Basel 3 News November 2012

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Basel iii Compliance Professionals Association (BiiiCPA)
1200 G Street NW Suite 800 Washington, DC 20005-6705 USA
Tel: 202-449-9750 Web: www.basel-iii-association.com

Dear Member,

Today we will start from the assessment
methodology for global systemically
important banks (G-SIBs) from the Basel
Committee on Banking Supervision.

BIS, A framework for dealing with domestic systemically
important banks

I. Introduction

1. The Basel Committee on Banking Supervision
(the Committee) issued the rules text on the
assessment methodology for global systemically
important banks (G-SIBs) and their additional
loss absorbency requirements in November 2011.

The G-SIB rules text was endorsed by the G20
Leaders at their November 2011 meeting.

The G20 Leaders also asked the Committee and the Financial Stability
Board to work on modalities to extend expeditiously the G-SIFI
framework to domestic systemically important banks (D-SIBs).

2. The rationale for adopting additional policy measures for G-SIBs was
based on the “negative externalities” (ie adverse side effects) created by

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systemically important banks which current regulatory policies do not
fully address.

In maximising their private benefits, individual financial institutions may
rationally choose outcomes that, from a system-wide level, are
sub-optimal because they do not take into account these externalities.

These negative externalities include the impact of the failure or
impairment of large, interconnected global financial institutions that can
send shocks through the financial system which, in turn, can harm the
real economy.

Moreover, the moral hazard costs associated with direct support and
implicit government guarantees may amplify risk-taking, reduce market
discipline, create competitive distortions, and further increase the
probability of distress in the future.

As a result, the costs associated with moral hazard add to any direct costs
of support that may be borne by taxpayers.

3. The additional requirement applied to G-SIBs, which applies over and
above the Basel III requirements that are being introduced for all
internationally-active banks, is intended to limit these cross-border
negative externalities on the global financial system and economy
associated with the most globally systemic banking institutions.

But similar externalities can apply at a domestic level.

There are many banks that are not significant from an international
perspective, but nevertheless could have an important impact on their
domestic financial system and economy compared to non-systemic
institutions.

Some of these banks may have cross-border externalities, even if the
effects are not global in nature. Similar to the case of G-SIBs, it was


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considered appropriate to review ways to address the externalities posed
by D-SIBs.

4. A D-SIB framework is best understood as taking the complementary
perspective to the G-SIB regime by focusing on the impact that the
distress or failure of banks (including by international banks) will have on
the domestic economy.

As such, it is based on the assessment conducted by the local authorities,
who are best placed to evaluate the impact of failure on the local financial
system and the local economy.

5. This point has two implications.

The first is that in order to accommodate the structural characteristics of
individual jurisdictions, the assessment and application of policy tools
should allow for an appropriate degree of national discretion.

This contrasts with the prescriptive approach in the G-SIB framework.

The second implication is that because a D-SIB framework is still
relevant for reducing cross-border externalities due to spillovers at
regional or bilateral level, the effectiveness of local authorities in
addressing risks posed by individual banks is of interest to a wider group
of countries.

A framework, therefore, should establish a minimum set of principles,
which ensures that it is complementary with the G-SIB framework,
addresses adequately cross-border externalities and promotes a
level-playing field.

6. The principles developed by the Committee for D-SIBs would allow for
appropriate national discretion to accommodate structural characteristics
of the domestic financial system, including the possibility for countries to
go beyond the minimum D-SIB framework and impose additional


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requirements based on the specific features of the country and its
domestic banking sector.

7. The principles set out in the document focus on the higher loss
absorbency (HLA) requirement for D-SIBs. The Committee would like to
emphasise that other policy tools, particularly more intensive supervision,
can also play an important role in dealing with D-SIBs.

8. The principles were developed to be applied to consolidated groups
and subsidiaries.

However, national authorities may apply them to branches in their
jurisdictions in accordance with their legal and regulatory frameworks.

