Basel 3 April 2012

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Basel iii Compliance ProfessionalsAssociation (BiiiCPA)
1200G Street NW Suite800Washington, DC 20005-6705USA Tel:
202-449-9750Web: www.basel-iii-association.com
Basel III News,April 2012
Dear Member,
“Prediction is very difficult, especiallyif it's about the future”
NilsBohr, Nobel laureatein Physics
In Basel iii, Solvencyii, and many other laws
and regulations,wehave to make economic
projections.
What I reallylove isthe need for “realistic
assumptions”.
So, wehave a crystal ball: The MonetaryPolicy
Report tothe Congresswhere wecan find the
“Summary of Economic Projections”
Monetary Policy Report to the Congress
Summary of Economic Projections
In conjunction withthe January 24–25, 2012,
FederalOpenMarket Committee(FOMC)
meeting, themembersof the Board of
Governorsand thepresidentsof the Federal
ReserveBanks, all of whom participatein thedeliberationsoftheFOMC,
submittedprojectionsfor growth of real output, theunemployment rate,
and inflation for theyears 2012to 2014and over the longer run.
Theeconomicprojectionswerebased on informationavailableat the
timeof the meeting and participants’individual assumptionsabout
Basel iii ComplianceProfessionalsAssociation (BiiiCPA)
www.basel-iii-association.com

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factorslikelytoaffecteconomicoutcomes,includingtheirassessmentsof
appropriatemonetarypolicy.
Startingwiththe Januarymeeting, participantsalsosubmitted their
assessmentsof thepath for thetarget federal fundsrate that theyviewed
asappropriateand compatiblewiththeir individual economic
projections.
Longer-run projectionsrepresent each participants’assessment of the
rate to whicheachvariable wouldbe expectedto con-verge over time
under appropriate monetary policyand in the absenceof further shocks.
“Appropriatemonetary policy” is defined asthe future path of policy that
participantsdeem most likely tofoster outcomesfor economic activity
andinflationthat bestsatisfytheir individual interpretationof theFederal
Reserve’sobjectivesof maximum employment and stableprices.
As depicted in figure1, FOMC participantsprojectedcontinued
economicexpansion over the 2012–14period, withreal grossdomestic
product (GDP) risingat a modest rate this year and then strengthening
further through 2014.

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Participantsgenerallyanticipated onlya small declinein the
unemployment rate thisyear.
In 2013and 2014,thepace of theexpansion wasprojected to exceed
participants’estimatesof the longer-runsustainablerateof increasein
real GDP by enough to result in a gradual further declinein the
unemployment rate.
However, at the end of 2014,participantsgenerallyexpected that the
unemployment rate wouldstill be well above their estimatesof the
longer-run normal unemployment ratethat they currentlyview as
consistent withthe FOMC’sstatutory mandatefor promoting maximum
employment and pricestability.
Participantsviewedtheupwardpressuresoninflationin 2011from factors
such assupplychain disruptionsand risingcommodity pricesashaving
waned, and theyanticipatedthat inflation wouldfall back in 2012.
Over theprojectionperiod, most participantsexpected inflation, as
measured by the annual changein theprice index for personal
consumption expenditures(PCE), to be atorbelowtheFOMC’s objective
of2percent that wasexpressedin theCommittee’sstatement of longer-
run goalsand policy strategy.

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Core inflationwasprojectedto run at about thesame rate asoverall
inflation.
As indicatedin table1, relativeto their previousprojectionsin November
2011, participantsmadesmall downwardrevisionstotheir expectationsfor
therateof increasein real GDP in 2012and 2013,but theydid not
materiallyalter their projectionsfor a noticeablystronger paceof
expansion by 2014.
With the unemployment rate havingdeclined in recent monthsby more
than participantshad anticipatedin thepreviousSummary of Economic
Projections(SEP), theygenerallyloweredtheir forecastsfor the level of
theunemployment rate over the next twoyears.
Participants’expectationsfor both the longer-run rate of increasein real
GDP and the longer-run unemployment rate werelittlechanged from
November.
Theydid not significantlyalter their forecastsfor the rateof inflationover
thenext threeyears.
However,in light of the 2percent inflationthat is the objectiveincluded
in thestatement of longer-run goalsand policy strategy adoptedat the
January meeting, the rangeand central tendencyof their projectionsof
longer-run inflationwereall equal to 2 percent.
As shown in figure 2, most participantsjudged that highly
accommodativemonetary policywaslikelyto bewarrantedover coming
years to promote a stronger economicexpansion in thecontext of price
stability.
In particular, withthe unemployment rate projectedto remain elevated
over theprojection period and inflation expectedtobe subdued, six
participantsanticipatedthat, under appropriate monetary policy, the first
increasein the target federal fundsrate wouldoccur after 2014,and five
expectedpolicy firmingto commenceduring 2014(theupper panel).

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Theremainingsix participantsjudged that raisingthe federalfundsrate
soonerwouldbe required to forestall inflationarypressuresor avoid
distortionsin the financial system.
As indicatedin the lowerpanel, all of theindividual assessmentsof the
appropriatetarget federal fundsrate over thenext several years were
below the longer-run level of the federal fundsrate, and 11participants
placedthetarget federalfundsrateat 1percent or lowerat theendof2014.
Most participantsindicated that theyexpected that thenormalization of
theFederalReserve’sbalancesheetshouldoccur in awayconsistent with
theprinciplesagreed on at the June2011meetingof the FOMC, withthe
timingof adjustmentsdependent on theexpecteddateof thefirst policy
tightening.
Afew participantsjudgedthat, given their current assessmentsof the
economicoutlook, appropriate policywouldincludeadditional asset
purchasesin 2012,and one assumed anearlyendingof thematurity
extensionprogram.
Asizablemajorityof participantscontinuedto judgethe level of
uncertaintyassociatedwiththeir projectionsfor real activityand the
unemployment rate asunusuallyhigh relativeto historical norms.
Many alsoattached a greater-than-normal level of uncertaintyto their
forecastsfor inflation, but, compared withthe November SEP, two
additional participantsviewed uncertaintyasbroadlysimilar to
longer-run norms.
As in November, many participantssawdownsiderisks attendingtheir
forecastsof real GDP growthand upsiderisks to their forecastsof the
unemployment rate; most participantsviewedthe riskstotheir inflation
projectionsasbroadlybalanced.

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TheOutlook for Economic Activity
Thecentral tendencyof participants’forecastsfor thechangein realGDP
in 2012was2.2 to2.7percent.
This forecast for 2012, while slightly lower than the projection prepared in
November, would represent a pickup in output growth from 2011 to a rate
closeto itslonger-run trend.
Participantsstated that the economic informationreceivedsince
November showedcontinued gradual improvement in thepaceof
economicactivityduring the second half of 2011, asthe influenceof the
temporaryfactorsthat damped activityin thefirst half of the year
subsided.
Consumer spendingincreasedat a moderate rate, exports expanded
solidly, and businessinvestment rosefurther.
Recently, consumersand businessesappeared to become somewhat
more optimistic about the outlook.
Financial conditionsfor domesticnonfinancialbusinessesweregenerally
favorable, and conditionsin consumer credit marketsshowedsignsof
improvement.
However,a number of factorssuggestedthat the paceof theexpansion
wouldcontinue to be restrained.
Although some indicators of activity in the housing sector improved
slightly at the end of 2011, new homebuilding and sales remained at
depressed levels, house priceswere still falling, and mortgage credit
remainedtight.
Households’realdisposableincomeroseonlymodestlythroughlate 2011.

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In addition, federal spendingcontracted towardyear-end, and the
restrainingeffectsoffiscalconsolidationappearedlikelytobegreaterthis
year than anticipatedat thetime of the November projections.
Participantsalsoread the information on economic activityabroad,
particularlyin Europe, aspointing to weakerdemand for U.S.exports
in comingquarters thanhadseemed likelywhenthey prepared their
forecastsin November.
Participantsanticipatedthat the paceof theeconomic expansion would
strengthenoverthe2013–14period, reachingratesof increasein realGDP
abovetheir estimatesof the longer-runratesof output growth.
Thecentral tendenciesof participants’forecastsfor the changein real
GDP were2.8 to3.2percent in 2013and 3.3to 4.0 percent in 2014.
Among the considerationssupportingtheir forecasts, participantscited
their expectationthat the expansion wouldbe supported by monetary
policy accommodation, ongoing improvementsin credit conditions,
risinghousehold and businessconfidence,and strengtheninghousehold
balancesheets.
Many participantsjudgedthat U.S.fiscal policy would still be a drag on
economicactivityin 2013,but many anticipatedthat progresswouldbe
madein resolving the fiscal situationin Europe and that theforeign
economicoutlookwouldbe more positive.
Over time and in theabsenceof shocks,participantsexpected that the
rate of increaseof real GDP would converge to their estimatesof its
longer-run rate, witha central tendencyof 2.3 to2.6percent, little
changedfrom their estimatesin November.
Theunemployment rate improved more in late 2011than most
participantshad anticipatedwhenthey prepared their November
projections,fallingfrom 9.1to8.7percent betweenthethird and fourth
quarters.

