Risk Management Presentation December 17 2012

7/28/2019 Risk Management Presentation December 17 2012

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International Association of Risk and ComplianceProfessionals (IARCP)

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

Top 10 risk and compliance management related news storiesand world events that (for better or for worse) shaped the

week's agenda, and what is nextDear Member,

We will start with theArchbishop of

Canterbury.

(Dontworry, you are not reading the wrongtop 10 list, this is the risk management list)

Let me gently remind them of the benchmark for this kind ofmis-reporting set by a cub-reporter covering the visit of theArchbishop ofCanterbury to the US, landing in New York.

The Archbishop had been advised to be cautiouswith the scandal -

mongering press.

Be discreet: be very discreet; but with a smile.

On arrival he was hijacked by a bevy of press men clamouring for a story.

One reporter asked What do you think of the night clubs in New York?

Remembering to be discreet, with a smile, the Archbishop ironicallyrespondedAre there any night clubs in New York?

Headlines next day: Archbishops first question on landing in New YorkAre there any night clubs here?

International Association of Risk and Compliance Professionals (IARCP)www.risk-compliance-association.com
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The speaker continued, but you must be careful although he said I havesanitised the story considerably for sensitive ears I am not sureabout that.

Read more at Number 9of our list the speech

by Mr Rundheersing Bheenick, Governor of theBank of Mauritius, at the Annual Dinner inhonour of Economic Operators, Pailles.

Not to forgetI love the logoof the Bank ofMauritius! No lions, no eagles

Also

Regulation is all about balance.

If regulation is too lax, excessive risk-taking may result with devastatingeffects.

If regulation is too tight, it may suppress beneficial financial activity andreduce growth.

Who said that?

Karen Kemp, Executive Director (Banking Policy), Hong Kong MonetaryAuthority.

He started with a reallyexcellent remark:

Last month the United States (US) regulatory authorities announcedthat theydid not expect their rules implementing Basel 3 would becomeeffective on 1 January 2013, although they are working asexpeditiouslyas possible to complete their rulemaking process.

Similarly in the European Union (EU), the trilogue between theEuropean Commission, the European Parliament and the Council ofMinisters to agree the text of Capital Requirements Directive IV (CRDIV, the EU version of Basel 3 is still ongoing and, even if a political

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agreement can be reached by year-end (which still appears to be theintention), it is recognised in the EU that there will not be sufficient timefor CRD IV to be codified as legislation and put into effect on 1 January2013.

His best question:

But notwithstanding the intrinsic benefits of Basel 3, should wenevertheless be swayed by the argument put to us that Asia is taking themedicinedesigned for the countries worst affected by the crisis, whilstthe intended patientsdeferand thereby give their banks significantcompetitive advantagesover our own?

Read more at N umber 1 below.

Also, host country supervisors worry after the Basel iii framework, butwhat if the host country is the United States?

As Daniel Tarullo said (member of the Board of Governors of the FederalReserve Board since January 28th, 2009):

The Basel I I I capital and liquidity frameworks are big improvements,and the proposed capital surcharges forsystemically important firms willbe another important step forward.

But these reforms are primarily directed at the consolidated level, withlittle attention to vulnerabilities posed by internationally active banks inhost markets.

The risks associated with large intra-group funding flows have remainedlargely unaddressed.

Read more at Number 2 below.

Welcome to the Top 10 list.



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Karen KempExecutive Director (Banking Policy)

Basel 3 The Timing Dilemma

Last month the United States (US) regulatory authorities announced thatthey did not expect their rules implementing Basel 3 would becomeeffective on 1 January 2013, although they are working asexpeditiously aspossible to complete their rulemaking process.

Similarly in the European Union (EU), the trilogue between theEuropean Commission, the European Parliament and the Council of

Ministers to agree the text of Capital Requirements Directive IV (CRDIV, the EU version of Basel 3 is still ongoing

Governor Daniel K. TarulloAt the Yale School of Management Leaders Forum,New Haven, Connecticut

Regulation of Foreign Banking Organizations

In the aftermath of the financial crisis, regulators around the worldcontinue to implement reforms designed to limit the incidence andseverity of future crises.

PCAOB Publishes Staff Audit Practice Alert

on Maintaining and Applying ProfessionalSkepticism in Audits



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James R. Doty, Chairman

Keynote Address

AICPA National Conference on Current SECand PCAOB Developments

Economic and Monetary Affairs Committee

EU bank supervision system must be strong, accountable andinclusive

Banking supervision powers transferred to the EU level must be matchedby measures that subject them to democratic scrutiny, said Economic andMonetary Affairs Committee MEPs on Thursday.

Opportunities facing Islamic finance andchallenges in managing capital flows in Asia

Outline of special address by Mr TharmanShanmugaratnam, Chairman of the MonetaryAuthority of Singapore, at the 8th World IslamicEconomic Forum, Johor Bahru, Malaysia



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Resolving Globally Active,Systemically Important, Financial I nstitutions

A joint paper by the Federal Deposit Insurance Corporation and the Bankof England

Resolving Globally Active, Systemically Important, Financial InstitutionsFederal Deposit I nsurance Corporation and the Bank of England

784 pages - Publication of the Creditinstitutions Register

EBA Register of Credit Institutionsprovided for in Article 14 of Directive 2006/48/ EC

Article 14 of Directive 2006/ 48/ EC as amended by Art. 9 (3) of Directive2010/78/EU requires the EBA to publish on its website a list of creditinstitutions to which authorisation has been granted in the Member

States , and to keep that list updated.