9. The implementation of the principles will be combined with a strong
peer review process introduced by the Committee.
The Committee intends to add the D-SIB framework to the scope of the
Basel III regulatory consistency assessment programme.

This will help ensure that appropriate and effective frameworks for
D-SIBs are in place across different jurisdictions.

10. Given that the D-SIB framework complements the G-SIB framework,
the Committee considers that it would be appropriate if banks identified
as D-SIBs by their national authorities are required by those authorities to
comply with the principles in line with the phase-in arrangements for the
G-SIB framework, ie from January 2016.

II. The principles

11. The Committee has developed a set of principles that constitutes the
D-SIB framework.

The 12 principles can be broadly categorised into two groups:


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The first group (Principles 1 to 7) focuses mainly on the assessment
methodology for D-SIBs while the second group (Principles 8 to 12)
focuses on HLA for D-SIBs.

12. The 12 principles are set out below:

Assessment methodology
Principle 1:
National authorities should establish a methodology for assessing the
degree to which banks are systemically important in a domestic context.

Principle 2:
The assessment methodology for a D-SIB should reflect the potential
impact of, or externality imposed by, a bank’s failure.

Principle 3:
The reference system for assessing the impact of failure of a D-SIB should
be the domestic economy.

Principle 4:
Home authorities should assess banks for their degree of systemic
importance at the consolidated group level, while host authorities should
assess subsidiaries in their jurisdictions, consolidated to include any of
their own downstream subsidiaries, for their degree of systemic
importance.

Principle 5:
The impact of a D-SIB’s failure on the domestic economy should, in
principle, be assessed having regard to bank-specific factors:

(a) Size


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(b) Interconnectedness

(c) Substitutability/financial institution infrastructure (including
considerations related to the concentrated nature of the banking sector)

(d) Complexity (including the additional complexities from cross-border
activity).

In addition, national authorities can consider other measures/data that
would inform these bank-specific indicators within each of the above
factors, such as size of the domestic economy.

Principle 6:
National authorities should undertake regular assessments of the
systemic importance of the banks in their jurisdictions to ensure that their
assessment reflects the current state of the relevant financial systems and
that the interval between D-SIB assessments not be significantly longer
than the G-SIB assessment frequency.

Principle 7:
National authorities should publicly disclose information that provides an
outline of the methodology employed to assess the systemic importance
of banks in their domestic economy.

Higher loss absorbency
Principle 8:
National authorities should document the methodologies and
considerations used to calibrate the level of HLA that the framework
would require for D-SIBs in their jurisdiction.

The level of HLA calibrated for D-SIBs should be informed by
quantitative methodologies (where available) and country-specific factors
without prejudice to the use of supervisory judgement.


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Principle 9:

The HLA requirement imposed on a bank should be commensurate with
the degree of systemic importance, as identified under Principle 5.

Principle 10:
National authorities should ensure that the application of the G-SIB and
D-SIB frameworks is compatible within their jurisdictions.

Home authorities should impose HLA requirements that they calibrate at
the parent and/or consolidated level, and host authorities should impose
HLA requirements that they calibrate at the sub-consolidated/subsidiary
level.

The home authority should test that the parent bank is adequately
capitalised on a stand-alone basis, including cases in which a D-SIB HLA
requirement is applied at the subsidiary level.

Home authorities should impose the higher of either the D-SIB or G-SIB
HLA requirements in the case where the banking group has been
identified as a D-SIB in the home jurisdiction as well as a G-SIB.

Principle 11:
In cases where the subsidiary of a bank is considered to be a D-SIB by a
host authority, home and host authorities should make arrangements to
coordinate and cooperate on the appropriate HLA requirement, within
the constraints imposed by relevant laws in the host jurisdiction.

Principle 12:
The HLA requirement should be met fully by Common Equity Tier 1
(CET1). In addition, national authorities should put in place any
additional requirements and other policy measures they consider to be
appropriate to address the risks posed by a D-SIB.