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As a result, most participantsadjusted downtheir projectionsfor the
unemployment rate thisyear.
Nonetheless,withreal GDP expectedtoincreaseat amodest rate in 2012,
theunemployment rate wasprojected to declineonlya littlethis year, with
thecentral tendencyof participants’forecastsat 8.2 to8.5percent at year-
end.
Thereafter, participantsexpected that the pickup in the paceof the
expansion in 2013and 2014wouldbe accompaniedby a furthergradual
improvement in labor market conditions.
The central tendency of participants’ forecasts for the unemployment rate
at the end of 2013was7.4 to8.1 percent, and it was6.7 to 7.6 percent at the
end of 2014.
Thecentral tendencyof participants’estimatesof the longer-run normal
rate of unemployment that would prevail in theabsence of further shocks
was5.2 to6.0 percent.
Most participantsindicated that theyanticipatedthat five or six years
wouldbe required toclosethe gap betweenthe current unemployment
rate and their estimatesof thelonger-runrate, although some noted that
more time wouldlikely be needed.
Figures 3.Aand 3.B providedetails on the diversity of participants’views
regardingthe likelyoutcomesfor real GDP growthand the
unemployment rate over thenext three years and over thelonger run.
Thedispersion in theseprojectionsreflected differencesin participants’
assessmentsof many factors, includingappropriatemonetary policy and
itseffectson economicactivity, theunderlying momentum in economic
activity, theeffectsof theEuropeansituation, theprospectivepathforU.S.
fiscalpolicy, thelikelyevolutionof credit andfinancialmarket conditions,
andtheextent of structuraldislocationsin the labor market.

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Compared withtheir November projections, the rangeof participants’
forecastsfor the changein real GDP in 2012narrowedsomewhat and
shiftedslightlylower, assome participantsreassessed theoutlook for
global economic growth and for U.S. fiscal policy.
Many, however,made nomaterial changeto their forecastsfor growthof
real GDP this year.
Thedispersion of participants’forecastsfor output growthin 2013and
2014remained relativelywide.
Having incorporated thedata showinga lowerrate of unemployment at
theend of 2011than previouslyexpected, thedistribution of participants’
projectionsfor the end of 2012shifted noticeablydownrelativeto the
November forecasts.
Therangesfor theunemployment rate in 2013and 2014showedless
pronouncedshiftstowardlowerratesand, aswasthecasewiththeranges
for output growth, remained wide.
Participantsmade onlymodest adjustmentsto their projectionsof the
ratesof output growthand unemployment over thelonger run, and, on
net, thedispersionsof their projectionsfor both werelittlechangedfrom
thosereported in November.
Thedispersion of estimatesfor the longer-run rateof output growthis
narrow,withonlyone participant’sestimate outside of a range of 2.2to
2.7 percent.
By comparison, participants’viewsabout the level towhichthe
unemployment rate wouldconverge in the long run aremore diverse,
reflecting, among other things,different viewson the outlookfor labor
supplyand on theextent of structural impedimentsin the labor market.

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BIS Quarterly Review, March 2012
International banking and financial market developments
European bank funding and deleveraging
Asset pricesbroadlyrecoveredsome of their previouslossesbetween
earlyDecember and the end of February, asthe severityof the euroarea
sovereign and bankingcriseseased somewhat.
Equitypricesrose byalmost 10% on average in developed countries and
bya littlemore in emerging markets.
Bank equitypricesincreasedparticularlysharply.
Gains in credit marketsreflectedthe same pattern.
Central to these developmentswas an easing of fears that funding strains
and other pressures on European banks to deleverage could lead to forced
asset sales,contractionsin credit and weakereconomicactivity.
This article focuseson developmentsin European bank funding
conditionsand deleveraging, documentingtheir impact to date on
financial marketsand the global economy.
Fundingconditionsat Europeanbanksimprovedfollowingspecialpolicy
measuresintroduced by central banks around thebeginningof December.
Before that time, many bankshad been unabletoraiseunsecured funds
in bond marketsand the cost of short-term funding had risen to levels
onlypreviouslyexceeded during the2008banking crisis.

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Dollarfundinghadbecome especiallyexpensive.
TheECB then announcedthat it would lend eurosto banksfor three
years against a wider set of collateral.
Furthermore,thecost of swappingeurosintodollarsfell around thesame
time, ascentral banksreduced the priceof their international swaplines.
Short-term borrowingcoststhen declined and unsecured bond issuance
revived.
At theirpeak,bank fundingstrainsexacerbatedfearsofforcedasset sales,
credit cutsand weakereconomicactivity.
New regulatory requirementsfor major European banksto raisetheir
capital ratiosbymid-2012added to thesefears.
European banks did sell certain assetsand cut some types of lending,
notably those denominated in dollars and those attracting higher risk
weights,in late2011and early2012.
However,therewaslittleevidencethat actualorprospectivesaleslowered
asset prices,and overall financingvolumesheld up for most typesof
credit.
This waslargely becauseother banks, asset managersand bond market
investorstook over thebusinessof European banks, thusreducingthe
impact on economicactivity.
Bank funding pressuresand policy responses
European bank fundingconditionsdeteriorated towardsthe end of 2011,
asfalteringprospectsfor economic growth and fiscal sustainability
underminedthevalueof sovereign and other assets.

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Bond issuance by euro area banksin the second half of the year, for
example, was just a fraction of its first half value (Graph 1, left-hand
panel).
Until December, uncollateralised issuancebybanksin countries facing
significant fiscal challengeswasespeciallyweak.
Depositsalsoflowedout of banksin thesecountries,withwithdrawals
from Italyand Spain accelerating in thefinal quarter of theyear (Graph 1,
centre panel).
At this time, US moneymarket fundssignificantlyreducedtheir claims
on French banks, having alreadyeliminatedtheir exposurestoGreek,
Irish, Italian, Portugueseand Spanishinstitutions(Graph 1, right-hand
panel).
Thepricing of long- and short-term euro-denominatedbank funding
instrumentsalsodeteriorated, both in absolutetermsand relative tothat
of non-euro instruments,asdid thecost of swappingeurosintodollars
(Graph 2).

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The policy response
Around earlyDecember, central banks announced further measuresto
help tacklethese fundingstrains.
On 8December, theECB saidthat it wouldsupplybanksin theeuroarea
with asmuch three-year euro-denominatedfundingastheybid for in two
special longer-term refinancingoperations(LTROs) on 21December 2011
and 29 February 2012.
At the same time, it announced that Eurosystem central bankswould
accept a widerrangeof collateral assetsthanpreviously.
TheECB alsosaid that it wouldhalveitsreserve ratio from 18 January,
reducingthe amount that banksmust hold in the Eurosystem by around
€100billion.

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A few days earlier, six major central banks, including the ECB, the Bank
of England and the SwissNational Bank, had announced a 50 basis point
cut tothe cost of dollar fundsoffered to banksoutsidetheUnited
States.
Theyalsoextended the availability of thisfunding by six monthsto
February2013.
Euroareabanksraisedlargeamountsoffundingvia theECB’sthree-year
LTROs,covering much of their potential funding needsfrom maturing
bondsover thenext few years.
Acrossboth operations,theybid for slightlymore than €1trillion.
This wasequivalent toaround 80% of their 2012–14debt redemption,
more than coveringtheir uncollateralisedredemptions(Graph 3,
left-handpanel).

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Banks in Italyand Spain made bidsfor a largeproportionof the funds
allocatedat the first three-year LTRO (Graph 3, centrepanel), while the
fundingsituationof banksin other regionsimproved indirectly.
Banks in Germany, Luxembourg and Finland, for example, did not take
much additional fundingat thefirst LTRO.
However,some of the allottedfunds,perhapsafter a number of
transactions,endedup asdepositswith thesebanks, boostingthe
liquidityof their balancesheets.
In turn, theysignificantlyincreased their Eurosystem deposits(Graph 3,
right-hand panel).
There wasalsolittlechangein the LTRO balanceat theGreek, Irish and
Portuguesecentral banks.
However,banks in thesejurisdictionshad alreadyborroweda combined
€165billion beforeDecemberand mayhavebeenshort of collateraltouse
at the first LTRO.
Bank funding conditionsimproved followingthesecentral bank
measures.
Investorsreturned tolong-term bank debt markets,buying more
uncollateralisedbondsin January and February 2012than in the previous
five months(Graph 1,left-hand panel).
US money market fundsalsoincreasedtheir exposureto some euro area
banksin January (Graph 1, right-hand panel).
Indicatorsof thecost of long- and short-term euro-denominatedbank
fundinginstrumentsalsoturned, asdidtheforeignexchangeswapspread
for converting eurosintodollars (Graph 2).
The nexusbetween sovereign and bank funding conditions

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Fundingconditionsfor euroareasovereignsimproved in parallel tothose
of banksin December 2011and early2012.
Secondarymarket yields on Irish, ItalianandSpanish government bonds,
for example, declined steadily during thisperiod (Graph 4, left-hand
panel).
Yieldson bondswith maturitiesof up tothree years fell by more than
thoseof longer-datedbonds(Graph 4, centre panel).
At this time, thesegovernmentsalsopaid loweryieldsat a series of
auctions,despiteheavy volumesof issuance.
Onenotableexceptionto thistrend wasthe continued risein yields on
Greek government bonds.

