that a bank creates a valuation adjustment/provision for CVA risk (i.e. writes down somecapital to take account of the risk) (i.e. "incurs CVA"), and how torecognise it in the respective capital treatment, i.e. how does the amountof the created valuation adjustment/written-off capital count towards the

overall capital requirements to reflect the fact that this amount cannot be


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lost twice. Addressing this issue requires assessing how much creditbanks should get for creating provisions for the CVA risk.

Important parts from the paper:Basel III: A global regulatory framework for more resilientbanks and banking systems, December 2010 (rev June 2011)

Enhancing risk coverage

One of the key lessons of the crisis has been the need to strengthen therisk coverage of the capital framework.

Failure to capture major on- and off-balance sheet risks, as well asderivative related exposures, was a key destabilising factor during thecrisis.

In response to these shortcomings, the Committee in July 2009 completeda number of critical reforms to the Basel II framework.

These reforms will raise capital requirements for the trading book andcomplex securitisation exposures, a major source of losses for manyinternationally active banks.

The enhanced treatment introduces a stressed value-at-risk (VaR) capitalrequirement based on a continuous 12-month period of significantfinancial stress.

In addition, the Committee has introduced higher capital requirementsfor so-called resecuritisations in both the banking and the trading book.

The reforms also raise the standards of the Pillar 2 supervisory review process and strengthen Pillar 3 disclosures.


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The Pillar 1 and Pillar 3 enhancements must be implemented by the endof 2011; the Pillar 2 standards became effective when they were introducedin July 2009.

The Committee is also conducting a fundamental review of the tradingbook. The work on the fundamental review of the trading book is targetedfor completion by year-end 2011.

This document also introduces measures to strengthen the capitalrequirements for counterparty credit exposures arising from banksderivatives, repo and securities financing activities.

These reforms will raise the capital buffers backing these exposures,reduce procyclicality and provide additional incentives to move OTC

derivative contracts to central counterparties, thus helping reducesystemic risk across the financial system.

They also provide incentives to strengthen the risk management of counterparty credit exposures.

To this end, the Committee is introducing the following reforms:

(a) Going forward, banks must determine their capital requirement forcounterparty credit risk using stressed inputs.

This will address concerns about capital charges becoming too low during periods of compressed market volatility and help address

procyclicality.

The approach, which is similar to what has been introduced for marketrisk, will also promote more integrated management of market andcounterparty credit risk.


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(b) Banks will be subject to a capital charge for potential mark-to-marketlosses (ie credit valuation adjustment CVA risk) associated with adeterioration in the credit worthiness of a counterparty.

While the Basel II standard covers the risk of a counterparty default, itdoes not address such CVA risk, which during the financial crisis was agreater source of losses than those arising from outright defaults.

(c) The Committee is strengthening standards for collateral management and initial margining.

Banks with large and illiquid derivative exposures to a counterparty willhave to apply longer margining periods as a basis for determining theregulatory capital requirement.

Additional standards have been adopted to strengthen collateral risk management practices.

(d) To address the systemic risk arising from the interconnectedness of banks and other financial institutions through the derivatives markets,the Committee is supporting the efforts of the Committee on Paymentsand Settlement Systems (CPSS) and the International Organization of Securities Commissions (IOSCO) to establish strong standards forfinancial market infrastructures, including central counterparties.

The capitalisation of bank exposures to central counterparties (CCPs) will be based in part on the compliance of the CCP with such standards,and will be finalised after a consultative process in 2011.

A banks collateral and mark -to-market exposures to CCPs meeting theseenhanced principles will be subject to a low risk weight, proposed at 2%;and default fund exposures to CCPs will be subject to risk-sensitivecapital requirements.


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These criteria, together with strengthened capital requirements forbilateral OTC derivative exposures, will create strong incentives for banksto move exposures to such CCPs.

Moreover, to address systemic risk within the financial sector, theCommittee also is raising the risk weights on exposures to financialinstitutions relative to the non-financial corporate sector, as financialexposures are more highly correlated than non-financial ones.

(e) The Committee is raising counterparty credit risk managementstandards in a number of areas, including for the treatment of so-called

wrong-way risk, ie cases where the exposure increases when the creditquality of the counterparty deteriorates.

It also issued final additional guidance for the sound backtesting of counterparty credit exposures.

Finally, the Committee assessed a number of measures to mitigate thereliance on external ratings of the Basel II framework.

The measures include requirements for banks to perform their owninternal assessments of externally rated securitisation exposures, theelimination of certain cliff effects associated with credit risk mitigation

practices, and the incorporation of key elements of the IOSCO Code of

Conduct Fundamentals for Credit Rating Agencies into the Committeeseligibility criteria for the use of external ratings in the capital framework.

The Committee also is conducting a more fundamental review of thesecuritisation framework, including its reliance on external ratings.


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Addressing systemic risk and interconnectedness

While procyclicality amplified shocks over the time dimension, excessiveinterconnectedness among systemically important banks also transmittedshocks across the financial system and economy.

Systemically important banks should have loss absorbing capacitybeyond the minimum standards and the work on this issue is ongoing.

The Basel Committee and the Financial Stability Board are developing a well integrated approach to systemically important financial institutions which could include combinations of capital surcharges, contingentcapital and bail-in debt.

As part of this effort, the Committee is developing a proposal on amethodology comprising both quantitative and qualitative indicators toassess the systemic importance of financial institutions at a global level.

The Committee is also conducting a study of the magnitude of additionalloss absorbency that globally systemic financial institutions should have,along with an assessment of the extent of going concern loss absorbency

which could be provided by the various proposed instruments.

The Committees analysis has also covered furt her measures to mitigatethe risks or externalities associated with systemic banks, includingliquidity surcharges, tighter large exposure restrictions and enhancedsupervision.

It will continue its work on these issues in the first half of 2011 inaccordance with the processes and timelines set out in the FSBrecommendations.

Several of the capital requirements introduced by the Committee tomitigate the risks arising from firm-level exposures among global


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financial institutions will also help to address systemic risk andinterconnectedness.

These include:

1. Capital incentives for banks to use central counterparties forover-the-counter derivatives;

2. Higher capital requirements for trading and derivative activities, as well as complex securitisations and off-balance sheet exposures (egstructured investment vehicles);

3. Higher capital requirements for inter-financial sector exposures; and

4. The introduction of liquidity requirements that penalise excessivereliance on short term, interbank funding to support longer dated assets.