Past I mperfect, Present Tense and FutureConditional

Speech by Mr Rundheersing Bheenick, Governor of the Bank ofMauritius, at the Annual Dinner in honour of Economic Operators,

Pailles.



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Understanding macroprudential regulation

Introductory remarks by Mr Jan F Qvigstad, DeputyGovernor of Norges Bank (Central Bankof Norway), at the workshop on Understandingmacroprudential regulation, organised byNorges Bank, Oslo.



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Basel 3The Timing Dilemma

Last month the United States (US) regulatory authorities announced thatthey did not expect their rules implementing Basel 3 would becomeeffective on 1 January 2013, although they are working asexpeditiously aspossible to complete their rulemaking process.

Similarly in the European Union (EU), the trilogue between the EuropeanCommission, the European Parliament and the Council of Ministers toagree the text of Capital Requirements Directive IV (CRD IV, the EUversion of Basel 3 is still ongoing and, even if a political agreement can be

reached by year-end (which still appears to be the intention), it isrecognised in the EU that there will not be sufficient time for CRD IV tobe codified as legislation and put into effect on 1 January 2013.

So, does it necessarily follow that we should delay Basel 3 implementationin H ong Kong because the US and the EU cannot meet theinternationally agreed timeline?

Or should we follow the timeline set by the Basel Committee on BankingSupervision and begin the first phase of Basel 3 implementation from 1January 2013?

Our Basel 3 rules (the Banking (Capital) (Amendment) Rules 2012) arecurrently tabled at LegCo and notwithstanding the expected delays in theUS and the EU, the Basel Committees timeline remains unchanged.

Its gradual phase-in of the new capital standards over six years beginsfrom January 2013 and extends until 2019.

In resolving the timing dilemma, it might first be instructive to remindourselves that Basel 3 is being introduced to rectify weaknessesmade alltoo starkly apparent in the recent global financial crisis.



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Or, put another way, Basel 3 is considered good for financial stability. The

Basel 3 capital standards are designed to strengthen banksresilience

by requiring more and better quality capital and by addressing andcapturing risks not adequately recognised previously.

The aim is to ensure that banks can weather future financial stormswithout disruption to their lending.

This should in turn make themless likely to create or amplify problems inother areas of the economy and facilitate their contribution to long-termsustainable economic growth.

The roller-coaster of excessive leverage pre-crisis and excessive

deleveraging post-crisis is not conducive to sustainable growth.

Regulation is all about balance.

If regulation is too lax, excessive risk-taking may result with devastatingeffects.

If regulation is too tight, it may suppress beneficial financial activity andreduce growth.

In our view, Basel 3 represents an appropriate balance in bolsteringresilience whilst at the same time (with its extended phase-in) not undulyhampering lending to business and households today and ensuring bankscan continue to lend in any downturn tomorrow.

For this reason we propose to begin implementing Basel 3 from 1 January2013.

We are not alone in this.

Our regional peers, Mainland China, Japan, Singapore and Australia haveall published theirfinal rules for Basel 3 implementation next year.

As hasSwitzerland, another important financial centre.



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But notwithstanding the intrinsic benefits of Basel 3, should wenevertheless be swayed by the argument put to us that Asia is taking themedicinedesigned for the countries worst affected by the crisis, whilstthe intended patientsdefer and thereby give their banks significantcompetitive advantagesover our own?

This competitive advantage argument would seem to be based on twoassumptions.

First that US and EU global banks (i.e. those banks that could realisticallycompete with our own) are currently holding much lower levels of capitalthan required by Basel 3 (and hence will have a genuine cost advantage);

and second that our banks will, come 1 January 2013, have to hold more

capital than they currently hold (and hence will incur additional cost).

Are these assumptions correct?

Well even though adoption of Basel 3 is delayed in the US and the EU,this certainly does not mean that banks in these regions remain at theirpre-crisis capital levels.

There has been significant re-capitalisation.

The Dodd Frank Wall Street Reform and Consumer Protection Act in theUS already requires the regulatory agencies to conduct stress-testingprogrammesto ensure banks and other systemically important financialinstitutionshave enough capital to weather severe financial conditionsand, even before the passage of the Dodd Frank Act, the US FederalReserve Board put some of the largest US bank holding companiesthrough stress-tests, the results of which have led to significant increasesin capital.

By 2012, the 19 bank holding companiessubject to the FedsComprehensive Capital Analysis and Review had increased theiraggregate tier 1 common capital to US$803 billion in the second quarter ofthe year from US$420 billion in the first quarter of 2009, with their tier 1common capital ratio (which compares high quality capital to assets



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weighted according to their riskiness) doubling to a weighted average of10.9% from 5.4%.

In the EU, under a recapitalisation exercise in 2011 that covered 71 of theEUs major banks, the European Banking Authority (EBA) required mostto attain acore tier 1ratio of not less than 9% by the end of June 2012.

In October 2012, the EBA indicated that it will focus on capitalconservation to support a smooth convergence to the CRD IV..regulatory requirementsand require the banks to maintain an absoluteamount of core tier 1 capital corresponding to the level of the 9% core tier1 ratio.