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This reflectedcountry-specific factors,includingthe revisedterms of a
private sectordebt exchangeand tough new conditionsfor continued
official sectorlending.
Part of the decline in government bond yieldsappeared to reflect
diminishedperceptionsof sovereign credit risk.
This wasconsistent with declinesin sovereignCDSpremia.
In turn, part of the reductionin sovereign credit risk probablyreflected
improvementsin bank fundingconditions.
This could haveworkedvia twochannels.
First, any reduction in the likelihood of banksfailingbecauseof funding
shortageswouldhavecut theprobabilityof government support for these
banks.
Second, any easingof pressure on banks toshedassetswouldhave
boosted the outlookfor economic activityand, hence, public finances.
In addition, some of the improvements in perceptions of sovereign credit
risk during this period probablyreflected announcementsmade at the 8–9
December EU summit.
Theseoutlined arrangementsto strengthenfiscaldisciplinein theunion
andtobring forwardthe launch of the European StabilityMechanism.
Afurther part of the declinein yieldson government bondsappearedto
reflect the additional cash in thefinancial system availabletofinance
transactionsin theseand other securities.
Thiswasconsistent with government bond yields decliningbymore than
CDSpremia.

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Banks in Italyand Spain, for example, usednew fundstosignificantly
boost their holdingsof government bonds(Graph 4, right-hand panel).
Whileothereuroareabankswerelessactivein thisrespect, theymayhave
committed new fundsto help financepositionsin government bondsfor
other investors.
Or theymay have purchased other assetsand thesellersof thoseassets
may have investedthe resultingfundsin government bonds.
Theseimprovementsin fundingterms for euro area sovereignsfedback
intobank fundingconditions.
In particular, higher market valuesof sovereign bondsenhanced the
perceivedsolvencyof banks,whichmadethem more attractivein funding
markets.However,this link earlier workedin reverseand could potentially
do soagain.
Deleveraging prospectsand consequences
Thesharp rise in funding costsand growingconcernsover adequate
capitalisationtowardthe end of 2011addedtoexistingmarket pressures
on European bankstodeleverage.
Deleveragingispart of a necessarypost-crisisadjustment to remove
excesscapacityand restructurebalancesheets,thusrestoring the
conditionsfor a sound bankingsector.
That said, theconfluenceoffundingstrainsandsovereignrisk ledtofears
of a precipitousdeleveragingprocessthat could hurt financial markets
andthewidereconomy via asset salesand contractionsin credit.
Theextension of central bank liquidityand the European Banking
Authority’s (EBA) recommendation on bank recapitalisation, however,
played important parts in paving thewaytowardamore gradual
deleveragingprocess.

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Deleveraging prospects: capital-raising and asset-shedding
TheEuropean bank recapitalisationplan announced in October 2011
brought fearsof deleveragingtothe forefront of financial market
concerns.
It required 65major banksto attain a 9% ratioof core Tier 1capital to
risk-weightedassets(RWA) by theend of June 2012,and theauthorities
identifiedacombinedcapitalshortfall of €84.7billionat 31majorbanksas
of end-September 2011.
Banks can deleverage either by recapitalisingor by reducing RWA, with
different economicconsequences.
In order tosafeguard the flowof credit totheEU economy, supervisory
authoritiesexplicitlydiscouraged banks from shedding assets.
Banks thusplannedtomeet their shortfallspredominantlythrough
capital measures,and some madeprogressin spiteof unfavourable
market conditions.
Low shareprices,asat present, causea strong dilution effect, drawing
resistancefrom incumbent shareholdersand management.
Theexperienceof UniCredit, whosedeeplydiscounted €7.5billion rights
issueled toa 45% (albeit transient) plungein itsshareprice, deterred
other banks from followingsuit.
Capital can alsobe built through retained earnings,debt-toequity
conversion or redemptionbelow par.
Somebanks opted toconvert outstandingbonds, notablySantander for
€6.83 billion. Overall, banks plan torely substantiallyon additionsto
capital and retained earningsto reachthe9% target ratio.

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Theactionsand plansof EBA banks thushelped to easemarket fearsover
potentialsheddingof assetsamongbankswithcapitalshortfalls(see
below).
Theextent of asset-sheddingobserved inmarketsreflectsabroadertrend
amongEuropean banks towardsdeleveragingover the medium term.
French and Spanish banks,for instance, solddollar-fundedassetsand
divestedforeign operationspartly to focustheir businessmodels on core
activities.
MajorUK banks,similarly, continued toshrink their balancesheets,
although none had tomeet any EBA capital shortfall.
In view of recurring funding pressures and changing business models,
many banks, with or without EBA capital shortfalls plan to extend the
ongoing trend of shedding assets.
Industryestimatesof overall assetdisposalsby European banks over the
comingyears thusrange from €0.5trillion to asmuch as€3 trillion.
Theextension of central bank liquidityeased the paceof asset-shedding
observed in late2011, but did not turn theunderlying trend.
If the banks in the EBA sample, for instance, failed toroll over their
seniorunsecured debt maturing over a two-yearhorizon, which amounts
tomore than €1,100billion (€600billionamongbankswitha capital
shortfall), theywouldhave toshed funded assetsin equal measure.
By covering thesefunding needs, the LTROs and dollar swap lines
helped avert an accelerateddeleveragingprocess.
But manybanks continued todivest assetsin anticipationof theeventual
expirationof thesefacilities.

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Banks are alsomindful that a sustained increasein their capitalisation
wouldfacilitateboth regulatory complianceand future accessto the
seniorunsecured debt market.
Limited asset-shedding among banks under the European
recapitalisation plan
TheEuropean BankingAuthority (EBA) published itsrecommendation
relatingtothe European bank recapitalisationplan on 8 December 2011.
Thisformspart ofabroadersetofEU measuresagreedinOctober2011to
restore confidencein the banking sector.
By theend of June 2012,65banks must reach a 9% ratio of core Tier 1
capital to risk-weightedassets(RWA).
Capital will be assessednet of valuation losseson EEA sovereign
exposuresincurredby end-September 2011(“sovereignbuffer”).
The31bankslocatedin theshadedarea belowtheregulatoryline(capital
= 0.09RWA) in GraphA(left-handpanel) werebelow the9% target ratio,
asof end-September2011, by an aggregateshortfall of €84.7billion.
Theaggregate shortfall among all 71banks in theEBAsamplereaches
€114.7 billion when six Greek banks are included with an estimated
shortfall of €30 billion against the (stricter) capital targets under the
EU/IMF financial assistanceprogramme.
Theplansbankssubmitted to regulatorsin January2012suggest that the
sheddingof bank assetswill play a small part in reachingthetarget ratio.
As the exampleof bank B in the left-handpanel illustrates,bankscan
deleverageeither byrecapitalising(moving upward) or by reducing
RWA(moving leftward).

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TheEBA’s firstassessment showsthat banksintendtocover96%of their
original shortfallsbydirect capital measures,although theproposed
measuresalsosurpassthe original capital shortfall by 26%.
Plannedcapital measuresthusaccount for 77% of theoverall effort, and
comprise new capital and reserves(26%), conversion of hybridsand
issuanceof convertiblebonds(28%), and retained earnings(16%), while
theremaining23% rely on RWA reductions,notablyon internal model
changespre-agreed withregulators(9%) and on theshedding of assets
(10%), comprisingplanned RWAcutsof €39billionin loan portfoliosand
some€73billion through asset sales.
In this regard, theEuropean bank recapitalisationplan reduced, but did
not eliminate, theneed for banks withcapital shortfallsto shed assets
(GraphA, right-hand panel).
Thelikely scaleof asset-sheddingcannot be inferredreliablyfrom RWA
reductions.
However,assuminga 75% averagerisk weight on loansand that the
averagerisk weight on disposed assetsequalsthat on holdings(43%,
from averageRWAasa share of total assets,usingBloomberg data), the
plannedRWAcutsof €112billion relatingto lendingcutsand asset sales
(= €39+ €73billion) translateinto an estimated€221billionreductionin
total assets.
Someof the lendingcutsare an inevitablepart of restructuringunder
stateaid rules.
While theseamountsare sizeable, theyare an order of magnitudesmaller
than if bankshad sought toreach the target ratiowithout significant
additionsto their capital.

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Evidence of asset salesand price falls
As deleveraging pressuresgrew towardsthe end of 2011, European banks
offeredforsaleasignificant volume ofassets,notablythosewithhigh risk
weightsor market prices close to holding values (Graph 5, left-hand
panel).
Offeringswithhigh risk weightsincluded low-ratedsecuritisedassets,
distressedbondsand commercial property and other riskyloans.