Stress testing

Banks must have a comprehensive stress testing program forcounterparty credit risk.

The stress testing program must include the following elements:

1. Banks must ensure complete trade capture and exposure aggregationacross all forms of counterparty credit risk (not just OTC derivatives) atthe counterparty-specific level in a sufficient time frame to conductregular stress testing.

2. For all counterparties, banks should produce, at least monthly,exposure stress testing of principal market risk factors (eg interest rates,FX, equities, credit spreads, and commodity prices) in order to

proactively identify, and when necessary, reduce outsized concentrationsto specific directional sensitivities.


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3. Banks should apply multifactor stress testing scenarios and assessmaterial non-directional risks (ie yield curve exposure, basis risks, etc) atleast quarterly.

Multiple-factor stress tests should, at a minimum, aim to addressscenarios in which

a) Severe economic or market events have occurred;

b) Broad market liquidity has decreased significantly; and

c) The market impact of liquidating positions of a large financialintermediary.

These stress tests may be part of bank-wide stress testing. 4. Stressed market movements have an impact not only on counterpartyexposures, but also on the credit quality of counterparties.

At least quarterly, banks should conduct stress testing applying stressedconditions to the joint movement of exposures and counterpartycreditworthiness.

5. Exposure stress testing (including single factor, multifactor and

material non-directional risks) and joint stressing of exposure andcreditworthiness should be performed at the counterparty-specific,counterparty group (eg industry and region), and aggregate bank-wideCCR levels.

6. Stress tests results should be integrated into regular reporting to seniormanagement.

The analysis should capture the largest counterparty-level impacts acrossthe portfolio, material concentrations within segments of the portfolio


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(within the same industry or region), and relevant portfolio andcounterparty specific trends.

7. The severity of factor shocks should be consistent with the purpose of the stress test.

When evaluating solvency under stress, factor shocks should be severeenough to capture historical extreme market environments and/orextreme but plausible stressed market conditions.

The impact of such shocks on capital resources should be evaluated, as well as the impact on capital requirements and earnings.

For the purpose of day-to-day portfolio monitoring, hedging, and

management of concentrations, banks should also consider scenarios of lesser severity and higher probability.

8. Banks should consider reverse stress tests to identify extreme, but plausible, scenarios that could result in significant adverse outcomes.

9. Senior management must take a lead role in the integration of stresstesting into the risk management framework and risk culture of the bank and ensure that the results are meaningful and proactively used tomanage counterparty credit risk.

At a minimum, the results of stress testing for significant exposuresshould be compared to guidelines that express the banks risk appetiteand elevated for discussion and action when excessive or concentratedrisks are present.


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Remarks from Herv Hannoun, Deputy General Manager, Bank forInternational Settlements2011 Research Conference: Financial crises: the role of depositinsurance International Associatio n of Deposit Insurers, Basel, 8 June2011

Reducing the default probability of systemically important financialinstitutions by increasing their loss absorption capacity

Although substantial progress is being made in strengthening nationalresolution regimes and improving coordination on cross border issues, weneed to be realistic about the feasibility of a global resolution regime thatcan cope with the failure of a global SIFI.

It is therefore critical to reduce the probability of SIFI failures byincreasing the loss absorption capacity of such institutions.

At the G20 Seoul Summit in November 2010, the leaders reiterated theimportance of the work on SIFIs.

Global SIFIs were defined as institutions of such size, marketimportance, complexity and global interconnectedness that their distressor failure would cause significant dislocation in the global financialsystem and adverse economic consequences across a range of countries.

It was also agreed that global SIFIs should have loss absorption capacitybeyond the minimum Basel III standards.

Indeed, additional capital requirements for global SIFIs find theirrationale in externalities that Basel III does not fully address.

To deal with the externalities of global SIFIs, the FSB and the BaselCommittee are currently developing an assessment methodology forsystemic importance that will identify global SIFIs.


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Based on their systemic importance, global SIFIs will be required tobolster their loss absorbency by holding a systemic capital surcharge oradding contingent capital.

I would like to underline that the Basel III capital requirements (the 7%common equity ratio, comprising the 4.5% minimum plus a 2.5% capitalconservation buffer) should be seen as setting a minimum requirement;they are not a maximum.

This is a fundamental point, which is the subject of an important debateat the moment in the European Union.

It is important in our view to allow national authorities to set highercapital requirements than the Basel III minima.

It is equally important to recognise the ability of supervisors, within eachjurisdiction, to require additional loss absorbency for SIFIs in the form of common equity beyond the 7% common equity ratio established by BaselIII.

To conclude, in the absence of a global resolution framework for the timebeing, the only reasonable course of action is to make SIFI failures lesslikely by imposing systemic capital surcharges.


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The Japanese earthquake and tsunami6 June 2011 (Extract from pages 4-5 of BIS Quarterly Review, June 2011)

The destruction and human tragedy following the earthquake andtsunami in Japan have been huge.

There was an immediate drop in economic activity due to damage tofacilities, disruptions to supply lines and power shortages.

Recent data releases show that household spending and production have plunged.

Damage to the nuclear power plant in Fukushima and ensuing radiationleaks have added to the challenges.

The possible implications of these events for the Japanese economy as well as the global economic outlook and financial markets are manifold,and uncertainties associated with these effects continue.

Initial assessments by the Japanese Cabinet Office put the damage to theeconomy's capital stock at around $240 billion, which is more than doublethe damage following the Kobe earthquake in 1995.

GDP declined by 0.9% on the previous quarter in the first three months of 2011.

For the year, GDP growth is expected to be about 1 percentage pointlower than earlier estimates.

Financial markets reacted very strongly in the immediate aftermath of thedisaster (Graph A).

The Tokyo stock market plummeted by almost 20% in the first twobusiness days after the earthquake, and Japanese sovereign CDS spreads


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jumped by 30 basis points, probably reflecting concerns about the extrafiscal burden implied by reconstruction.

The foreign exchange market was also very volatile, with the Japanese yenappreciating sharply against the US dollar, reaching a high of 76.3 on 17March.