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Assessment methodology
Principle 1: National authorities should establish a methodology for
assessing the degree to which banks are systemically important in a
domestic context.

Principle 2: The assessment methodology for a D-SIB should reflect
the potential impact of, or externality imposed by, a bank’s failure.
13. A starting point for the development of principles for the assessment of
D-SIBs is a requirement that all national authorities should undertake an
assessment of the degree to which banks are systemically important in a
domestic context.

The rationale for focusing on the domestic context is outlined in
paragraph 17 below.

14. Paragraph 14 of the G-SIB rules text states that “global systemic
importance should be measured in terms of the impact that a failure of a
bank can have on the global financial system and wider economy rather
than the risk that a failure can occur.
This can be thought of as a global, system-wide, loss-given-default
(LGD) concept rather than a probability of default (PD) concept.”

Consistent with the G-SIB methodology, the Committee is of the view
that D-SIBs should also be assessed in terms of the potential impact of
their failure on the relevant reference system.

One implication of this is that to the extent that D-SIB indicators are
included in any methodology, they should primarily relate to “impact of
failure” measures and not “risk of failure” measures.

Principle 3: The reference system for assessing the impact of failure
of a D-SIB should be the domestic economy.


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Principle 4: Home authorities should assess banks for their degree of
systemic importance at the consolidated group level, while host
authorities should assess subsidiaries in their jurisdictions,
consolidated to include any of their own downstream subsidiaries,
for their degree of systemic importance.
15. Two key aspects that shape the D-SIB framework and define its
relationship to the G-SIB framework relate to how it deals with two
conceptual issues with important practical implications:

• What is the reference system for the assessment of systemic impact

• What is the appropriate unit of analysis (ie the entity which is being
assessed)?

16. For the G-SIB framework, the appropriate reference system is the
global economy, given the focus on cross-border spillovers and the
negative global externalities that arise from the failure of a globally active
bank.

As such this allowed for an assessment of the banks that are systemically
important in a global context.

The unit of analysis was naturally set at the globally consolidated level of
a banking group (paragraph 89 of the G-SIB rules text states that “(t)he
assessment of the systemic importance of G-SIBs is made using data that
relate to the consolidated group”).

17. Correspondingly, a process for assessing systemic importance in a
domestic context should focus on addressing the externalities that a
bank’s failure generates at a domestic level.

Thus, the Committee is of the view that the appropriate reference system
should be the domestic economy, ie that banks would be assessed by the
national authorities for their systemic importance to that specific
jurisdiction.


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The outcome would be an assessment of banks active in the domestic
economy in terms of their systemic importance.

18. In terms of the unit of analysis, the Committee is of the view that home
authorities should consider banks from a (globally) consolidated
perspective.

This is because the activities of a bank outside the home jurisdiction can,
when the bank fails, have potential significant spillovers to the domestic
(home) economy.

Jurisdictions that are home to banking groups that engage in
cross-border activity could be impacted by the failure of the whole
banking group and not just the part of the group that undertakes
domestic activity in the home economy.

This is particularly important given the possibility that the home
government may have to fund/resolve the foreign operations in the
absence of relevant cross-border agreements.

This is in line with the concept of the G-SIB framework.

19. When it comes to the host authorities, the Committee is of the view
that they should assess foreign subsidiaries in their jurisdictions, also
consolidated to include any of their own downstream subsidiaries, some
of which may be in other jurisdictions.

For example, for a cross-border financial group headquartered in country
X, the authorities in country Y would only consider subsidiaries of the
group in country Y plus the downstream subsidiaries, some of which may
be in country Z, and their impact on the economy Y.

Thus, subsidiaries of foreign banking groups would be considered from a
local or sub-consolidated basis from the level starting in country Y.


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The scope should be based on regulatory consolidation as in the case of
the G-SIB framework.