Soeven absent formal adoption of Basel 3, the capital levels of the largest

banks in the US and the EU have increased significantlypost-crisis tolevels comparable with, or even in excess of, those required under Basel 3and so the prospect of such banks competing by being allowed tomaintain much lower capital levels than Basel 3 banks would seem moreapparent than real.

Turning to the second competitiveassumption, will the first phase ofBasel 3, which starts next year, require local banks to hold significantlymore capital than they do at present, to the extent that they may becomeconstrained in their ability to lend and compelled to pass on the costs of

the extra capital to borrowers?

Well, the results of the HKMAs quantitative impact studies tell us thatour local banks are already very well-placed to meet the new Basel 3capital ratios.

Their capital levels are already in excess of the standard taking effect on 1January 2013 and the issuance of ordinary shares (common equity) alreadyaccounts for a very significant proportion of their capital base, positioningthem well for Basel 3snew focus on common equity as the highest qualitycapital for the purpose of loss absorption.



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In summary then, irrespective of any delay in formal implementation ofBasel 3, major banks in the US and EU are inexorably moving to higherlevels of capital.

This, together with the benefits offered by Basel 3 and the relative easewith which local banks can comply, serves to underpin our view that weshould proceed to implement the first phase of Basel 3 in line with theBasel Committees timeline.

Generally speaking, jurisdictions in Asia have in the past tended to adoptregulations that are in some respectshigher than the Basel Committeesminimum standards.

This may have helped Asia weather the global financial crisis relatively

unscathed when compared with the jurisdictions worst affected.

There would, therefore, seem little to be gained from seeking to engagein, or indeed prompt, arace-to-the-bottom in regulatory terms bydeliberately delaying the introduction of Basel 3 at this point in time.

In implementing on 1 January 2013, we will be fulfilling our commitmentboth as an international financial centre which customarily adopts bestinternational standardsand as a member of the Basel Committee onBanking Supervision.

Karen KempExecutive Director (Banking Policy)



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Governor Daniel K. TarulloAt the Yale School of Management Leaders Forum,New Haven, Connecticut

Regulation of Foreign Banking Organizations

In the aftermath of the financial crisis, regulators around the worldcontinue to implement reforms designed to limit the incidence andseverity of future crises.

My subject today pertains to an area in which reforms have yet to bemade--the regulation of the U.S. operations of large foreign banks.

Applicable regulation has changed relatively little in the last decade,despite a significant and rapid transformation of those operations, asforeign banks moved beyond their traditional lending activities to engagein substantial, and often complex, capital market activities.

The crisis revealed the resulting risks to U.S. financial stability.

In taking a fresh look at regulation of foreign banks in the United States, Iby no means want to imply that the United States should revoke itswelcome to foreign banks.

On the contrary, this reconsideration reflects the important role foreignbanks have played.

The presence of foreign banks can bring particularcompetitive andcountercyclical benefits because foreign banks often expand lending inthe United States when U.S. banking firms labor under commondomestic strains.

But just as we are adapting our regulatory approach to U.S. banks, so we

need to incorporate important lessons learned from the crisis into ouroversight program for foreign banks.

The question of how best to regulate foreign banks is hardly a new one,either here or in other countries.



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Debates over the relative merits of territorial versus global or mutualrecognition approaches, the difficulties in achieving strictly equal termsof competition between banks with different home regulatory systems,and the degree to which harmonization of international standards andsupervisory consultations can mitigate the resulting inconsistencies andfrictions are all familiar topics to academics, banking lawyers, andsupervisory authorities.

While I do not aim to resolve this afternoon the complicated interactionamong these perspectives and considerations, I will try to outline apractical and reasonable way forward.

To be effective, a new approachmust address the vulnerabilities that havebeen created by the shift in foreign bank activities, in keeping with soundprudential policy and congressional mandates in the Dodd-Frank Wall

Street Reform and Consumer Protection Act.

At the same time, a modified regulatory system should maintain theprinciple of national treatment and allow foreign banks to continue tooperate here on an equal competitive footing, to the benefit of the U.S.banking system and the U.S. economy generally.

Foreign Bank Regulation in the United States

Regulating the U.S. operations of foreign banks presents uniquechallenges.

Although U.S. supervisors have full authority over the local operations offoreign banks, we see only a portion of a foreign bank's worldwideactivities, and regular access to information on its global activities can belimited.

Foreign banks operate under a wide variety of business models andstructures that reflect the legal, regulatory, and business climates in thehome and host jurisdictions in which they operate.

Despite these difficulties, the United States has traditionally accordedforeign banks the same national treatment as domestic banks, and U.S.regulators generally have allowed foreign banks to choose amongstructures that they believe promote maximum efficiency at theconsolidated level.



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Under the statutory scheme established by Congress, permissible U.S.structures include cross-border branching and direct and indirectsubsidiaries, provided that they operate in a safe and sound manner.

U.S. law also allows well-managed and well-capitalized foreign banks to

conduct a wide range of bank and nonbank activitiesin the United Statesunder conditions comparable to those applied to U.S. bankingorganizations.

Still, it is worth noting that even as there has been continuity in this basicpolicy, U.S. regulation of foreign banks has evolved over the years inresponse to changes in the extent and nature of foreign bank activities.Let me mention two examples.

Before 1978, foreign bank branches in the United States were licensed and

regulated by individual states, with little in the way of federal regulation orrestrictions.