Reportedly, this was driven by market speculation that Japaneseinsurance companies would repatriate US dollar funds to meet

yen-denominated claims.

The Bank of Japan responded swiftly.

To ensure ample liquidity, it offered funding of 82.4 trillion in the first

week after the earthquake, of which 57.8 trillion was actually provided tothe market.

The Bank also increased the amount of its asset purchase programme by 5 trillion, to prevent a deterioration in risk sentiment from adverselyaffecting output.

In response to the yen's sharp appreciation, the Ministry of Finance andthe central bank, together with other G7 countries, embarked on aconcerted intervention in the foreign exchange market.

On 6-7 April, the Bank of Japan unveiled a 1 trillion special lendingfacility to channel funds to banks for lending to distressed businesses inthe affected areas, and broadened the range of eligible collateral assets formoney market operations.

In addition, the government announced a supplementary budget of 4trillion for reconstruction purposes on 22 April.

These measures supported market functioning despite the severity of theshock.


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Markets calmed quickly after their initial reaction: the stock marketrecovered somewhat; the yen retreated to trade in the range of 82-83against the US dollar; and Japan's CDS spread declined.

Outside Japan, the impact on financial markets was limited, and largelyconfined to sectors seen as being most directly affected by supply chaindisruptions or direct loss exposures.

A primary concern in financial markets has been that an extended period

of power shortages in Japan might adversely affect industrial productionthrough global supply chains, given that Japan is a major producer of components for the semiconductor and automotive industries.

Thus, while broad equity market indices have shown signs of resilience(Graph B, left-hand panel), certain sectoral indices fell sharply followingthe news of the disaster, and have subsequently recouped only part of their initial losses (Graph B, right-hand panel).


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Monetary policy in a world with macroprudential policyRemarks by Mr Jaime Caruana, General Manager of the BIS, at theSAARCFINANCE Governors' Symposium 2011, Kerala, 11 June 2011.

We need proper governance arrangements: independence, clarity andaccountability.

Regardless of the specific type of cooperation mechanisms put in place,financial stability requires governance arrangements that incorporate the

principles of independence, clarity and accountability.

Independence from political cycles is needed for macroprudential policyno less than for monetary policy.

A common problem for both policies is the need to intervene during theupswing, when things are going well and the public might be sceptical

that problems loom down the road.


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Operational independence will be needed to shield unpopular policydecisions.

Strong accountability and clarity of communication will bolster publicsupport for the independence of macroprudential policy and hence itscredibility and effectiveness.

Clarity about mandates, responsibilities and powers is important for theeffectiveness and timeliness of actions and for managing the difficulttrade-offs.

Sufficient powers imply control over relevant instruments and appropriatesafeguards.

For example, access to micro supervisory data is important. At the same time, our limited technical knowledge means thatmacroprudential frameworks need room to adapt and grow withexperience.

Very specific and inflexible mandates raise the risk that the specifiedtargets are, or quickly become, poorly matched to the economy's andfinancial system's needs.

As a result, the policymaker's ability to respond to unexpectedcircumstances could be severely constrained.

Accountability is critical. That said, since financial stability objectives aredifficult to quantify or define precisely, accountability is harder to achievethan, say, for price stability objectives in monetary policy.

A clear and transparently communicated strategy that sets out the centralbank's intentions can serve as the basis for accountability.


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Regardless of the specific governance and cooperation arrangements, theemerging reality is that central banks have a key role to play.

This role requires mandates and governance structures that are consistent with their primary monetary policy function.

In some cases, central banks' duties and powers to promote financialstability are being enhanced.

More active financial stability roles will raise issues of reputational risk that central banks will need to manage carefully, especially if their viewson specific decisions are not shared by other agencies involved in the

process.

Central banks will also face additional challenges. They will face an added burden to be very clear about what policy actionsare being taken and for what reason.

They will need to be careful not to undermine price stability mandatesand hard-won credibility.

And they will need to preserve their operational autonomy, includingfinancial independence.

In turn, this requires control over their balance sheet and ex-ante clearmechanisms to transfer losses to the Treasury.

A forthcoming Central Bank Governance Forum report describes thecurrent range of practice across central banks and analyses the issues

posed by various choices.


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Sarbanes Oxley News, June 2011

We have some breaking news

On May 25, the SEC issued a new Regulation 21F under the Exchange Act to implement the whistleblower directive under the Dodd-Frank Act.

Section 922 of Dodd-Frank added Section 21F to the Exchange Act toincentivize individuals that act as whistleblowers regarding violations of the federal securities laws.

Individuals who voluntarily provide the SEC with original information about a possible violation of the federal securities laws that leads to anenforcement action resulting in monetary sanctions exceeding $1 million,

can receive between 10% and 30% of the amount recovered (!!!).

Regulation 21F will be effective on August 12, 2011

Final Rule from the SEC

The Commission is adopting rules and forms to implement Section 21F of the Securities Exchange Act (Exchange Act) entitled Securities

Whistleblower Incentives and Protection.

The Dodd-Frank Wall Street Reform and Consumer Protection Act,enacted on July 21, 2010 (Dodd -Frank), established a whistleblower

program that requires the Commission to pay an award, underregulations prescribed by the Commission and subject to certainlimitations, to eligible whistleblowers who voluntarily provide theCommission with original information about a violation of the federalsecurities laws that leads to the successful enforcement of a coveredjudicial or administrative action, or a related action.


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Dodd-Frank also prohibits retaliation by employers against individuals who provide the Commission with information about possible securities violations.

Background and Summary

Section 922 of Dodd-Frank added new Section 21F to the Exchange Act,entitled Securities Whistleblower Incentives and Protection.

Section 21F directs that the Commission pay awards, subject to certainlimitations and conditions, to whistleblowers who voluntarily provide theCommission with original information about a violation of the securitieslaws that leads to the successful enforcement of an action brought by theCommission that results in monetary sanctions exceeding $1,000,000.

On November 3, 2010, we proposed Regulation 21F to implement new Section 21F.

The rules contained in proposed Regulation 21F defined certain termscritical to the operation of the whistleblower program, outlined the

procedures for applying for awards and the Commissions procedures formaking decisions on claims, and generally explained the scope of the

whistleblower program to the public and to potential whistleblowers.

We received more than 240 comment letters and approximately 1300 formletters on the proposal.