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Although some suchtransactionswerecompleted, othersdid not go
throughbecausetheofferedpriceswerebelowbanks’holdingvalues.
Sellingat thesepriceswouldhave generatedlosses, thusreducingcapital
and preventing the banksfrom achievingthe intended deleveraging.
In contrast, other offeringsincluded aircraft and shippingleasesand
other assetswithsteadycashflowsand collateral backing, sincethese
often fetched facevaluesand thusavoided losses.
Moreover,asdollar funding remained more expensivethan
homecurrencyfunding for manyEuropean banks, dollar-denominated
assetswerein especiallystrong supply.
Despitethis,there is littleevidencethat actual or expectedfuture sales
significantlyaffected asset prices.
Graph 5 (centreand right-hand panels) showstime seriesof price quotes
for selected high-spreadsecuritisedassets,distressedbondsand
leveragedloans.

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True,thepriceof US leveragedloansfell andspreadsonsomesecuritised
assetsroseafter theEBA capital target announcement, consistent with
thedeleveragingimplicationsof this news.
And thepriceof distressed Lehman Brothersbondsincreased after the
reduction in the cost of dollar financingfrom central banks.
But thesechangeswerenot unusuallylargecomparedwith past price
movements.
Furthermore, someof the other price reactionsshownin thegraph were
in directionsopposite to thoseimplied bythedeleveragingnews.
That said, banksalsoofferedfor salesomeassetsthat donot haveregular
price quotes, includingpartsof their loanportfolios.
Marketparticipantsreportedgapsbetweenthebest bid andofferedprices
for some of theseassets,withlow bid pricessometimesattributed to
prospectivesuppliesof similarassetsfrom other banks.
Conclusion
Pressureson European bankstodeleverageincreasedtowardsthe end of
2011asfunding strainsintensified and regulatorsimposed new
capitalisationtargets.
Many of thesebanks shed assets, both through salesand by cutting
lending.
However,thisdid not appear toweighheavily on asset prices, nor did
overall financingfall for most typesof credit.
Thiswasbecauseotherbanks,asset managersandbond market investors
took over the businessof European banks.

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An open question is whetherother financial institutionswill be able to
substitutefor European banksasthe latter continuetodeleverage.
Thereduction in deleveragingpressuresin late 2011and early 2012,after
measuresbycentral banksmitigatedbank fundingstrains,meansat least
that this processmay run more gradually.
This should reduceanyimpact on financial marketsand economic
activity.

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From Chairman Ben S.Bernanke
At the Independent CommunityBankersofAmerica National Convention
andTechworld,Nashville,Tennessee(via prerecordedvideo)
March14, 2012
Community Banking
I'm glad to havethechancetospeak again to the Independent
CommunityBankersofAmerica, even if it'sby wayof prerecorded
remarks.
Thiswill bethefirsttimein quiteafew yearsthat I haven't beenwithyou
in person, but, asyou may know,the Federal Open Market Committee
met justyesterdayinWashington, soI am unabletojoin you in Nashville.
I havevery much enjoyed attendingtheseannual ICBAget-togethers,
especiallysinceI get the chanceto hear directlyfrom you about what's
happening in your localeconomiesand in communitybanking more
generally.
It's a tradition I hope to reestablish in thefuture.
The Role of Community Banks in a Challenging Economy
Communitybanks remain a critical component of our financial system
and our economy.
Theyhelp keep their local economiesvibrant and growingbytakingon
andmanagingthe risksof locallending, whichlarger banksmay be
unwillingor unabletodo.
Theyoften respond with greater agilitytolendingrequeststhantheir
national competitorsbecauseof their detailedknowledgeof the needsof
their customersand their closeties tothecommunitiestheyserve.
As you well know, however, community banksare alsofacingdifficult
challenges. Theirclosetiestolocaleconomiesare,onbalance, asourceof
strength, but a drawbackof thoseties isthat the fortunesof communities
andtheir banks tend to rise and fall together.

33
Another concern for community banks isthenarrowingof the rangeof
their profitablelendingactivities:Because larger bankshave used their
scaleto gain a pricingadvantage in volume-driven businessessuch as
consumer lending, communitybanks havetended to specialize in other
areas,such asloanssecured by commercial real estate.
That said, I know that communitybanksare continuingto look for ways
toprudentlydiversify their revenue sources.
Like larger banks, communitybanks arealsobeing affected by the state
of the national economy.
Despitesome recent signsof improvement, the recoveryhasbeen
frustratinglyslow,constrainingopportunities for profitablelending.
And, asI will discussmomentarily, actual and prospectivechangesin the
regulatorylandscapehave alsoraised concernsamong community
bankers.
Thegood newsis that, for the most part, communitybanks appear tobe
meetingtheir challenges.
Profitsof smallerbanks wereconsiderablyhigher in 2011than in the
previousyear, nonperformingassetswerelower,provisionsforloanlosses
fell appreciably, and capital ratiosimproved.
Outreach and Communication with Community Banks
As I noted, togetherwith economicconditions,regulation and
supervision are among the top concernsfor communitybanks.
In that regard, I think wewouldall agree that two-waycommunication
betweenregulators and communitybanksis critical.
Banks need to understand supervisors'policiesand expectations,but
supervisorsmust alsolistento and understand banks' concerns.
At the Federal Reserve, wepursueour dialoguewithcommunitybankers
through manychannels.

34
Oneimportant channel is the recentlyestablished Community
DepositoryInstitutionsAdvisory Council (CDIAC).
Thecouncil's membership is drawnfrom smallerbanks, credit unions,
and savingsassociations.
Each of the 12Reserve Banksaround thecountry hasa localadvisory
council, and one representativefrom each localcouncil serveson the
national council that meetswiththe Board in Washington twicea year.
At arecent meeting, forexample,oneofour CDIAC membersaskedusto
beclearerabout whetherparticular rules and guidanceapplyto
communitybanks.
Having heard from this banker as well as others, we are now working to
more explicitly indicate which banks will be affected when we issue new
regulatoryproposals, final rules,or regulatory guidance.
Although thischangeseemsrelativelysimple, wehope it will help banks
avoid allocatingpreciousresourcesto poring over supervisory guidance
that doesnot apply tothem.
In additiontothe advisorycouncil, the Board last year establisheda
supervision subcommitteeon smallerregional and communitybanking.
Because of their professional backgrounds in community banking and
bank supervision, I asked Governors Elizabeth Duke and Sarah Bloom
Raskin to serve on this subcommittee.
Its primary role is toimproveour understandingof community and
regional banking conditionsand toreview policy proposalsfor their
potential effect on thesafetyand soundnessof, and the regulatorycosts
imposedon, communityand regional institutions.
GovernorsDukeandRaskinarealsokeenlyinterestedin howour policies
could affect the availabilityof credit to sound borrowers.
Wehaveothercontactswithcommunitybanksthat haveprovedvaluable.
For quitea few years, the ReserveBanks have maintained local training
and outreach programsfor banks.

35
Morerecently, several of theseprogramshave been expanded nationally.
For example, theFederal Reserve Bank of St. Louisorganizesnational
"Ask the Fed" callstoprovidebankerswithan opportunitytohear
Federal Reservestaff discussrecent policy initiativesand issuesthat
examinersare encounteringin thefield.
In addition, theFederal Reserve Bank of SanFranciscohostsconsumer
compliancewebinars, and the Federal Reserve Bank of Philadelphia
publishesaquarterlyoverview of consumer complianceissuesthat allows
Federal Reserve staff toaddressquestionsfrom banks.
We are exploring optionsfor building on these initiatives. It is critical to
keep the communications channels open if supervisors and banks are to
worktogether constructively.
The Regulation and Supervision of Community Banks
Bank supervision requiresa delicatebalance--particularlynow.
Theweakeconomy, togetherwithlooselendingstandardsin thepast, has
put pressure ontheentire bankingindustry, includingcommunitybanks.
Toprotect banksfrom newproblemsdowntheroad,and tosafeguardthe
Deposit InsuranceFund, supervisorsmust insist on high standardsfor
lending, risk management, and governance.
At thesametime, it isimportant for banks,for their communities, and for
thenational economy that banks lend tocreditworthyborrowers.
Lending tocreditworthyborrowers,after all, is how banks earn profits.
We alsoknow that supervision imposescostson institutions,and we
recognizethat newregulationsandsupervisoryrequirementsmayimpose
disproportionatecostson community banks.
Thus, wetake quiteseriouslythe importanceof evaluatingthe costsand
benefitsof new rules.
Supervisionis conductedthrough theFederal Reserve's decentralized
structure of 12regional Reserve Banks, whichhelps ustailor our

36
examinationsand supervisionto the size, complexity, risk profile, and
businessmodel of each institution.
Communitybankerstell usrepeatedlythat theyare concerned about the
changingregulatory environment.
Oneparticular worryis the implementationof the Dodd-Frank Wall
Street Reform and Consumer ProtectionAct (Dodd-Frank Act).
It is important to emphasizethat the Congressenacted theDodd-Frank
Act largely in responsetothe"too big tofail" problem, and that most of
itsprovisions--regarding, for example, capital, liquidity, and risk
management--applyonly, or principally, tothe largest, most complex,
and internationallyactivebanks.
Thesenew standardsare not meant toapply to, and clearlywouldnot be
appropriatefor, community banks.
We will workto maintain a clear distinction betweencommunitybanks
and larger institutionsin the application of new regulations.
Conclusion
Toconclude, I wouldlike to reemphasizetheimportancethat my
colleagueson theBoard andI placeontheFederalReserve's relationship
with communitybanks.
TheFed iscommittedtofair, consistent, andinformedexaminationsthat
take intoaccount thesize, complexity, and individual circumstancesof
each bank weoversee.
We will do all wecan to support the banks' safetyand soundnessand
eliminate unnecessarycosts.Despiteeconomic uncertainties,the
condition of communitybanks is improving.
That'sgood newsnot only for banks, but for their communities and the
national economy aswell. Thanks, and enjoytherest of your meetings.