They werenot subject to the full panoply of limitations on interstatebanking, equity investments, or affiliations with securities firms that wereapplicable to domestic banks.

The rapid growth of foreign banking in the 1970s, particularly branching,prompted an end to this lighter regulatory regime.

The International Banking Act of 1978 gave the Federal Reserve Board

regulatory authority over the domestic operations of foreign banks andsignificantly equalized regulatory treatment of foreign and domesticfirms.

Congress maintained this approach of basic competitive equality in the1999Gramm-Leach-Bliley Act.

That law substantially removed restrictions on affiliations betweencommercial banks and other kinds of financial firms for both domesticand foreign institutions operating in the United States.

Moreover, in light of provisions in Gramm-Leach-Bliley that permitted aforeign bank to be a financial holding company (FHC), the FederalReserve announced in 2001 that a bank holding company (BHC) in theUnited States that was owned and controlled by a well-capitalized and



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well-managed foreign bank generally would not be required to meet theBoard's capital requirements normally applicable to BHCs.

My second examplerelates to the massive fraud uncovered at the Bank ofCredit and Commerce International (BCCI) and its subsequent collapse

in 1991, which highlighted the need for more effective supervision ofbanks operating in multiple countries.

The Foreign Bank Supervision Enhancement Act of 1991 (FBSEA)required foreign banks to receive approval from the Board beforeestablishing a branch or agency in the United States.

The law required the Federal Reserve, in turn, to determine that theforeign bank is subject to "comprehensive supervision or regulation on aconsolidated basis" in its home country before approving an application

either to open a branch or to acquire a U.S. subsidiary bank.

It is further worth noting that changes in U.S. law and regulatory practiceaffecting foreign banking organizations have often corresponded tochanges in international regulatory agreements.

For example, FBSEA was enacted at the same time as the BaselCommitteeon Banking Supervision was working to address the problemsrevealed by BCCI--an effort that bore fruit the next year in changes to theso-calledBasel Concordat, which established minimum standards for thesupervision of international banking groups.

Another instance was the substantial reduction or removal of remainingasset-pledge and asset-maintenance requirements for most U.S. branchesof foreign banks, prompted in part by implementation of the newinternational capital standards included in the 1988 Basel Accord.

The Shift in Foreign Bank Activities

Although foreign banks expanded steadily in the United States during the1970s, 1980s, and 1990s, their activities here posed limited risks to overall

U.S. financial stability.

Throughout this period, the U.S. operations of foreign banks were largelynet recipients of funding from their parents and generally engaged intraditional lending to home-country and U.S. clients.



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U.S. branches and agencies of foreign banks held large amounts of cashduring the 1980s and '90s, in part to meet asset-maintenance andasset-pledge requirements put in place by regulators.

Their cash-to-third-party liability ratio from the mid-1980s through the

late 1990s generally ranged between 25 percent and 30 percent.

The U.S. branches and agencies of foreign banks that borrowed from theirparents and lent those funds in the United States ("lending branches")held roughly 60 percent of all foreign bank branch and agency assets in theUnited States during the 1980s and '90s.

Commercial and industrial lending continued to account for a large partof foreign bank branch and agency balance sheets through the 1990s.

This profile of foreign bank operations in the United States changed in

the run-up to the financial crisis.

Reliance on less stable, short-term wholesale funding increasedsignificantly.

Many foreign banks shifted from the "lending branch" model to a"funding branch" model, in which U.S. branches of foreign banks wereborrowing large amounts of U.S. dollars to upstream to their parents.

These "funding branches" went from holding 40 percent of foreign bankbranch assets in the mid-1990s to holding 75 percent of foreign bankbranch assets by 2009.

Foreign banks as a group moved from a position of receiving fundingfrom their parents on a net basis in 1999 to providing significant fundingto non-U.S. affiliates by the mid-2000s--more than $700 billion on a netbasis by 2008.

A good bit of this short-term funding was used to finance long-term, U.S.dollar-denominated project and trade finance around the world.

There is also evidence that a significant portion of the dollars raised byEuropean banks in the pre-crisis period ultimately returned to the UnitedStates in the form of investments in U.S. securities.



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Indeed, the amount of U.S. dollar-denominated asset-backed securitiesand other securities held by Europeans increased significantly between2003 and 2007, much of it financed by the short-term, dollar-denominatedliabilities of European banks.

Meanwhile, commercial and industrial lending originated by U.S.branches and agencies as a share of their third-party liabilities fellsignificantly after 2003.

In contrast, U.S. broker-dealer assets of the top-10 foreign banksincreased rapidly during the past 15 years, rising from 13 percent of allforeign bank third-party assets in 1995 to 50 percent in 2011.

Lessons from the Recent Financial Crisis

The 20072008 financial crisis and the continuing financial stress inEurope have revealed financial stability risks associated with the foreignbanking model as it has evolved in the United States.

To some extent the concerns associated with foreign banking operationstrack the more general shortcomings of pre-crisis financial regulation.

Internationally agreed minimum capital levels were too low, the qualitystandards for required capital were too weak, the risk weights assigned tocertain asset classes did not reflect their actual risk, and the potential forliquidity strains was seriously underappreciated.

But some risks are more closely tied to the specifically internationalcharacter of certain global banks, both here and in some other parts of theworld.