Commenters included individuals, whistleblower advocacy groups, public companies, corporate compliance personnel, law firms andindividual lawyers, academics, professional associations, nonprofitorganizations and audit firms.

The comments addressed a wide range of issues.


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Commenters were sharply divided on the issues raised by this topic.

After considering these different viewpoints, we have determined not toinclude a requirement that whistleblowers report violations internally, but

we have made additional changes to the rules to further incentivize whistleblowe rs to utilize their companies internal compliance andreporting systems when appropriate.

1. With respect to the criteria for determining the amount of an award, thefinal rules expressly provide:

First, that a whistleblowers voluntary participation in an entitys internalcompliance and reporting systems is a factor that can increase theamount of an award; and,

Second, that a whistleblowers interference with internal compliance andreporting is a factor that can decrease the amount of an award.

2. The final rules contain a provision under which a whistleblower canreceive an award for reporting original information to an entitys internalcompliance and reporting systems, if the entity reports information to theCommission that leads to a successful Commission action.

Under this provision, all the information provided by the entity to theCommission will be attributed to the whistleblower, which means that the

whistleblower will get credit -- and potentially a greater award -- for anyadditional information generated by the entity in its investigation.

3. The final rule extends the time for a whistleblower to report to theCommission after first reporting internally and still be treated as if he orshe had reported to the Commission at the earlier reporting date.

We proposed a lookback period of 90 days after the whistleblowersinternal report, but in response to comments, we are extending this

period to 120 days in the final rules.


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Procedures for Submitting Information and Claims:

The proposed rules set forth a two-step process for submittinginformation, which required the submission of two different forms.

In response to comments that urged us to streamline the procedures forsubmitting information, we have adopted a simpler process, combiningthe two proposed forms into a single Form TCR that would be submittedby a whistleblower under penalty of perjury.

With respect to the claims application process, we have made one sectionof that form optional to make the form less burdensome.

We also describe in greater detail below several other features of the

process to assist whistleblowers that we expect will become part of theOffice of the Whistleblowers standard practice.

Aggregation of smaller actions to meet the $1,000,000 threshold:

The proposed rules stated that awards would be available only when theCommission had successfully brought a single judicial or administrativeaction in which it obtained monetary sanctions of more than $1,000,000.

In response to comments, we have provided in the final rules that, for

purposes of making an award, we will aggregate two or more smalleractions that arise from the same nucleus of operative facts.

This will make whistleblower awards available in more cases.

Exclusions from aw ard eligibility for certain persons and information:

The proposed rules set forth a number of exclusions from eligibility forcertain categories of persons and information.


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In response to comments suggesting that some of these exclusions wereoverly broad or unclear, we have revised a number of these provisions.

Most notably, the final rules provide greater clarity and specificity aboutthe scope of the exclusions applicable to senior officials within an entity

who learn information about misconduct i n connection with the entitys processes for identifying, reporting, and addressing possible violations of law.

Rule 21F-1 General

Rule 21F-1 provides a general, plain English description of Section 21F of the Exchange Act.

It sets forth the purpos es of the rules and states that the CommissionsOffice of the Whistleblower administers the whistleblower program.

In addition, the rule states that, unless expressly provided for in the rules,no person is authorized to make any offer or promise, or otherwise to bindthe Commission with respect to the payment of an award or the amountthereof.

B. Rule 21F-2 Definition of a Whistleblowera. Proposed Rule

As proposed, Rule 21F-2(a) defined a whistleblower as an individual who,alone or jointly with others, provides information to the Commissionrelating to a potential violation of the securities laws.

Under the proposed rule, a company or another entity could not qualify asa whistleblower.

Paragraph (b) of the proposed rule stated that the anti-retaliation protections set forth in Section 21F(h)(1) of the Exchange Act would applyirrespective of whether a whistleblower satisfied all the procedures and


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conditions to qualify for an award under the Commissions whistleblower program.

Similarly, the protections against retaliation applied to any individual who provided information to the Commission about a potential violation of thesecurities laws.

Paragraph (c) of the proposed rule stated that, to be eligible for an award, a whistleblower must submit original information to the Commission inaccordance with all the procedures and conditions described in ProposedRules 21F-4, 21F-8, and 21F-9.

b. Comments Received

Commenters advanced a number of suggestions to refine the definition of whistleblower.

Many commenters agreed that the definition of whistleblower shouldnot turn on whether a violation of the securities laws is ultimatelyadjudged to have occurred, but expressed differing opinions on our

proposal to use the term potential violation.

One commenter agreed that the whistleblower definition should includethe term potential violation because this would allow broad application

of the anti-retaliation measures in Section 21F.

Several other commenters recommended that the term potential violation should be coupled with a requirement that the individual have areasonable belief or good faith belief that the information relates to asecurities law violation.

Some commenters suggested instead of the term potential violation, weshould use the terms probable violation, likely violation, or claimed

violation.


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On other aspects of the definition of whistleblower, one commenterrecommended that we clarify that a violation of the securities lawsrelates only to the federal securities laws and not to violations of state orforeign securities laws.

A few commenters recommended that a whistleblower be limited to a person who provided information relating to a material violation of thesecurities laws.

Two commenters disa greed with the proposed rules limiting whistleblower status to natural persons, suggesting thatnon-governmental organizations and/or worker representatives,including labor unions, should be permitted to bring claims.

A number of commenters responded to our request for comment on whether we should limit the definition of whistleblower to a person who provides information regarding violations of the securities laws byanother person some favoring this, others opposing it.

Several of the commenters recommended that we limit the whistleblowerdefinition based on an individuals relative culpability for the reported

violation.

For example, some commenters stated that the definition of

whistleblower should cover only individuals who report violations byanother person, and who did not participate in or facilitate the violations.

Commenters made several suggestions relating specifically to the scopeof the anti-retaliation protections. Among other things, commentersrecommended that we expressly state in the rules that the anti-retaliation

provisions do not apply to an individual if

(1) He files a false, fraudulent, or bad faith and meritless submission;

(2) He lacks a good faith or reasonable belief of a violation;or


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(3) The submission does not ev ince a reasonable likelihood of a violationof securities laws.17 Another commenter suggested the anti -retaliation

provisions should only apply to those who qualify for an award.