37
Interesting!
Thepaper starts with the phrase:“Weaknessesin the “plumbing” of the
financial system that came tolight during thefinancial crisisof
2007-2009…”
Thepaper hasthe title:ReplumbingOur Financial System: Uneven
Progress(Preliminary, Darrell Duffie, Stanford University, March17,
2012). This paper is for a conferenceof theBoard of Governorsof the
Federal Reserve System, “Central Banking:Before, During andAfter the
Crisis” March 23-24, 2012,WashingtonD.C.
Replumbing Our Financial System: Uneven Progress
(Preliminary, Darrell Duffie, Stanford University, March 17, 2012).
This paper isfor a conferenceof the Board of Governorsof theFederal
ReserveSystem, “Central Banking:Before, During andAfter the Crisis”
March23-24, 2012,Washington D.C.
Abstract
Thefinancial crisisof 2007-2009hasspurredsignificant ongoingchanges
in the“pipesand valves” through whichcash and riskflowthroughthe
center of our financial system.

38
Theseincludeadjustmentsto the formsof lender-of-last-resort financing
from thecentral bank and changestheinfrastructurefor thewholesale
overnight financingof major dealer banks.
Significant changesin the regulation of money market fundsareunder
consideration.
TheDodd-Frank Act mandatesthecentral clearingof standardized
over-the-counterderivatives,although a pending exemption of
foreign-exchangederivativesremainstobe decided.
Thevulnerabilityof major dealerstorunsby primebrokerage clients is
alsoan issuetobe addressed.
I focus on U.S. financial plumbingand on areaswherefinancial stability
remainsa concern.
Introduction
Weaknessesin the “plumbing” of the financial system that came tolight
during thefinancial crisisof 2007-2009haveprompted reformsthat are
ongoing.
On thepath towardgreater financial stability, progresshasbeen uneven.
My objectivehereis tofocuson some weaknessesthat remain.
“Plumbing” is a common metaphor for institutional elementsof the
financial system that are fixedin theshort run and enableflowsof credit,
capital, and financial risk.
This institutional structure includessome big “valvesand pipes” that
connect central banks, dealer banks, moneymarket funds, major
institutional investors, repo clearingbanks, over-the-counter(OTC)
derivativescentral clearingparties, and exchanges.

39
Theconnectorsincludelendingfacilitiesofferedbycentral bankstoeach
other and to dealer banks, tri-partyrepoand clearingagreements, OTC
derivativesmaster swapagreements,prime-brokerageagreements,and
settlement systems arrangedthrough FedWire, CLSBank, DTC, and
other major custodiansand settlement systems.
Theinstitutional frameworkdependson regulations.Largely becauseof
changesin financial regulation, weare headingtowarda safer financial
system.
Of primary importancein this progressare improvementsin capital and
liquidityrequirementsfor regulated banks, although these arenot my
main focushere.
Improvementsin theplumbingof the financial system, however,have in
some areasbeen partial or halting.
Just asthewidereconomy dependson an effectivefinancialsystem for
transferringcredit, capital, and risk among ultimateeconomicactors, the
internaleffectivenessof the financial system dependson theproper
functioningof financial infrastructure.
At the onset of a financial crisis, institutional arrangementsthat are fixed
in theshort run determinethe scope for discretionaryaction, of both
harmful and risk-reducingtypes.
Someof thesearrangements,such ascentral-bank emergencyliquidity
facilities,are only activated during a crisis.
Plumbingelementsshould not onlybe resilient tostressessuch asthe
defaultsof interactingentities, theyshould alsobe placed and designed
soasto permit thesorts of transfersthat may be needed in acrisis.
Typical approachestofinancialriskmanagement that balancefailure risk
against away-from-failure operatingefficiencyshould, in my view, be

40
fullyre-calibratedfor applicationstocertain keyfinancial market
infrastructure.
Although regulatorsare workingtowarda worldthat can more easily
toleratethe failure of largefinancial institutions,I doubt that weshould
view some of the keyfinancial infrastructurein thesame way.
Obviouslythere should be effectivefailure-management plansfor repo
clearingfacilitiesand OTC derivativescentral clearingparties(CCPs),
but the publicinterestsuggeststhat thesekindsof utilitiesshould be
designed, regulated, and managed withthe objectivethat it isextremely
difficult for them tofail catastrophically.
Theexpected spillover costsof the failureof largefinancial utilitiessuch
asthese aresignificant relativeto thecostsof saferdesigns.
Moreover,thethreat of their potential failure can lead financial market
participantsto react defensively in waysthat destabilize markets.
Consideringaswell the narrow scopefor moral hazard associatedwith
dedicatedfinancial market utilities,my view isthat wecan afford to
designand regulatesome of theseutilitiesasthough theyare “too
important tofail”.
If that is the case, the operationsand capital structureof theseutilities
should not be entangledwith thoseof larger and more complex financial
institutions,especiallyif there is an intention to let thosefinancial
institutionsfail whenevertheycannot meet their obligations.
In the courseof thisoverview, I will focuson the followingpolicy issues:
1.The emergencyplumbing availableto the Fedhaschanged.
We are now in an environment in whichthe importanceof emergency
accessto a securedlender of last resort iswidelyrecognized, but is

41
availablefor a systemically important non-bank financial institution
under a limitedand potentiallyshrinkingset of circumstances.
Eventscould some day arisein whichit wouldbedifficult for the central
bank toprovideeffectiveemergencyliquidity.
2.Giventhe systemic importanceof tri-party clearingagents,and given
their high fixed costsand additional economies of scale, tri-party repo
clearingservicesfor U.S. dealers and cash investorsshouldprobably
operatethrough a dedicated regulatedutility.
Although thiswouldlikely increaseoperating costsfor market
participants,it wouldenableinvestment in more advanced clearing
technologyand financial expertise, allowinggreater resilienceof the
tri-partyrepomarket in the faceof financial shockssuch asthedefault of
a major dealer.
Themoral hazard associatedwith lendingof last resort toa dedicated
utilityis much reducedrelativeto thecaseof a financial institutionwith
a widescope of risk-takingactivities.
3.Largeinstitutional investorsin moneymarket fundsare pronetorun in
thefaceof losses.
Systemicallyimportant borrowerssuchasdealerbanksremaindependent
on short-term financingfrom money market funds, particularlythrough
tri-partyrepos.
TheSecurities and ExchangeCommission (SEC) isconsidering new
regulatoryrequirementsfor money market funds, such ascapital buffers
andredemptiongates,withthegoal ofloweringtheriskof runsbymoney
market fund investors.
Further reform of moneymarket fundsisindeed necessaryfor financial
stability.

42
Theunintendedconsequencesof the reform of money market funds,
however, may includea shift toother forms of run-pronewholesale
short-term lendingtocritical borrowers.
Closeprinciples-basedsupervision of systemically important short-term
wholesalefinancingwill alsobe needed.
4.Central clearingparties for OTC derivativesare proliferating.
Thisrisksasignificant and unnecessaryrisein counterparty exposuresas
well asthedilution of regulatory oversight acrossmany CCPs.
Competition among CCPscould involvereducedmembership
requirementsfor collateral.
Fewer CCPs, each closelysupervised, should be a goal.
Tothis end, arrangementsshould be made for the cross-jurisdictional
regulatory supervisionof CCPs wherever possible, with clearassignment
of regulatory responsibilitiesand linesof accesstocentral-bank liquidity
support.
Regulatoryminimum margin standardsshould be strong and
harmonized.
Effectiveplansfor dealingwiththe failure of a CCP are yet tobe
established, to my knowledge.
5.If it is agreedthat the central clearingof standardized OTC derivatives
is an important sourceof financial stability, there is every reasonto
includeforeign exchange(FX) derivativesin the requirement for central
clearing, or some effectivesubstitute.
It is currentlyproposedthat FX derivativesshould be exempted from
clearingand all other major new regulationsof theswapmarket, which
includecollateral standardsfor unclearedpositions,trade execution in

43
swapexecution facilities,trade recordingin swap data repositories, and
post-tradetransaction reporting.
Regulatorsabroadare likely tofollowthe lead of the United Statesin this
area.
6. Prime brokeragewasrevealedtobe an important weaklink in the
financialsystem immediatelyafterthefailureofLehmanBrothersin2008.
Rule15-c-3of theU.S.SecuritiesExchangeAct of 1934had appearedto
safelylimit the dependence of a U.S. dealer for liquidityon its
prime-brokeragebusiness. It did not.
TheUnited Kingdom had almost no regulatory standardson this
dimension.
MorganStanleysuffered a lossof liquiditydue toa suddenrun by its
prime brokeragehedge-fund clientsin both theUnited Statesand the
UnitedKingdom after the failure of Lehman Brothers.
An in-depth forensic analysisof themechanics of this run iswarranted.
The lessons learned should be published and used to revise Rule 15-c-3
and to improve the regulatory treatment of prime brokerage in London
and emerging global financial centers.