The location of capital and liquidity proved critical in the resolution ofsome firms that failed during the financial crisis.

Capital and liquidity were in some cases trapped at the home entity, as inthe case of the Icelandic banks and, in our own country, LehmanBrothers.

Actions by home-country authorities during this period showed that whilea foreign bank regulatory regime designed to accommodate centralizedmanagement of capital and liquidity can promote efficiency during goodtimes, it also increases the chances of ring-fencing by home and host



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jurisdictions at the moment of a crisis, as local operations come undersevere strain and repayment of local creditors is called into question.

Resolution regimes and powers remain nationally based, complicatingthe resolution of firms with large cross-border operations.

The large intra-firm, cross-border flows that grew rapidly in the yearsleading up to the crisis also created vulnerabilities.

To be fair, the ability to move liquidity freely throughout a banking groupmay have provided some financial stability benefits during the crisis byenabling banks to respond to localized balance-sheet shocksanddysfunctional markets in some areas (such as the interbank and foreignexchange swap markets) and by transferring resources from healthierparts of the group.

Nevertheless, this model also created a degree of cross-currency fundingrisk and heavy reliance on swap markets that proved destabilizing.

Moreover, foreign banks that relied heavily on short-term, U.S. dollarliabilities were forced to sell U.S. dollar assets and reduce lending rapidlywhen that funding source evaporated, thereby compounding risks to U.S.financial stability.

Although the United States did not suffer a destabilizing failure of foreignbanks, many rode out the crisis only with the help of extraordinary

support from home- and host-country regulators.

Following national treatment practice, the Federal Reserve itself providedsubstantial discount window access to U.S. branches and the opportunityto participate in the Primary Dealer Credit Facility to U.S. primary-dealersubsidiaries of foreign banks.

Moreover, the potential for funding disruptions did not disappear with thewaning of the global financial crisis.

In 2011, for example, as concerns about the euro zone rose, U.S. money

market funds suddenly pulled back their lendingto large euro area banks,reducing lending to these firms by roughly $200 billion over just fourmonths.



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While there has been some reduction in operations and some change infunding patterns by foreign banking organizations in the United Statessince the crisis, particularly by European firms reacting to euro zonefinancial stress, the basic circumstances have not changed.

The proportion of foreign banking assets to total U.S. banking assets hasremained at about one-fifth since the end of the 1990s.

But the concentration and complexity of those assets have changednoticeably from earlier decades, and have not reversed in recent yearsdespite the global financial crisis and subsequent events.

Ten foreign banks now account for more than two-thirds of foreign bankthird-party assets held in the United States, up from 40 percent in 1995.

And while the largest U.S. operations of foreign banks do not approach

the size of our largest domestic financial institutions, it is striking thatthere are 23 foreign banks with at least $50 billion in assets in the UnitedStates--thethreshold established by the Dodd-Frank Act for specialprudential measures for domestic firms--compared with 25 U.S. firms.

Most notably, perhaps, five of the top-10 U.S. broker-dealers are owned byforeign banks.

Like their U.S.-owned counterparts, large foreign-owned U.S.broker-dealers were highly leveraged in the years leading up to the crisis.

Their reliance on short-term funding also increased, with much of theexpansion of both U.S.-owned and foreign-owned U.S. broker-dealeractivities attributable to the growth in secured funding markets duringthe past 15 years.

Finally, we should note that one of the fundamental elements of thecurrent approach--our ability, ashost supervisors, to rely on the foreignbank to act as a source of strength to its U.S. operations--has come intoquestion in the wake of the crisis.

The likelihood that some home-country governments of significantinternational firms will backstop their banks' foreign operations in a crisisappears to have diminished.



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It also appears that constraints have been placed on the ability of thehome offices of some large international banks to provide support to theirforeign operations.

The motivations behind these actions are not hard to understand and

appreciate, but they do affect the supervisory terrain for host countriessuch as the United States.

International and Domestic Regulatory Response

Since the crisis, important changes have been made to strengtheninternational regulatory standards.

TheBasel I I I capital and liquidity frameworks arebig improvements, andthe proposed capital surcharges forsystemically important firms will beanother important step forward.

But these reforms are primarily directed at the consolidated level, withlittle attention to vulnerabilities posed by internationally active banks inhost markets.

The risks associated with large intra-group funding flows have remainedlargely unaddressed.

Managing international regulatory initiatives also has become moredifficult, as the number of complex items on the agenda has increased.

And despite continued work by the Financial Stability Board, challengesto cross-border resolution are likely to remain significant.

For the foreseeable future, then, our regulatory system must recognizethat while internationally active banks live globally, they may well dielocally.

Quite apart from the need to act pragmatically under the circumstances,it is not clear that we should aim toward extensive harmonization ofnational regulatory practices related to foreign banking organizations.

The nature and extent of foreign banking activities vary substantiallyacross national markets, suggesting that regulatory responses might bestvary as well.



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For instance, the importance of the U.S. dollar in many internationaltransactions can motivate foreign banks to use their U.S. operations toraise dollar funding for their international operations, potentially creatingvulnerabilities.

Such a model is unlikely to prevail in most other host financial marketsaround the world.

Indeed, in response to financial stability risks highlighted during thecrisis, ongoing challenges associated with the resolution of largecross-border firms, and the limitations of the international reform agenda,several national authorities have already introduced their own policies tofortify the resources of internationally active banks within theirgeographic boundaries.