Several commenters proposed that the anti-retaliation provisions shouldcategorically exempt a companys adverse action against an employeebased on factors other than whistleblower status, such as engaging inculpable conduct, failing to comply with the reporting requirements of acompanys internal compliance programs, or vio lating a professionalobligation to hold information in confidence.

One commenter explained that, without a categorical exemption, thebroad anti-retaliation provisions of the statute could prompt a wave of litigation alleging retaliation in such circu mstances

Commenters made a series of other suggestions related to the scope andenforceability of the anti-retaliation protections, including that we should:

(1) Clarify our authority to bring enforcement actions based on retaliation;

(2) Provide that the anti-retaliation remedies may not be waived by anyagreement, policy, or condition of employment; and

(3) Exclude from anti-retaliation protection employees whose

submissions are based on information that is either publicly disseminatedor which the employee should reasonably know is already known to thecompanys board of directors or chief compliance officer, a court, theCommission or another governmental entity.

c. Final Rule

In response to the comments, we have made several changes to thedefinition of whistleblower in Rule 21F-2(a) and the application of theanti-retaliation provisions in Rule 21F-2(b) to more precisely track thescope of Section 21F(h)(1).


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We are adopting Rule 21F-2(c) as proposed, but have re-designated it asRule 21F-2(a)(2).

With respect to the definition of whistleblower, we agree with thosecommenters who suggested that the term potential violation may beimprecise, and thus in the final rule have changed this to possible

violation that has occurred, is ongoing, or is about to occur.

We believe that this modification provides greater clarity concerning when an individual who provides us with information about possible violations, including possible future violations, of the securities lawsqualifies as a whistleblower.

An individual would meet the definition of whistleblower if he or she

provides information about a possible violation that is about tooccur.

Although some commenters recommended that we use the termsprobable violation or likely violation, we have decided to use the termpossible violation.

In our view, this requires that the information should indicate a facially plausible relationship to some securities law violation frivoloussubmissions would not qualify for whistleblower status.

We believe that a higher standard requiring a probable or likely violation is unnecessary, and would make it difficult for the staff to promptly assess whether to accord whistleblower status to a submission.

In the final rule, the definition of whistleblower clarifies that thesubmission must relate to a violation of the federal securities laws, or arule or regulation promulgated by the Commission.

An individual who submits information that relates only to a state law orforeign law violation would not satisfy the whistleblower definition.


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The final rule also clarifies that, to qualify as a whistleblower eligible forthe award program and the heightened confidentiality provisions of Section 21F(h)(2) of the Exchange Act, an individual must submit his orher information to the Commission in accordance with the procedures setforth in Rule 21F-9(a).

Rule 21F-9(a) establishes procedures for an individual to mail, fax, orelectronically submit to us information relating to a possible securitieslaw violation.

As proposed, our definition could have been misconstrued to apply to anyindividuals who provide us with information relating to a securities law

violation, including individuals whom we subpoena and law enforcement personnel from other governmental authorities.

This result would have been outside the intended scope of Section 21F.

We have not added a requirement that the information relate to amaterial violation of the securities laws.

We believe that, rather than use a materiality threshold barrier that mightlimit the number of submissions to us, it is preferable for individuals to

provide us with any information they possess about possible securities violations (irrespective of whether it appears to relate to a material

violation) and for us to evaluate whether the information warrants action.

To the extent that commenters advanced this suggestion as a way to prevent individuals from abusing the anti-retaliation protections affordedby Section 21F(h) of the Exchange Act, we believe this issue is sufficientlyaddressed by the revisions to Rule 21F-2(b), discussed further below.

To the extent that commenters suggested this approach as a way toreduce frivolous submissions, we believe our use of the term possible

violation suffici ently addresses this concern.


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We have decided not to extend the definition of whistleblower beyondnatural persons because we believe that this is consistent with thestatutory definition, which provides that a whistleblower must be anindividual.

Th e ordinary meaning of individual is natural person, and nothing inthe statutory text or legislative history suggests a different meaning here.

Although one commenter identified a reference to individuals in theFalse Claims Act to argue that the term should be read to extend beyondnatural persons, we note that the False Claims Act otherwise repeatedlyrefers to whistleblowers as persons (which ordinarily extends beyondnatural persons), and we believe this explains the different result underthat Act.

We have modified proposed Rule 21F- 2(b)s anti -retaliation protections, which are now in Rule 21F-2(b)(1).

We are also adding Rule 21F-2(b)(2), which expressly states that theCommission may enforce the anti-retaliation provisions of Section21F(h)(1) of the Exchange Act and any rules promulgated thereunder.

Rule 21F-2(b)(1) provides that, for purposes of the anti-retaliation protections afforded by Section 21F of the Exchange Act, an individual is

a whistleblower if

(i) he possesses a reasonable belief that the information he is providingrelates to a possible securities law violation (or, where applicable, to a

violation of the provisions set forth in 18 U.S.C. 1514A(a)) that hasoccurred, is ongoing, or is about to occur, and

(ii) he reports that information in a manner described in Section21F(h)(1)(A).


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With respect to the first prong of this standard, the employee must possess a reasonable belief that the information he is providing relates toa possible securities law violation (or, where applicable, to a violation of the provisions set forth in 18 U.S.C.

This approach is consistent with the approach followed by various courtsthat have construed the anti-retaliation provisions of other federal statutes,including the False Claims Act that has occurred, is ongoing, or is aboutto occur.

The reasonable belief standard requires that the employee hold asubjectively genuine belief that the information demonstrates a possible

violation, and that this belief is one that a similarly situated employeemight reasonably possess.

We believe that requiring a reasonable belief on the part of a whistleblower seeking anti-retaliation protection strikes the appropriatebalance between encouraging individuals to provide us with high-qualitytips without fear of retaliation, on the one hand, while not encouragingbad faith or frivolous reports, or permitting abuse of the anti-retaliation

protections, on the other to require that a whistleblower have a reasonablebelief that he or she is reporting a violation of that statute even where thestatute does not expressly require such a showing.

The second prong of the Rule 21F-2(b)(1) standard provides that, for purposes of the anti-retaliation protections, an individual must providethe information in a manner described in Section 21F(h)(1)(A).