44
2 Changesin Central Bank Plumbing
Before the financial crisisof 2007-2009, central bank liquiditywas
provided to financial markets mainlythrough normal monetary
operationsconducted through primary dealers,and through limited
formsof lender-of-last-resort financing.
Thelatterincluded secured lendingthrough thediscount window to
regulated banks aswell asthepotential emergency securedlendingto
essentiallyany market participant under Section 13(3) of theFederal
ReserveAct.
TheDodd-Frank Act now restricts13(3) emergencyfinancing to a
program or facilitywith broad-basedeligibility.
Thus, individual non-bank firmscan nolonger obtain emergency
financingdirectlyfrom thecentral bank.
Becauseoftheextremestressesofthefinancialcrisis, theFederalReserve
set up a range of broad lender-of-last-resort programsand facilities,such

45
asthe PrimaryDealer Credit Facility(PDCF), the TermAuction Facility
(TAF), theMoneyMarket Investor Funding Facility (MMIFF), theAsset-
Backed Commercial Paper MoneyMarket Mutual Fund Liquidity
Facility, the Commercial Paper Funding Facility(CPFF), and theTerm
Asset-Backed Securities Loan Facility (TALF).
Theseprograms wouldpresumablyhavemet the statutory criterion, had
it applied at thetime, of “broad-basedeligibility.”
Theyplayed a crucial role in mitigatingtheseverityof the financial crisis
of 2007-2009. Versionsof thesefacilitiescould be resurrectedin a future
crisis.
In addition, asillustratedin Figure 1,in 2007theFed set up “currency
swaplines” that provideddollar liquidityto foreign central banks.
Thesecurrencyswaplinesenablea foreign central bank toprovide
lender-of-last-resortfinancingin dollars tobankswithinin itsown
jurisdiction, and in principleallowedtheFed togiveU.S. banksaccessto
foreign currencies.
Becauseof the “reserve-currency" statusof theU.S.dollar, global
financial stabilitydependson global accessto emergencysecured loans
of last resort in dollars.
With the innovation of thesecurrencycentral-bank swap lines,the U.S.
central bank hasimproved financial stability while allowingforeign
central banksto monitor and absorb thecredit risk of thebanks towhich
thedollarsultimatelyflow.
That these currencyswaplineshave been a useful addition tothe
plumbingof the financial system wasdemonstrated during the 2007-2009
crisis and more recentlyduring the Eurozone debt crisis.

46
TitleVIII of theDodd-FrankAct allowsthecentral bank toprovide
liquiditysupport tofinancial market utilitiessuch ascentral clearing
parties.
Theabilitytotake advantage of thisemergencysecured lendingto
stabilize a financial market utility(FMU) dependsin part on thedefault
management planof theFMU. Becauseof thenatureof itsbalancesheet,
a CCP may havea limitedsetsof assetstopost ascollateralto thecentral
bank by thetime of its near failure or failure.
As opposedtothe caseof a largebank, there wouldbe nolargeclassof
unsecuredcreditorstoabsorblosses.
Thecounterpartiesof a CCP are typically systemicallyimportant
themselves.
Becauseof theseconcerns, Duffe and Skeel (2012) point tothepotential
importanceof a short stayon theOTC derivativesof a CCP at its
bankruptcy, or at itsresolutionunder TitleII of the Dodd-Frank Act.
Theabilityof theFederal Reserve to provideindirect liquidityto affliates
ofregulatedbanks,suchasbroker-dealers,islimitedbysection23Aofthe
Federal ReserveAct, whichrestrictstransactionsbetweena bank and its
affliates.
Argues that during the financial crisis of 2007-2009 section 23A included
suffcient exemptive power for the Fed to provide substantial emergency
liquidity.
TheDodd-Frank Act, however, hasplacedsigniffcant additional
restrictionson “23Atransactions.”
Section 23Aand section 23B still providesomescope for exemptive
liquidityprovision, subject howevertoa findingbythe Federal Deposit
InsuranceCorporation that the exemption doesnot placetheDeposit
InsuranceFund at risk, amongother requirements.

47
In summary, if a systemicallyimportant non-bank market participant is
threatened by a liquiditycrisis,lender-of-last-resort secured financing
from theFed can now be obtained only under broad programs or
indirectlyvia thenew versionof section 23A, whichis generallymore
restrictive.
Even assuming that a broad program could be arranged quickly enough
in an emergency situation, the design of such a program places a central
bank under some stress.
Dependingonthebreathof eligibility ofsuchaprogram, thecentralbank
could be accusedof exceedingitsmandate.
If the program is aimed broadlybut few borrowersultimatelyparticipate,
thesameconcernscould be raised, whether or not theyare legitimate.
Someof the targetedmarket participantsmight hold back in the face of
concernsover stigma regardingtheir need for fundingor over the
potential for expectationsby the publicor some public officialsof
quid-pro-quobehavior by the borrower.
Among other implications,the new and more limited scope for
lender-of-last-resortfinancingtonon-banksmeritsattention giventhe
potential for new regulationssuch asthe Volcker Rule to incitethe
emergenceof large broker-dealersthat are not affliatesof bank holding
companies.
If that wereto occur, significant quantitiesof collateral wouldbe placed
further from accesstolender-of-lastresort financing.
Theseassetsmay include, for example, over-the-counter derivativesand
foreign assetsheld on the balancesheetsof U.S.banksand bank
subsidiaries.Section 23Aprovidesan exception for derivatives.

48
Of the fivemajor U.S.bank holding companies operatingOTC
derivativesdealers,J.P. Morgan, Bank ofAmerica, Goldman Sachs,
Citigroup, and MorganStanley, all but MorganStanleykeepmost of their
OTC derivativeson thebalancesheetsof the respectiveregulatedbanks.
TheEdgeAct allowsclassesof foreign assetsto be held by subsidiaries
U.S. banks, where23Arestrictionsare lessonerous.
For a broker-dealerunaffliatedwitha bank, accessto a lender of last
resortthrough transactionsallowedunder Section 23A(and its
exemptions)is irrelevant, and onlybroad programmatic emergency
lendingwouldbe available. This issuealsoelevatesthe importanceof
strongcapital and liquiditystandards for non-bank financial firms, which
donot fall under thescopeof the BaselIII process.
Toread the paper (you must read thepaper is what I mean):
http:/ / www.federalreserve.gov/ newsevents/ conferences/Duffie.pdf

49
PRESSRELEASE
22 March 2012- Meeting of the European Systemic Risk Board
TheGeneral Boardof theEuropeanSystemic RiskBoard (ESRB) heldits
fifth regular meeting.
Thecurrent situation
Sincethe lastmeetingof the General Board in December 2011, the ESRB
hasobserved signsof stabilisationin theEU economy and an
improvement in thesituation of financial markets, notablyin responseto
themeasuresadopted by central banks, the agreement on thefiscal
compact, and the progressmade in fiscal consolidationand economic
reforms in many countries.
At thesametime, anenvironment ofuncertaintyandfragilityin segments
of the EU financial system persists.
Thekey systemic risk remainsthe mutual negativefeedback loops
betweenthree main risks, namely:
(i)Persistent uncertaintieson sovereigndebt;
(ii)Pressureson bank fundingand excessiveand/ ordisorderlybank
deleveragingin some countries;and
(iii)Subdued growthprospects.It
is thereforecrucial that:
1.Countriesmake further progresstowardsrestoring sound fiscal
positionsand implementingthe structural reform agenda in order to

50
strengthentheir growthpotential, increaseemployment and enhance
competitiveness;
2. Banks strengthen their resiliencefurther – the soundnessof banks’
balancesheetsis a keyfactor in exitingfrom current dependenceon
central bank support measuresand facilitatingan appropriate provision
of credit to the economy.
Market conditionscontinuetobecharacterisedbydifficultiesin financial
intermediationacrossEU borders(includingwithinthe euroarea).
TheESRB callson all public and privateinstitutionsto undertake efforts
topreserve the integrity of the European financial system.
In this respect, theESRB supports effortsbyinternational and European
institutionsto reduce– through the so-called“ Vienna2.0Initiative” –
risksof financial fragmentationin some economiesfrom central, eastern
and south-eastern Europe, both within and outsidethe EU.
Looking ahead
Themain issueishow toensure theprovisionof credit totheeconomy in
thecurrent environment.
TheESRB hasidentified the followingareasthat might warrant
macro-prudential policy measures.
1.Sincesummer 2011, banks havestarted a deleveragingprocess.
Theongoing deleveragingcan alsobe seen asan overdue correctionof
excessiveleverageaccumulated over thepast– albeit at different speeds
acrosscountries.
At thepresent time such readjustment could be achieved without risksto
a smooth provisionof credit to theeconomy.
2.Towardstheendof 2011, banksfacedseverestrainsinfundingmarkets,
both domesticallyand internationally.