Regulators in the United Kingdom, for example, have recently increasedrequirements for liquidity to cover local operations of domestic andforeign banks, set stricter rules around intra-group exposures of U.K.banks to foreign subsidiaries, and moved to ring-fence home-countryretail operations.

Meanwhile, Swissauthorities have explicitly prioritized the domesticsystemically important operations of their large, internationally activefirms in resolution.

Here in the United States, Congress included in the Dodd-Frank Act a

number of changes directed at the financial stability risk posed by foreignbanks.

Sections 165 and 166 instruct the Federal Reserve to implement enhancedprudential standards for large foreign banks as well as for large domesticBHCs and nonbank systemically important financial institutions.

Dodd-Frank also bolstered capital requirements for FHCs, includingforeign FHCs, by extending the well-capitalized and well-managedrequirements beyond U.S. bank subsidiaries to the top-tier holding

company.

In addition, the so-called Collins Amendment in Dodd-Frank removedthe exemption from BHC capital requirements granted by the FederalReserve's Supervision and Regulation Letter 01-01.



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The required phase-out of SR 01-01 was clearly intended to strengthen thecapital regime applied to the U.S. operations of foreign banks; however,the organizational flexibility that the amendment gave to foreign banks inthe United States has allowed some large foreign banks to restructuretheir U.S. operations to minimize the impact of this regulatory change.

As a result, in the absence of additional structural requirements forforeign banks in the United States, the effectiveness of our capital regimefor large foreign banks with both bank and nonbank operations in theUnited States depends on the foreign bank's own organizational choices.

A Rebalanced Approach to Foreign Bank Regulation

As has been the case in the past, we need to adjust the regulatoryrequirements for foreign banks in response to changes in the nature of

their activities in the United States, the risks attendant to those changes,and instructions from Congress in new statutory provisions.

The modified regime should counteract the risks posed to U.S. financialstability by the activities of foreign banking organizations, as manifestedin the years leading up to, and through, the financial crisis.

Special attention must be paid to the risk of runs associated withsignificant reliance on short-term funding.

In addition, the regime should reduce the difficulties in resolution of

cross-border firms.

Finally, it should take steps to diminish the potential need for ex-postring-fencing when losses mount or runs develop during a crisis, sincesuch actions may well be unhelpfully procyclical.

At the same time, in modifying our regulatory regime for foreign bankingorganizations, we must remain mindful of the benefits that foreign bankscan bring to our economy and of the important policies of nationaltreatment and comparable competitive opportunity.

Thus, we should chart a middle course, not moving to a fully territorialmodel of foreign bank regulation, but instead making targetedadjustments to address the risks I have identified.

In basic terms, three such adjustments are desirable.



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First, a more uniform structure should be required for the largest U.S.operations of foreign banks--specifically, that these firms establish atop-tier U.S. intermediate holding company (IH C) over all U.S. bank andnonbank subsidiaries.

An IHC would make application of enhanced prudential supervisionmore consistent across foreign banks and reduce the ability of foreignbanks to avoid U.S. consolidated-capital regulations.

Because U.S. branches and agencies are part of the foreign parent bank,they would not be included in the IHC.

However, they would be subject to the activity restrictionsapplicable tobranches and agencies today as well as to certain additional measuresdiscussed below.

Second, the same capital rules applicable to U.S. BHCs should also applyto U.S. IHCs.

These rules have been reshaped to counteract the risks to the U.S.financial system revealed by the crisis and should be implementedconsistently across all firms that engage in similar activities.

Similarly, other enhanced prudential standards required by theDodd-Frank Act--including stress testing requirements, riskmanagement requirements, single counterparty credit limits, and early

remediation requirements--should be applied to the U.S. operations oflarge foreign banks in a manner consistent with the Board's domesticproposal.

Third, there should be liquidity standards for large U.S. operations offoreign banks.

Standards are needed to increase the liquidity resiliencyof theseoperations during times of stress and to reduce the threat of destabilizingruns as dollar funding channels dry up and short-term debt cannot be

rolled over.

For IH Cs, the standards should be broadly consistent with the standardsthe Federal Reserve has proposed for large domestic BHCs, pending final



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adoption and phase-in of quantitative liquidity requirements by the BaselCommittee.

That is, they should be designed to ensure that, in stressedcircumstances, the U.S. operations have enough high-quality liquid

assets to meet expected net outflows in the short term.

There should also be liquidity standards for foreign bank branch andagency networks in the United States, although they may be lessstringent, in recognition of the integration of branches and agencies intothe global bank as a whole.

By imposing a more standardized regulatory structure on the U.S.operations of foreign banks, we can ensure that enhanced prudentialstandards are applied consistently across foreign banks and in

comparable ways between U.S. banking organizations and foreignbanking organizations.

As with domestic firms subject to enhanced prudential standards, theFederal Reserve would work to ensure that the new regime is minimallydisruptive, through transition periods and other means.

An IHC structure would also provide the Federal Reserve, as umbrellasupervisor of the U.S. operations of foreign banks, with a uniformplatform to implement a consistent supervisory program across largeforeign banks.

In the case of foreign banks with the largest U.S. operations, the IH Cwould alsohelp mitigate resolution difficultiesby providing U.S.regulators with one consolidated U.S. legal entity to place intoreceivership under title I I of the Dodd-Frank Act if the failure of theforeign bank would threaten U.S. financial stability.