This change to the rule reflects the fact that the statutory anti-retaliation protections apply to three different categories of whistleblowers, and thethird category includes individuals who report to persons orgovernmental authorities other than the Commission.

Specifically, Section 21F(h)(1)(A)(iii) which incorporate theanti-retaliation protections specified in Section 806 of the Sarbanes-Oxley


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Act, 18 U.S.C. 1514A(a)(1)(C) provides anti-retaliation protections foremployees of public companies, subsidiaries whose financial informationis included in the consolidated financial statements of public companies,and nationally recognized statistical rating organizations when theseemployees report to

(i) A federal regulatory or law enforcement agency,

(ii) Any member of Congress or committee of Congress, or

(iii) A person with supervisory authority over the employee or such other person working for the employer who has authority to investigate,discover, or terminate misconduct.

However, the retaliation protections for internal reporting afforded bySection 21F(h)(1)(A) do not broadly apply to employees of entities otherthan public companies.

In addition, Rule 21F-2(b)(1)(iii) provides that the retaliation protectionsapply to a whistleblower irrespective of whether the whistleblower isultimately entitled to an award.

This provision of the rule restates a result compelled by the text of Section21F(h)(1), which on its face provides retaliation protection to

whistleblowers irrespective of whether they actually collect an award.

Rule 21F-2(b)(2) states that Section 21F(h)(1) of the Exchange Act,including any rules promulgated thereunder, shall be enforceable in anaction or proceeding brought by the Commission.

Because the anti-retaliation provisions are codified within the Exchange Act, we agree with commenters that we have enforcement authority for violations of Section 21F(h)(1) by employers who retaliate againstemployees for making reports in accordance with Section 21F.


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With regard to the other significant comments made regarding theanti-retaliation provisions in Rule 21F-2(b), for the reasons set forth below

we find that it is either inappropriate or unnecessary to make themodifications that those commenters recommended.

Regarding the comments that we should categorically provide thatemployees who make whistleblower reports to us may be disciplined forreasons independent of their whistleblowing activities, we think this isunnecessary.

By its terms, the statute only prohibits adverse employment actions thatare taken because of any lawful act by the whistleblower to provideinformation; adverse employment actions taken for other reasons are notcovered.

Moreover, there is a well-established legal framework for making thisfactual determination on a case-by case basis, and we see no indicationthat Congress intended to depart from this framework here.

With regard to the comment expressing concern that entities mightrequire employees to waive their anti-retaliation rights under Section 21F,

we believe that possibility is foreclosed by the Exchange Act.

Specifically, because Section 21F is codified in the Exchange Act, it is

covered by Section 29(a) of the Exchange Act, which specifically providesthat [a]ny condition, stipulation, or provision binding any person to

waive compliance with any provision of this title or any rule or regulationthereunder . . . shall be void.

Thus, under Section 29(a), employers may not require employees to waiveor limit their anti-retaliation rights under Section 21F.


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The European Systemic Risk Board (ESRB)

Mission, objectives and tasks

According to the ESRB Regulation: The ESRB shall be responsible forthe macro-prudential oversight of the financial system within the Unionin order to contribute to the prevention or mitigation of systemic risks tofinancial stability in the Union that arise from developments within thefinancial system and taking into account macro-economic developments,so as to avoid periods of widespread financial distress.

It shall contribute to the smooth functioning of the internal market andthereby ensure a sustainable contribution of the financial sector toeconomic growth.

For this purpose, the ESRB shall carry out the following tasks:

1. Determining and/or collecting and analysing all the relevant andnecessary information;

2. Identifying and prioritising systemic risks;

3. Issuing warnings where such systemic risks are deemed to besignificant and, where appropriate, make those warnings public;

4. Issuing r ecommendations for remedial action in response to the risksidentified and, where appropriate, making those recommendations

public;

5. When the ESRB determines that an emergency situation may ariseissuing a confidential warning addressed to the Council and providing theCouncil with an assessment of the situation, in order to enable theCouncil to adopt a decision addressed to the European Supervisory

Authorities (ESAs) determining the existence of an emergency situation;monitoring the follow-up to warnings and recommendations;


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Intellectual challenges to financial stability analysis in the era of macroprudential oversight

Jean-Claude Trichet, President of the European Central Bank, Chairmanof the European Systemic Risk Board

This article discusses the main intellectual challenges related to theconceptual foundations, analytical models and regulatory assessmenttools in the field of financial stability analysis.

The focus is on ways to detect and contain systemic risk.

The article also tries to point in directions that could be helpful inresolving these intellectual challenges.

The article starts with a discussion of the nature and origins of financialstability and systemic risk.

It then goes through four areas in which lessons from the present crisishave illustrated major analytical challenges in enhancing theunderstanding of financial stability and systemic risk.

The article concludes that

1) The understanding of the fundamental working of financial systemsand the risks they generate needs to be deepened, in particular in relationto financial innovation and the role of nonbank financial intermediaries

2) Better insights need to be developed about when and how financialsystems migrate from stability to instability,

3) Models need to be developed that capture the interactions between widespread financial instability and the performance of the economy atlarge (including the related amplification effects and nonlinearities), and


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4) Such models need to be further extended to be able to assess theeffectiveness and efficiency of macroprudential regulatory policies incontaining systemic risks.

Meeting this agenda will require reorienting signifi cant resources inacademia, central banks and supervisory authorities in these directions.

It will also require enriching the way of thinking in economics andfinance.

New approaches should be considered that do not necessarily rely only onthe notions of equilibrium, universal rationality and efficiency, but gobeyond those concepts.

Approaches that have been used successfully in other fields, such as thenatural sciences, may be a helpful source of inspiration.

My starting point is that we have recently entered a new era of financialstability policies, the era of macroprudential oversight.

The new supervisory bodies that have just been created in Europe suchas notably the European Systemic Risk Board (ESRB) in the EuropeanSystem of Financial Supervision (ESFS) would benefit significantly fromintellectual progress in those directions.

The article starts with a discussion of the nature and origins of financialstability and systemic risk, in particular how systemic risk can be definedand which factors can make financial instability widespread anddangerous.

It then goes through four areas in which lessons from the present crisishave illustrated major analytical challenges in enhancing ourunderstanding of financial stability and systemic risk.


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The first area concerns challenges at the very fundamental level of thefunctioning of financial systems, in particular how they change over timethrough innovation.