Therefore, for the purposes of assessing D-SIBs, insurance or other
non-banking activities should only be included insofar as they are
included in the regulatory consolidation.

20. The assessment of foreign subsidiaries at the local consolidated level
also acknowledges the fact that the failure of global banking groups could
impose outsized externalities at the local (host) level when these
subsidiaries are significant elements in the local (host) banking system.

This is important since there exist several jurisdictions that are
dominated by foreign subsidiaries of internationally active banking
groups.

Principle 5: The impact of a D-SIB’s failure on the domestic
economy should, in principle, be assessed having regard to
bank-specific factors:
(a) Size;
(b) Interconnectedness;
(c) Substitutability/financial institution infrastructure (including
considerations related to the concentrated nature of the banking
sector); and
(d) Complexity (including the additional complexities from
cross-border activity).
In addition, national authorities can consider other measures/data
that would inform these bank-specific indicators within each of the
above factors, such as size of the domestic economy.
21. The G-SIB methodology identifies five broad categories of factors that
influence global systemic importance: size, cross-jurisdictional activity,
interconnectedness, substitutability/financial institution infrastructure
and complexity.


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The indicator-based approach and weighting system in the G-SIB
methodology was developed to ensure a consistent international ranking
of G-SIBs.

The Committee is of the view that this degree of detail is not warranted
for D-SIBs, given the focus is on the domestic impact of failure of a bank
and the wide ranging differences in each jurisdiction’s financial structure
hinder such international comparisons being made.

This is one of the reasons why the D-SIB framework has been developed
as a principles-based approach.

22. Consistent with this view, it is appropriate to list, at a high level, the
broad category of factors (eg size) that jurisdictions should have regard to
in assessing the impact of a D-SIB’s failure.

Among the five categories in the G-SIB framework, size,
interconnectedness, substitutability/financial institution infrastructure
and complexity are all relevant for D-SIBs as well.

Cross-jurisdictional activity, the remaining category, may not be as
directly relevant, since it measures the degree of global
(cross-jurisdictional) activity of a bank which is not the focus of the
D-SIB framework.

23. In addition, national authorities may choose to also include some
country-specific factors.

A good example is the size of a bank relative to domestic GDP.
If the size of a bank is relatively large compared to the domestic GDP, it
would make sense for the national authority of the jurisdiction to identify
it as a D-SIB whereas a same-sized bank in another jurisdiction, which is
smaller relative to the GDP of that jurisdiction, may not be identified as a
D-SIB.


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24. National authorities should have national discretion as to the
appropriate relative weights they place on these factors depending on
national circumstances.

Principle 6: National authorities should undertake regular
assessments of the systemic importance of the banks in their
jurisdictions to ensure that their assessment reflects the current state
of the relevant financial systems and that the interval between D-SIB
assessments not be significantly longer than the G-SIB assessment
frequency.
25. The list of G-SIBs (including their scores) is assessed annually, based
on updated data submitted by each participating bank, but measured
against a global sample that is largely unchanged for three years.

It is expected that the names and buckets of G-SIBs and the data used to
produce the scores will be disclosed.

26. The Committee believes it is good practice for national authorities to
undertake a regular assessment as to the systemic importance of the
banks in their financial systems.

The assessment should also be conducted if there are important
structural changes to the banking system such as, for example, a merger
of major banks.

A national authority’s assessment process and methodology will be
reviewed by the Committee’s implementation monitoring process.

27. It is also desirable that the interval of the assessments not be
significantly longer than that for G-SIBs (ie one year).
For example, a SIB could be identified as a G-SIB but also a D-SIB in the
same jurisdiction or in other host jurisdictions.

Alternatively, a G-SIB could drop from the G-SIB list and
become/continue to be a D-SIB.


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In order to keep a consistent approach in these cases, it would be sensible
to have a similar frequency of assessments for the two frameworks.