Branches and agencies would remain separate, but all other entitieswould be included.

Further, an IHC structure would facilitate a consistent U.S. capitalregime for bank and nonbank activities of foreign banks under the IHC,similar to the approach taken in other jurisdictions, such as the UnitedKingdom and some continental European countries.



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Some observers will, I am sure, ask if it is necessary to depart from theprevailing firm-by-firm approach to foreign banking regulation and toadopt generally applicable requirements in implementing theDodd-Frank enhanced prudential standards for foreign banks.

It is difficult to see how reliance on this approach can be effective inaddressing risks to U.S. financial stability, at least in the absence ofextraterritorial application of our own standards and supervision, andperhaps not even then.

We would, at a minimum, need to make regular and detailed assessmentsof each firm's home-country regulatory and resolution regimes, thefinancial stability risk posed by each firm in the United States, and thefinancial condition of the consolidated banking organization.

In fact, such an approach might result in the worst of both worlds--anongoing intrusiveness into the consolidated supervision of foreign banksby their home-country regulators without the ultimate ability to evaluatethose banks comprehensively or to direct changes in a parent bank'spractices necessary to mitigate risks in the United States.

Although the Federal Reserve will continue to cooperate with its foreigncounterparts in overseeing large, multinational banking operations, thatsupervisory tool cannot provide complete protection against risksengendered by U.S operations as extensive as those of many large U.S.institutions.

It is also important to note that while the reforms I have described todaycontain some elements that are more territorial than our currentapproach, includingrequiring some additional capital and liquiditybuffers to be held in the United States, they do not represent a completedeparture from prior practice.

This enhanced approach would allow foreign banks to continue to operatebranches in the United Statesand would generally allow branches to meetcomparable capital requirements at the consolidated level.

Similarly, this approach would not impose a cap on intra-group flows,thereby allowing foreign banks in sound financial condition to continue toobtain U.S. dollar funding for their global operations through their U.S.entities.



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It would instead provide an incentive to term out at least some of thisfunding in a way that reduces the risk of runs.

Requiring additional local capital and liquidity buffers, like anyprudential regulation, may incrementally increase cost and reduce

flexibility of internationally active banks that manage their capital andliquidity on a centralized basis.

However, managing liquidity and capital on a local basis can havebenefits not just for financial stability generally, but also for firmsthemselves.

During the crisis, the more decentralized global banks relied somewhatless on cross-currency funding and were less exposed to disruptions ininternational wholesale funding and foreign exchange swap markets than

the more centralized banks.

Indeed, as noted earlier, in the wake of the crisis and of subsequentstresses, many foreign banks have modified their funding practices andbusiness models.

In revamping our approach, we will both be guarding against a return topre-crisis practices and, more generally, ensuring that foreign bankingoperations in the United States that pose potential risks to U.S. financialstability are regulated similarly to domestic banking operations posingsimilar risks.

Conclusion

The imperative for change in our foreign bank regulation is clear and,indeed, mandated by Dodd-Frank.

Of course, I have provided only an outline of the three key measures thatwill best navigate the middle course I have suggested.

The all-important details are under discussion at the Board.

I anticipate that in the coming weeks we will complete our work and issuea notice of proposed rulemaking that will elaborate the basic approach Ihave foreshadowed.



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I look forward to hearing your general reactions today and more specificfeedback after the Board has adopted a proposed rule.



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PCAOB Publishes Staff Audit PracticeAlert on Maintaining and Applying

Professional Skepticism in Audits

The Public Company Accounting Oversight Board published a StaffAudit Practice Alert to remind auditors of their requirement to exerciseprofessional skepticismthroughout their audits.

"Investors depend on independent auditsto provide a meaningful checkon the financial statements prepared by company management," saidPCAOB Chairman James R. Doty.

"Without professional skepticism, the audit cannot serve that essentialfunction."

The PCAOB continues to observe instancesin which circumstancessuggest that auditors did not appropriately apply professional skepticismin their audits.

Staff Audit Practice Alert No. 10: Maintaining and Applying Professional

Skepticism in Auditsfocuses on the importance of professionalskepticism, the appropriate application of professional skepticism inaudits, and certain important considerations for audit firms' qualitycontrol systems.

PCAOB standards define professional skepticism as an attitude thatincludes a questioning mind and a critical assessment of audit evidence,and it is essential to the performance of effective audits under Boardstandards.

"This Alert discusses factors that impair an auditor's skepticism, andsteps that firms and auditors can take to enhance their application ofprofessional skepticism," said Martin F. Baumann, PCAOB ChiefAuditor and Director of Professional Standards.



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"PCAOB standards require every individual auditor to exerciseprofessional skepticism throughout their audits."

The timing of the release ofStaff Audit Practice Alert No. 10 is intendedto assist audit firms' emphasis in upcoming calendar year-end audits onthe importance of the appropriate use of professional skepticism.

Due to the fundamental importance of the appropriate application ofprofessional skepticism in performing an audit in accordance withPCAOB standards, the Board is also continuing to explore whetheradditional actions might meaningfully enhance auditors' professionalskepticism.

The PCAOB publishes Staff Audit Practice Alerts to highlight new,

emerging, or otherwise noteworthy circumstances that may affect howauditors conduct audits under the existing requirements of PCAOBstandards and relevant laws.