The second area relates to challenges with respect to our understandingof the transition from tranquil times to crisis times.

Third , it is extremely challenging to develop better tools assessing themacroeconomic implications of financial instabilities.

Fourth and last, we have very limited analytical tools and models (andexperiences) to assess how regulatory policy can be used to contain risksat the level of the financial system as a whole and the overall economy.

1| FINANCIAL CRISES, STABILITY AND SYSTEMIC RISK 1|1 The meaning of systemic risk and experiences with systemiccrises

The crisis that we have experienced over the last three years is anoverwhelming case of the materialisation of systemic risk.

Systemic financial risk can be defined as the risk that financial instabilitybecomes so widespread that it impairs the functioning of a financialsystem to the point where economic growth and welfare suffer materially.


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Chart 1 displays one indicator a Composite Indicator of Systemic Stress(CISS) that ECB staff developed to capture in real time how muchsystemic instability is present at a given point in time.

The chart clearly shows how systemic stress emerged in the EuropeanUnion in August 2007, how the situation degenerated to a full-blownsystemic crisis in September 2008 with, in particular, the bankruptcy of Lehman Brothers (when the indicator shoots up towards its maximum

value of 1) and how the process of relaxation was countered in May 2010,in particular due to the Greek debt crisis.

There were many financial crises in history and a share of them reachedsystemic dimensions.

Examples include in particular the worlds Great Depression in the 1930sand, at national levels, the Nordic and Japanese banking crises during the1990s.


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Every crisis possesses its own characteristics, and having learnt thelessons from the last crisis does not provide protection against future,necessarily different, crises.

Moreover, in a dynamic economic system, progress and growth can onlybe achieved in accepting risks, which could indeed include a tail risk of crises.

The experience of the last three years suggests that policy authorities inall advanced economies need to improve considerably their capacity todetect and contain systemic risks.

Financial supervision was too much focused on the microprudentialdimension of individual risks at the level of single intermediaries and

markets, rather than looking how risks could add up and compound eachother.

In order to become better in this regard, authorities need to considermore the deep underlying sources of systemic instability and, in

particular, how risks can reach the systemic dimension.

1|2 How financial instability can become systemic

Research suggests that there are, in particular, three broad ways through which financial instability can reach systemic dimensions.

The first is contagion.

The failure of one financial agent (or crash of one market) can lead tofailures of other financial agents (or crashes of other markets), even whenthe latter have not invested in (or are exposed to) the same risks and arenot subject to the same original shock as the former.

Second, widespread financial imbalances can build up over time and thenunwind abruptly.


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Hyman Minsky described how in good times consumption andinvestment increase, generating income, which fuels the financing of more consumption and investment but also the neglect of increasingrisks.

Even small events can then lead to a re-pricing of risk and an endogenousunravelling of the credit boom, which adversely affects many agents andmarkets at the same time.

Third, severe negative aggregate shocks can adversely affectintermediaries and markets simultaneously.

Historical research has shown that many banking crises were related tosevere economic downturns.

Note that the three mechanisms can happen independently, but that mostof the time they are mutually reinforcing.

There are a number of inherent features of financial systems that makethem particularly prone to these forms of systemic risk.

The first is externalities.

They particularly relate to the complex and dynamic network of

exposures among major intermediaries.

What in tranquil times is an efficient mechanism to share risk, can, intimes of stress, become a dangerous channel for transmitting instability.

Two contracting parties do not have an incentive to take account of theeffects of their risk-taking on third parties.

As a consequence, the risk at the level of the system may be higher thanthe sum of perceived individual risks.

The second feature is asymmetric information.


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Financial systems allocate funds from agents who have them but possessno specific knowledge about promising investment opportunities, toagents who have knowledge about the opportunities but not the funds toengage in them.

This creates an agency problem between the two parties, which may behandled more or less well through the underlying financial contracts.

If contracts are incomplete and negative news arrive on some of theinvestment projects, but information asymmetries do not allow lenders tojudge whether this also affects other investment projects, funding mayevaporate for all projects alike a phenomenon often referred to asadverse selection.

The special propensity of financial systems to systemic risk is not simplythe result of these two imperfections.

Externalities and information problems are also present in othereconomic sectors.

But there are some other features of financial systems, which render theirimplications much more severe and widespread.

First, illiquid assets, maturity mismatches between assets and liabilitiesand leverage amplify the force with which problems of one financialintermediary are pushed through the complex network of exposures.

Second, sizable amounts of debt relative to capital and short-termfunding have more dramatic effects in situations of stress.

These features in conjunction with the above imperfections lead to powerful feedback and amplification mechanisms, which may causesudden regime changes, driving the system from a state of relative


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tranquillity to a state of turmoil (see, for example, the soaring values of the CISS in August 2007 and September 2008 in Chart 1).

In the aggregate, one observes the abrupt nonlinear adjustments that areso characteristic of financial instability.

A well-developed analytical apparatus for supporting policies in this area would have to fully capture all these elements.

The following sections try to address some of the intellectual challengesin providing such an apparatus, using the experiences of the present and

previous crises.

2| ADVANCING THE ANALYTICAL APPARATUS FOR

FINANCIAL STABILITY AND SYSTEMIC RISK POLICIES2|1 The basic functioning of financial systems and the risks theyimply

The first set of intellectual challenges in advancing the analyticalapparatus for financial stability and systemic risk policies relates to thedeep functioning of financial systems.

The crisis has shown that financial systems are much less understood

than what was thought. While some important parts and implications of the DNA of financialsystems are known their main components, their main functions,indicators of their efficiency or which basic risks can emerge , there aredifficulties in grasping the essence of some major mutations ( financialinnovations) and in predicting how the overall body reacts to specificstresses; two elements that, on occasion, may be strongly related.


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As also a growing body of financial research suggests, asset valuations,corporate financing activities and intermediation processes are subject toa range of important imperfections to which greater attention is

warranted.

The two examples of externalities and asymmetric information havealready been mentioned.

Another example is oligopolistic structures in major wholesale financialmarkets. Many derivatives markets are dominated by a small number of highly sophisticated and complex financial intermediaries.