Principle 7: National authorities should publicly disclose
information that provides an outline of the methodology employed
to assess the systemic importance of banks in their domestic
economy.
28. The assessment process used needs to be clearly articulated and made
public so as to set up the appropriate incentives for banks to seek to
reduce the systemic risk they pose to the reference system.

This was the key aspect of the G-SIB framework where the assessment
methodology and the disclosure requirements of the Committee and the
banks were set out in the G-SIB rules text.

By taking these measures, the Committee sought to ensure that banks,
regulators and market participants would be able to understand how the
actions of banks could affect their systemic importance score and thereby
the required magnitude of additional loss absorbency.

The Committee believes that transparency of the assessment process for
the D-SIB framework is also important, even if it is likely to vary across
jurisdictions given differences in frameworks and policy tools used to
address the systemic importance of banks.

Higher loss absorbency
Principle 8: National authorities should document the
methodologies and considerations used to calibrate the level of HLA
that the framework would require for D-SIBs in their jurisdiction.
The level of HLA calibrated for D-SIBs should be informed by
quantitative methodologies (where available) and country-specific
factors without prejudice to the use of supervisory judgement.


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29. The purpose of an HLA requirement for D-SIBs is to reduce further
the probability of failure compared to non-systemic institutions,
reflecting the greater impact a D-SIB failure is expected to have on the
domestic financial system and economy.

30. The Committee intends to assess the implementation of the
framework by the home and host authorities for its degree of
cross-jurisdictional consistency, having regard to the differences in
national circumstances.

In order to increase the consistency in the implementation of the D-SIB
framework and to avoid situations where banks similar in terms of the
level of domestic systemic importance they pose in the same or different
jurisdictions have substantially different D-SIB frameworks applied to
them, it is important that there is sufficient documentation provided by
home and host authorities for the Committee to conduct an effective
implementation review assessment.

It is important for the application of a D-SIB HLA, at both the parent and
subsidiary level, to be based on a transparent and well articulated
assessment framework to ensure the implications of the requirements are
well understood by both the home and the host authorities.

31. The level of HLA for D-SIBs should be subject to policy judgement by
national authorities.

That said, there needs to be some form of analytical framework that
would inform policy judgements.

This was the case for the policy judgement made by the Committee on
the level of the additional loss absorbency requirement for G-SIBs.

32. The policy judgement on the level of HLA requirements should also
be guided by country-specific factors which could include the degree of
concentration in the banking sector or the size of the banking sector
relative to GDP.


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Specifically, countries that have a larger banking sector relative to GDP
are more likely to suffer larger direct economic impacts of the failure of a
D-SIB than those with smaller banking sectors.

While size-to-GDP is easy to calculate, the concentration of the banking
sector could also be considered (as a failure in a medium-sized highly
concentrated banking sector would likely create more of an impact on the
domestic economy than if it were to occur in a larger, more widely
dispersed banking sector).

33. The use of these factors in calibrating the HLA requirement would
provide justification for different intensities of policy responses across
countries for banks that are otherwise similar across the four key
bank-specific factors outlined in Principle 5.

Principle 9: The HLA requirement imposed on a bank should be
commensurate with the degree of systemic importance, as identified
under Principle 5.
34. In the G-SIB framework, G-SIBs are grouped into different categories
of systemic importance based on the score produced by the
indicator-based measurement approach.

Different additional loss absorbency requirements are applied to the
different buckets (G-SIB rules text paragraphs 52 and 73).

35. Although the D-SIB framework does not produce scores based on a
prescribed methodology as in the case of the G-SIB framework, the
Committee is of the view that the HLA requirements for D-SIBs should
also be decided based on the degree of domestic systemic importance.

This is to provide the appropriate incentives to banks which are subject to
the HLA requirements to reduce (or at least not increase) their systemic
importance over time. In the case where there are multiple D-SIB buckets
in a jurisdiction, this could imply differentiated levels of HLA between
D-SIB buckets.