Auditors should determine whether and how to respond to thesecircumstances based on the specific facts presented.

The statements contained in Staff Audit Practice Alerts do not establishrules of the Board and do not reflect any Board determination or

judgment about the conduct of any particular firm, auditor, or any other

person.



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STAFF AUDIT PRACTICE ALERTNO. 10

MAINTAINING AND APPLYING

PROFESSIONAL SKEPTICISM I N AUDITS

Staff Audit Practice Alerts highlight new, emerging, or otherwisenoteworthy circumstances that may affect how auditors conduct auditsunder the existing requirements of the standards and rules of the PCAOBand relevant laws.

Auditors should determine whether and how to respond to thesecircumstances based on the specific facts presented.

The statements contained in Staff Audit Practice Alerts do not establishrules of the Board and do not reflect any Board determination or judgmentabout the conduct of any particular firm, auditor, or any other person.

Executive Summary

Professional skepticism is essential to the performance of effective auditsunder Public Company Accounting Oversight Board ("PCAOB" or"Board") standards.

Those standards require that professional skepticism be appliedthroughout the audit by each individual auditor on the engagement team.

PCAOB standardsdefine professional skepticism as an attitude thatincludes a questioning mind and a critical assessment of audit evidence.

The standards also state that professional skepticism should be exercisedthroughout the audit process.

While professional skepticism is important in all aspects of the audit, it isparticularly important in those areas of the audit that involve significantmanagement judgments or transactions outside the normal course ofbusiness.



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Professional skepticism also is important as it relates to the auditor'sconsideration of fraud in an audit.

When auditorsdo not appropriately apply professional skepticism, theymay not obtain sufficient appropriate evidence to support their opinions

or may not identify or address situations in which the financial statementsare materially misstated.

Observations from the PCAOB's oversight activities continue to raiseconcerns about whether auditors consistently and diligently applyprofessional skepticism.

Certain circumstances can impede the appropriate application ofprofessional skepticism and allow unconscious biases to prevail, includingincentives and pressures resulting from certain conditions inherent in the

audit environment, scheduling and workload demands, or aninappropriate level of confidence or trust in management.

Audit firms and individual auditors should be alert for these impedimentsand take appropriate measures to assure that professional skepticism isapplied appropriately throughout all audits performed under PCAOBstandards.

Firms' quality control systems can help engagement teams improve theapplication of professional skepticism in a number of ways, including

setting a proper tone at the top that emphasizes the need for professionalskepticism; implementing and maintaining appraisal, promotion, andcompensation processes that enhance rather than discourage theapplication of professional skepticism; assigning personnel with thenecessary competencies to engagement teams; establishing policies andprocedures to assure appropriate audit documentation, especially in areasinvolving significant judgments; and appropriately monitoring the qualitycontrol system and taking necessary corrective actions to addressdeficiencies, such as, instances in which engagement teams do not applyprofessional skepticism.

The engagement partner is responsible for, among other things, settingan appropriate tone that emphasizes the need to maintain a questioningmind throughout the audit and to exercise professional skepticism in



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gathering and evaluating evidence, so that, for example, engagementteam members have the confidence to challenge managementrepresentations.

It is also important for the engagement partner and other seniorengagement team members to be actively involvedin planning, directing,and reviewing the work of other engagement team members so thatmatters requiring audit attention, such as unusual matters orinconsistencies in audit evidence, are identified and addressedappropriately.

It is the responsibility of each individual auditortoappropriately applyprofessional skepticism throughout the audit, including in identifyingand assessing the risks of material misstatement, performing tests of

controls and substantive procedures to respond to the risks, andevaluating the results of the audit.

This involves, among other things,considering what can go wrong withthe financial statements, performing audit procedures to obtain sufficientappropriate audit evidence rather than merely obtaining the most readilyavailable evidence to corroborate management's assertions, and criticallyevaluating all audit evidence regardless of whether it corroborates orcontradicts management's assertions.

The Office of the Chief Auditoris issuing this practice alert to remindauditors of the requirement to appropriately apply professionalskepticism throughout their audits.

The timing of this release is intended to facilitate firms' emphasis inupcoming calendar year-end audits, as well as in future audits, on theimportance of the appropriate use of professional skepticism.

Due to the fundamental importance of the appropriate application ofprofessional skepticism in performing an audit in accordance with

PCAOB standards, the PCAOB also is continuing to explore whetheradditional actions might meaningfully enhance auditors' professionalskepticism.



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Professional Skepticism and Due Professional Care

Professional skepticism, an attitude that includes a questioning mind anda critical assessment of audit evidence, is essential to the performance of

effective audits under PCAOB standards.

The audit is intended to provide investors with an opinion on whether thefinancial statements prepared by company management are presentedfairly, in all material respects, in conformity with the applicable financialreporting framework.

If the audit is conducted without professional skepticism, the value of theaudit is impaired.

The auditor has a responsibility to plan and perform the audit to obtain

reasonable assurance about whether the financial statements are free ofmaterial misstatement, whether caused by error or fraud.

This responsibility includes obtaining sufficient appropriate evidence todetermine whether the financial statements are materially misstatedrather than merely looking for evidence that supports management'sassertions.

PCAOB standardsrequire the auditor to exerc

Risk Management Presentation December 17 2012

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