51
Central bank measures,such asthe recent LTROs, have alleviatedsuch
pressures.
Thefull extent of their impact on thecredit supplywill become clear over
time.
TheESRB will monitor lendingconditionsin theEU and standsreadyto
draw attentiontotheneed for correctiveactionsin caseclearsignsof a
credit crunch materialise.
3.Investorshaveshownuncertaintyover banks’resilience.
By providingampleliquidityand requiring banks to achievestronger
capital positions,authoritiesare puttingbanksin a position toimprove
their financial conditions.
There arefirst signsof banksreturning tomarket funding, namely by
issuingsecuredand unsecured liabilities.
Banks should usethiswindow of opportunitytofurther strengthen their
capital base(e.g. by retainingearnings) and toimplement business
modelsthat rely on private funding.
4.In a weakeconomybanksare exposed toa materialisationof credit
risk;theyshouldmake adequateprovision for this.
Banks should managetheir loan portfoliosthrough the cycle by taking
intoaccount themedium-term creditworthinessof their borrowers
without perpetuatingnon-viablecredit positions.
TheESRB intendstowork – in cooperation withthe EBA and national
supervisoryauthorities– on the lack of qualitativeand quantitative
information on forbearance.
5.In thepast, ampleliquidityconditionshave been associatedwiththe
emergenceof imbalancesin different segmentsof financial markets.
While marketsarestill recoveringtheir pre-crisisvalues,therearesignsof
a decreasein risk aversion in some selectedfinancial market segments.

52
6.Finally, it iscentral that governmentscontinuewithfiscalconsolidation
and structural reforms, the provision of crediblefirewallsagainst
contagion risk, and implementationof thefiscal compact.
This would contain the impact of further adverseshocksand limit
negative spillover.
Activity of the ESRB
Work is alsocontinuingon structural issues,such asdevelopinga sound
basisfor macro-prudential policy and instrumentsin the EU and at the
national level.
At theEU level,theESRB ismonitoring developmentsregardingrelevant
legislativeinitiativesin the EU, such asthe implementationof the Basel
III agreement in a revised Capital RequirementsDirectiveand a new
Regulation for banksand other credit institutions(the so-called“CRD4”).
TheESRB welcomesrecent progressin the legislativeprocess.
In this respect, theESRB hasbrought tothe attentionof competent
Europeaninstitutionsthefact that relevant nationalauthoritiesneedtobe
equippedwiththetoolsnecessaryfor takingearlyaction at thelocal
level – either on their owninitiativeor on therecommendation of the
ESRB, takingintoaccount reciprocity – tostem build-upsof systemic
risk associatedwith banks.
Thisshould occur within theframeworkofanEU system ofsafeguardsof
theSingle Market, towhichtheESRB is ready to contribute.
TheESRB decided todaytosend a letter totheEU legislativebodies
puttingforwarditsmacro-prudential viewson certain aspectsof the
CRD4, takingintoaccountrecent developmentsinthelegislativeprocess.
In its letter, the ESRB has identified a number of areasin whichit
considersfurther strengtheningand development of the proposalstobe
critical.

53
Such areasrelate to: thescope for macro-prudential policies,the
flexibilityfor authorities toconduct effectivemacro-prudential policies,
andthe governancearrangementsfor theuse of macro-prudential
instruments.
This letterwill be published on theESRB’s websiteonce it hasbeen
communicated to the recipients.

54
Cayman Islands– An Overview
Thethree Cayman Islands,Grand Cayman, Cayman Brac and Little
Cayman, arelocated in the westernCaribbean about 150milessouth of
Cuba, 460milessouth of Miami, Florida, and 167milesnorthwest of
Jamaica.
GeorgeTown, the
capital, is on the
westernshore of
Grand Cayman.
Grand Cayman, the
largest of the three
islands,hasan areaof about 76square milesand isapproximately 22
mileslong withan averagewidth of four miles.
Its most strikingfeature istheshallow,reef-protectedlagoon, the North
Sound, whichhasan area of about 35 squaremiles.The island is
low-lying, withthe highest point about 60 feet above sealevel.
Cayman Brac lies about 89 milesnortheast of Grand Cayman.
It is about 12 miles long withan averagewidth of 1.25miles and hasan
area of about 15 square
miles.
Its terrain is themost
spectacular of thethree
islands.
TheBluff, a massive
central limestone
outcrop, risessteadily
alongthelengthoftheislandupto140ft. abovetheseaattheeasternend.

55
LittleCayman lies fivemileswestof Cayman Brac and is approximately
tenmileslong withan average widthof just over a mile.
It hasan area of about 11square miles. Theisland islow-lyingwitha few
areason the north shore rising to 40 ft. above sealevel.
There areno riverson
anyof theislands.The
coastsare largely
protectedby offshore
reefsand in some places
bya mangrove fringe
that sometimesextends
intoinland swamps.
Geographically, theCayman Islandsis part of the Cayman Ridge, which
extendswestwardfrom Cuba. The Cayman Trench, thedeepest part of
theCaribbean at a depth of over four miles,separatesthe threesmall
islandsfrom Jamaica.
Theislandsare alsolocated onthe plate boundary betweenthe North
American and Caribbean tectonic plates.
Thetectonic platesin Cayman’s region are in continuouslateral
movement against each other.
This movement, withtheCaribbean platetravellingin an eastward
direction and the NorthAmerican plate moving west, limitsthesizeof
earthquakesand there hasnever been an event recorded of more than
magnitude7.
It is not unusual for minor tremorsto berecorded. Manyresidentsdon’t
even noticethem. However in December 2004a quake of 6.8magnitude
rocked Grand Cayman and everyone noticed. Theearthquake, short in
duration, opened some small sinkholesbut otherwisedidn’t cause any
damage.

56
Christopher Columbusfirst sighted Cayman Brac and LittleCayman on
10May 1503.On hisfourthtrip totheNewWorld, Columbuswasenroute
toHispaniola whenhis ship wasthrust westwardtoward "twovery small
and low islands,full of tortoises, aswasall the seaall about, insomuch
that theylooked like littlerocks, for whichreason these islandswere
calledLasTortugas."
A1523map show all three Islandswiththename Lagartos,meaning
alligatorsorlargelizards,but by1530thenameCaymanaswasbeingused.
It isderivedfromtheCarib Indianwordforthemarinecrocodile,whichis
now known to have lived in the Islands.
Sir Francis Drake, on his1585-86voyage, reported seeing"great serpents
calledCaymanas, like largelizards,whichare edible."
It wastheIslands' amplesupply of turtle, however, that madethem a
popular callingplacefor shipssailingtheCaribbean and in need of meat
fortheir crews. Thisbeganatrendthat eventuallydenudedlocalwatersof
theturtle, compellinglocal turtle fishermento gofurther afield toCuba
andthe MiskitoCaysin searchof their catch.
Thefirst recorded settlementswerelocatedon LittleCayman and
Cayman Brac during 1661-71.
Becauseof the depredationsof Spanish privateers,the governor of
JamaicacalledthesettlersbacktoJamaica,thoughbythistimeSpainhad
recognisedBritishpossessionof theIslandsin the1670Treatyof Madrid.
Often in breach of the treaty, British privateers roamed the area taking
their prizes, probably using the Cayman Islands to replenish stocks of
food and waterand careentheir vessels.
Thefirst royal grant of land in Grand Cayman wasmadeby thegovernor
of Jamaica in 1734.

57
It covered 3,000acresin the areabetweenProspect and North Sound.
Others followedup to1742, developing an existing settlement, which
includedthe useof slaves.
On 8 February1794,an event occurred whichgrew intoone of Cayman's
favouritelegends-- The Wreck of theTen Sail.
Aconvoy of more than 58 merchantmen sailingfrom Jamaicato England
found itselfdangerouslycloseto thereef on theeast end of Grand
Cayman.
Ten of the ships,includingHMS Convert, thenavy vessel providing
protection, foundered onthe reef. With the aid of Caymanians, the crews
andpassengersmostly survived, although some eight liveswerelost.
ThefirstcensusoftheIslandswastakenin 1802,showingapopulationon
Grand Cayman of 933, of whom 545wereslaves.Beforeslaverywas
abolishedin 1834, there wereover 950slaves ownedby 116families.
Though Cayman wasregarded asa dependency of Jamaica, thereinsof
government by that colonywerelooselyheld in the earlyyears, and a
traditiongrewofself-government, withmattersof public concerndecided
at meetingsof all free males.In 1831a legislativeassemblywas
established.
Theconstitutional relationship betweenCayman and Jamaica remained
ambiguousuntil 1863whenanactoftheBritishparliament formallymade
theCayman Islandsa dependencyof Jamaica.
When Jamaicaachievedindependencein 1962, theIslandsopted to
remain under theBritish Crown, and anadministratorappointed from
London assumed theresponsibilitiespreviouslyheld bythe governor of
Jamaica
Theconstitutioncurrentlyprovidesfor a Crown-appointedGovernor, a
LegislativeAssembly and a Cabinet.