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Principle 10: National authorities should ensure that the application
of the G-SIB and D-SIB frameworks is compatible within their
jurisdictions. Home authorities should impose HLA requirements
that they calibrate at the parent and/or consolidated level, and host
authorities should impose HLA requirements that they calibrate at
the sub-consolidated/subsidiary level. The home authority should
test that the parent bank is adequately capitalised on a stand-alone
basis, including cases in which a D-SIB HLA requirement is applied
at the subsidiary level. Home authorities should impose the higher
of either the D-SIB or G-SIB HLA requirements in the case where
the banking group has been identified as a D-SIB in the home
jurisdiction as well as a G-SIB.
36. National authorities, including host authorities, currently have the
capacity to set and impose capital requirements they consider appropriate
to banks within their jurisdictions.

The G-SIB rules text states that host authorities of G-SIB subsidiaries
may apply an additional loss absorbency requirement at the individual
legal entity or consolidated level within their jurisdiction.

The Committee has no intention to change this aspect of the status quo
when introducing the D-SIB framework.

An imposition of a D-SIB HLA by a host authority is no different (except
for additional transparency) from their current capacity to impose a Pillar
1 or 2 capital charge.

Therefore, the ability of the host authorities to implement a D-SIB HLA
on local subsidiaries does not raise any new home-host issues.

37. National authorities should ensure that banks with the same degree of
systemic importance in their jurisdiction, regardless of whether they are
domestic banks, subsidiaries of foreign banking groups, or subsidiaries of


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G-SIBs, are subject to the same HLA requirements, ceteris paribus.
Banks in a jurisdiction should be subject to a consistent, coherent and
non-discriminatory treatment regardless of the ownership.

The objective of the host authorities’ power to impose HLA on
subsidiaries is to bolster capital to mitigate the potential heightened
impact of the subsidiaries’ failure on the domestic economy due to their
systemic nature.

This should be maintained in cases where a bank might not be (or might
be less) systemic at home, but its subsidiary is (more) systemic in the host
jurisdiction.

38. An action by the host authorities to impose a D-SIB HLA requirement
leads to increases in capital at the subsidiary level which can be viewed as
a shift in capital from the parent bank to the subsidiary, unless it already
holds an adequate capital buffer in the host jurisdiction or the additional
capital raised by the subsidiary is from outside investors.

This could, in the case of substantial or large subsidiaries, materially
decrease the level of capital protecting the parent bank.

Under such cases, it is important that the home authority continues to
ensure there are sufficient financial resources at the parent level, for
example through a solo capital requirement.

Indeed, paragraph 23 of the Basel II rules text states “(f)urther, as one of
the principal objectives of supervision is the protection of depositors, it is
essential to ensure that capital recognised in capital adequacy measures
is readily available for those depositors.

Accordingly, supervisors should test that individual banks are adequately
capitalised on a stand-alone basis.”


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39. Within a jurisdiction, applying the D-SIB framework to both G-SIBs
and non-G-SIBs will help ensure a level playing field within the national
context.

For example, in a jurisdiction with two banks that are roughly identical in
terms of their assessed systemic nature at the domestic level, but where
one is a G-SIB and the other is not, national authorities would have the
capacity to apply the same D-SIB HLA requirement to both.

In such cases, the home authorities could face a situation where the HLA
requirement on the consolidated group will be the higher of those
prescribed by the G-SIB and D-SIB frameworks (ie the higher of either
the D-SIB or G-SIB requirement).

40. This approach is also consistent with the Committee’s standards,
which are minima rather than maxima.

It is also consistent with the G-SIB rules text that is explicit in stating that
home authorities can impose higher requirements than the G-SIB
additional loss absorbency requirement (G-SIB rules text paragraph 74).

41. The Committee is of the view that any form of double-counting should
be avoided and that the HLA requirements derived from the G-SIB and
D-SIB frameworks should not be additive.