Their strategic behaviour is likely to have very different effects on thosemarkets than the benchmark of perfect and atomistic markets might

suggest.How this strategic, and maybe sometimes also predatory behaviour can

on occasion have destabilising effects needs to be understood muchbetter.

A more radical line of work responds to analytical challenges of the crisisat a more fundamental theoretical level.

It starts from the presumption that certain inherent features of the

standard economic paradigms, in particular in macroeconomics preventthem from capturing crucial features of exceptional situations like theones experienced in the last few years.

Notably, analytical models based on a strong tendency to convergetowards equilibrium, a high level of market efficiency and representativerational agents have great difficulties in generating the amplificationeffects, nonlinearities and crashes characteristic for systemic instability(see Section 1 and Chart 1).


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So-called agent-based models do not rely on strong equilibrium attractorsand incorporate heterogeneous agents whose direct interactions havesignificant influence on overall economic outcomes.

They are based on bottom-up simulations of individual behaviour ratherthan top-down maximisations.

They have been applied successfully to a wide range of problems indifferent sciences, including physics, biology, computer science, trafficsystems and mass panics, in particular to problems where amplification,intermittent changes and nonlinearities play a significant role.

2|2 The transition from tranquil times to crises

The second set of intellectual challenges for financial stability analysisrelates to the period in which the system moves from stability toinstability.

One distinguishing feature of this crisis relative to previous crises isspeed.

While the unfolding of the sovereign debt crises in the 1980s occurredover the course of years, the Asian financial crisis developed, at its peak,over months rather than years.

The major intensification of the present crisis, starting in mid-September2008 (see Chart 1), spread around the globe in the course of half-days.

In physics such phenomena are described as phase transitions. Whensome factors exceed a critical level, a system behaves qualitativelydifferently from a situation when the factors stay below this level.

Building on some fundamental physics research on crackling noise andself -organised criticality, Bouchaud (2009) describes how the randomfield Ising model originally developed to analyse how spins order within


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a disordered magnet can be applied to the persistence and breakdownsof financial bubbles.

Investors take their decisions based on slowly moving fundamental variables, such as interest rates, inflation, earnings forecasts etc.

At the same time, however, they are influenced by the majority opinion of other investors.

For that latter fact, the aggregate opinion can be subject to largediscontinuous changes, even though dramatic changes do not necessarilyhappen in the fundamentals.

Moreover, the physics analogy illustrates hysteresis in optimism.

Much as supersaturated vapour refuses to turn into a liquid, optimism isself-consistently maintained (until a critical threshold is reached and anavalanche of opinion changes is launched).

This analogy from physics illustrates how imbalances that have built upendogenously over an extended period of time can suddenly unravel.

Another lesson in this area concerns the role of confidence.

Ultimately fi nancial transactions rely on promises about future payments.

If agents begin to doubt such promises, trust may vanish triggering sharpdrops in asset valuations.

Arguably, this is even more the case in a highly complex andinterconnected system, such as the one that decades of financialdeepening and sophistication have rendered.


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But the non-fundamental factors that also determine whether fi nancialagents have confidence in the payment promises embedded in such acomplex system are hard to characterise in quantitative models.

More generally in practice, it is challenging to assess how and whenconfidence abruptly evaporates at a very large scale, as it did for examplein September 2008 after the demise of Lehman Brothers (see Chart 1).

One direction is the analysis of asymmetric and imperfect information.

For example, recent research has illustrated which factors generateadverse selection phenomena, so that markets dry up and instability

propagates through contagion.

Another direction is a greater incorporation of psychological factors ineconomic analyses, as actually the field of behavioural finance is startingto do.

Whereas the former approach still relies on the assumption of fullyrational agents, the latter approach starts from empirical evidence thatcontradicts this assumption.

Akerlof and Shiller (2009) discuss a variety of psychological factors that played a role in the present crisis, and much more work would appear

beneficial.

The combination of complexity, interconnectedness, payment promisesin debt contracts, limits of information and basic human behaviour

animal spirits can lead to the violent feedback and amplificationmechanisms that are so typical for the transition from stability toinstability.

For all these reasons, enhanced and deep market intelligence shouldcontinue to play a very substantial role.


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2|3 Financial crises and the macroeconomy

The third area of intellectual challenges in financial stability analysisrelates to why authorities care so much about financial stability, namely

to which extent financial instability affects the overall economy, notablygrowth and consumer welfare, and why the transmission to the realeconomy may sometimes be so severe.

Chart 2 shows the range of GDP growth forecasts for the euro area acrossmajor forecasting institutions (dashed blue line) and the realised GDPgrowth rates (solid orange line) as policy makers saw them during thecritical years of 2008 and 2009, respectively.

By comparing the corridor of dashed lines and the solid orange linein panel a) of Chart 2 one can see that all forecasting institutionsconsistently over-estimated the growth rate for 2008, even until very latethe same year.


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Moving on to panel b) of Chart 2, it can be seen that the strongly negativegrowth rate of 4% in 2009 the free fall in economic activity wasdramatically missed until the end of 2008.

In this sense, left alone with unreliable forecasts policy-makers had to acton informal information, real-time data releases and their own wisdomand judgements on how the situation was evolving.

There can be many reasons for these sizable forecasting errors. One maysimply be that it is particularly difficult to look into the future inextraordinary circumstances.

It would, however, be too simple to just stop here.

Another reason for the errors may be that standard macroeconomicmodels, as they tend to be used as input in projections, do not have welldeveloped financial sectors and are mostly linear in nature.

Therefore, it is not all that surprising that they were not able to predict thedrastic effects of the financial meltdown on growth figures.

So, a tremendous intellectual challenge is to develop aggregate modelsthat

(i) Give the central role to financial systems that they actually play in theeconomy by channelling funds from firms, households and governments

with surpluses to the agents that need them to finance real investmentand smoothen consumption and

(ii) Incorporate states of widespread instability in these financial systemsthat feature the characteristics discussed before (bank defaults and othernonlinearities, feedback and amplification effects etc.).

Although a new literature of macroeconomic models with financialfrictions is emerging, we are presently still very far from a new


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generation of macroeconomic models that would fully meet the challengedescribed.

As this fundamental research field advances, such models could alsoenrich the toolkit for macroeconomic forecasts.

A related challenge can be identified in the very important field of macro-stress testing.

Documents

Risk Compliance News June 2011