58
Unless there are exceptional reasons, the Governor accepts the advice of
the Cabinet, which comprises three appointed official members and five
ministerselectedfrom the 15electedmembersof theAssembly.
TheGovernor hasresponsibilityfor the police, civil service, defenceand
externalaffairs but handedover thepresidencyof theLegislative
Assembly to theSpeaker in 1991.
Cayman Islands, Banking Statistics
Overview
There werea total of 234banks
under the supervision of the
BankingSupervision Division at
theend of December 2011.
Thefundamentalsof the banking
sectorremain sound and the
industryin general hasbeen
relativelyresilient in a very challengingmarket environment.
Banks continuetoconsolidateand restructure in search of cost
efficiencies,and improvementsin operational risk management and
governance.
As of September 2011,total assetswerereportedat US$1.607
trillion downfrom thesame period of thepreviousyear wheretotal assets
stood at US$1.725trillion.

59

60
TheCayman Islandsis recognised asone of thetop 10international
financial centresin the world, withover 40of the top 50banks holding
licenceshere.
Over80percent ofmorethanUS$1trillionondepositandbookedthrough
theCayman Islands,representsinter-bank bookingsbetweenonshore
banksand their Cayman Islandsbranchesor subsidiaries.
Theseinstitutionspresent a very low risk profile for money laundering.
Basel II
TheCayman IslandMonetaryAuthority (CIMA) is implementingthe
Basel II Framework.
TheBasel II Framework describesa more comprehensive measureand
minimum standard for capital adequacythat seeksto improve on the
existingBasel I rulesby aligningregulatorycapital requirementsmore
closelytotheunderlying risksthat banksface.
TheFramework isintendedtopromotea more forwardlookingapproach
tocapital supervision that encouragesbankstoidentify risksand to
develop or improvetheir ability to manage thoserisks.
Asaresult, it isintendedtobemoreflexibleandbetterabletoevolvewith
advancesin marketsand risk management practices.
Akey objectiveof therevisedFramework is topromote the adoption of
stronger risk management practicesby the banking industry.
Banks to Which Basel II Applies
The Basel II Framework applies to banks that are locally incorporated in
the Cayman Islands (Category A and B banks), all home regulated banks
and host regulated banks (subsidiaries of foreign banks), with or without
aphysical presence.
Branchesof foreign banksoperatingtheCayman Islands,will not be

61
requiredtomaintaina separatecapital requirement, and assuchwill be
excludedfrom the local Basel II requirements.
However,theseforeign banks includingtheoperationsof theCayman
Islandsbranchesmust maintain theminimum capital adequacy
requirementsasstipulatedby their home jurisdictions.
Implementation Phases
CIMA proposesto apply theBasel II Frameworkin two
phases leveraginga practical measured approach.
First Phase
Thefirst phaseof theimplementationwascompleted on December 31,
2010and comprised the followingPillar 1approaches:
• Credit Risk – Standardized
• Market Risk – Standardized
• OperationalRisk– BasicIndicatorApproach and TheStandardized
Approach
Thefirst phaseof theBaselII implementationincludesPillar 2 –
SupervisoryReview Processand Pillar 3 - Market Discipline.
Second Phase
Thesecond phaseof the CIMA BaselII implementation will be
consideredfor implementationafter 2012.
It will includeconsideringthe implementation of advanced approaches,
specificallyPillar 1– Credit Risk– Advanced Approaches (IRB),
OperationsRisk– Advanced Measurement Approaches(AMA) and
Market Risk – Internal Risk Management Models.
IndustryInput
Sincethe majority of banksimpactedbythe applicationof theBaselII
Frameworkare membersof theCayman IslandBankersAssociation

62
(CIBA), CIM Ahasestablisheda joint CIMA/CIBA Basel II Working
Committee.
Theprimary objectiveof the workingcommitteeis toprovidebanksand
CIMA a forum for consultation, discussionand agreement on BaselII
relatedissues.CIMAproposestoobtainthemajorityoffeedbackonBasel
II related issuesfrom theCIBA/CIMABasel II Working Committee.
CIMA alsoproposesto communicatedirectlywiththosebanks that are
not membersof CIBAor thosebanksthat have principal agentsthat are
not membersof CIBA.
However,thesebanks will not have thebenefit of consultationor
participationin discussionson BaselII issueswiththe majorityof
impactedbanks.
Banks wishingtoparticipatein the CIBAconsultationsand discussions
should contact CIBAdirectly.
Basel iii
This is thenext step, but wehave notimeline yet.
According to ReinaEbanks, Head of BankingSupervision, Cayman
IslandsMonetaryAuthorityat theOpeningoftheFSI & CGBSSeminar -
Regional Seminar on CapitalAdequacy & BaselIII GeorgeTown, Grand
Cayman, Cayman IslandsFebruary22-24, 2011:
“It is good that somany of our colleaguesfrom regulatorybodies in the
Caribbeanregionhaveseenthevalueof thisseminar and haveseizedthis
opportunitytoparticipate.
I alsoappreciatetheinvolvement of our localindustry partnerswhowill
serve aspresenters.
We all have experiencesto share, and by sharingthoseexperienceswe
will learnfrom each other.

63
TheCayman IslandsMonetaryAuthority believesstronglyin the
necessityand benefitsof professional training.
We have alwayssought to ensure that our ownstaff membershaveevery
opportunitytoenhancetheskillsthat are necessaryfor theAuthority to
effectivelycarryout itsrole.
Theregulatory reform packageof the BaselCommitteeaddresses
identifiedweaknessesofthepre-crisisbankingsectorandoutlinesseveral
measuresto promote a more resilient banking sector.
Theobjectiveof thereforms is to improve thebankingsector’sabilityto
absorb shocks arisingfrom financial and economicstress, thusreducing
theriskof spill over from thefinancial sector tothe real economy.
Thenew global standardsreferred toa “BaselIII” cover both
firm-specific and broader, systematic risks.At this 3day seminar our
presenterswhoare experts in their field are expectedto cover specific
aspectsof BaselIII.
Oneof thethingsyou learnquicklyasa regulator is how rapidlychanges
occurwithintoday’sfinancial systemsand how interconnectedand
interdependent theyare.
Theinternational financial crisisunderscored this forcefully, but it isnot
goingto changeit.
Productswill continuetoevolve;marketswillcontinuetochange;waysof
doing businesswill continuetobe constantlychallenged by new
innovationsdespitethe new regulationsand standardsput in place asa
result of the crisis.
However,oneof thestronglessonswhichit hastaught usasregulatorsis
that, in order tostayahead of the curve, wemust expand our knowledge
of the marketsand productsweare charged withregulating and the role
of the different jurisdictions,largeand small, that are part of theglobal
marketplace.

64
We must applythat knowledgeefficientlyin our day-to-day operations.
We must cooperateasregulatorsat theorganizational level.
We must engagein dialogue and wemust takejoint action. This
isnecessaryif weare toregulate effectively without stifling
legitimatebusinessand economic growth.”

65
TheBaseliii ComplianceProfessionalsAssociation (BiiiCPA) is the
largest associationof Basel iii Professionalsin theworld. It is a business
unit of theBasel ii ComplianceProfessionalsAssociation (BCPA), which
is alsothe largest associationof Basel ii Professionalsin theworld.
Basel III SpeakersBureau
TheBasel iii ComplianceProfessionalsAssociation (BiiiCPA) has
established the Basel III Speakers Bureau for firmsand organizations
that want toaccessthe Basel iii expertise of Certified Baseliii
Professionals(CBiiiPros).
TheBiiiCPAwill be the liaisonbetweenour certified professionalsand
theseorganizations,at nocost. We stronglybelievethat this can be a
great opportunityfor both, our certified professionalsand theorganizers.
Tolearnmore:
www.basel-iii-association.com /Basel_iii_Speakers_Bureau.html
Certified Basel iii Professional (CBiiiPro)
Distance Learning and Online Certification Program.
Theall-inclusivecost is $297
What is included in this price:
A. The official presentationsweuse in our instructor-led classes
(1426 slides)
You can find the coursesynopsis at:
www.basel-iii-association.com/ Course_Synopsis_Certified_Basel_III_Pr
ofessional.html

66
B. Up to 3 Online Exams
There is onlyone exam you need topass, in order tobecomea Certified
Basel iii Professional (CBiiiPro).
If you fail, you must studyagain theofficial presentations,but you donot
needtospendmoneytotryagain. Upto3examsareincludedintheprice.
Tolearnmore you may visit:
www.basel-iii-association.com/ Questions_About_The_Certification_An
d_The_Exams_1.pdf
www.basel-iii-association.com/ Certification_Steps_CBiiiPro.pdf
C. Personalized Certificate printed in full color.
Processing, printingand posting toyour office or home.
Tobecome a CertifiedBaseliii Professional (CBiiiPro) you must follow
thestepsdescribedat:
www.basel-iii-association.com/ Basel_III_Distance_Learning_Online_C
ertification.html

67

Basel 3 April 2012

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