This will ensure the overall consistency between the two frameworks and
allows the D-SIB framework to take the complementary perspective to the
G-SIB framework.

Principle 11: In cases where the subsidiary of a bank is considered to
be a D-SIB by a host authority, home and host authorities should
make arrangements to coordinate and cooperate on the appropriate
HLA requirement, within the constraints imposed by relevant laws
in the host jurisdiction.


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42. The Committee recognises that there could be some concern that host
authorities tend not to have a group-wide perspective when applying
HLA requirements to subsidiaries of foreign banking groups in their
jurisdiction.

The home authorities, on the other hand, clearly need to know D-SIB
HLA requirements on significant subsidiaries since there could be
implications for the allocation of financial resources within the banking
group.

43. In these circumstances, it is important that arrangements to
coordinate and cooperate on the appropriate HLA requirement between
home and host authorities are established and maintained, within the
constraints imposed by relevant laws in the host jurisdiction, when
formulating HLA requirements.

This is particularly important to make it possible for the home authority
to test the capital position of a parent on a stand-alone basis as mentioned
in paragraph 38 and to prevent a situation where the home authorities are
surprised by the action of the host authorities.

Home and host authorities should coordinate and cooperate with each
other on any plan to impose an HLA requirement on a subsidiary bank,
and the amount of the requirement, before taking any action.

The host authority should provide a rationale for their decision, and an
indication of the steps the bank would need to take to avoid/reduce such
a requirement.

The home and host authorities should also discuss

(i) The resolution regimes (including recovery and resolution plans) in
both jurisdictions,

(ii) Available resolution strategies and any specific resolution plan in
place for the firm, and


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(iii) The extent to which such arrangements should influence HLA
requirements.

Principle 12: The HLA requirement should be met fully by Common
Equity Tier 1 (CET1). In addition, national authorities should put in
place any additional requirements and other policy measures they
consider to be appropriate to address the risks posed by a D-SIB.
44. The additional loss absorbency requirement for G-SIBs is to be met by
CET1, as stated in the G-SIBs rules text (paragraph 87).

The Committee considered the use of CET1 to be the simplest and most
effective way to increase the going concern loss-absorbing capacity of a
bank.

HLA requirements for D-SIBs should also be fully met with CET1 to
ensure a maximum degree of consistency in terms of effective loss
absorbing capacity.

This has the benefit of facilitating direct and transparent comparability of
the application of requirements across jurisdictions, an element that is
considered desirable given the fact that most of these banks will have
cross-border operations being in direct competition with each other.

In addition, national authorities should put in place any additional
requirements and other policy measures they consider to be appropriate
to address the risks posed by a D-SIB.

45. National authorities should implement the HLA requirement through
an extension of the capital conservation buffer, maintaining the division
of the buffer into four bands of equal size (as described in paragraph 147
of the Basel III rules text).

This is in line with the treatment of the additional loss absorbency
requirement for G-SIBs.


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The HLA requirement for D-SIBs is essentially a requirement that sits on
top of the capital buffers and minimum capital requirement, with a
pre-determined set of consequences for banks that do not meet this
requirement.

46. In some jurisdictions, it is possible that Pillar 2 may need to adapt to
accommodate the existence of the HLA requirements for D-SIBs.

Specifically, it would make sense for authorities to ensure that a bank’s
Pillar 2 requirements do not require capital to be held twice for issues that
relate to the externalities associated with distress or failure of D-SIBs if
they are captured by the HLA requirement.

However, Pillar 2 will normally capture other risks that are not directly
related to these externalities of D-SIBs (eg interest rate and concentration
risks) and so capital meeting the HLA requirement should not be
permitted to be simultaneously used to meet Pillar 2 requirement that
relate to these other risks.


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Mario Draghi: Opening
statement at Deutscher
Bundestag
Speech by Mr Mario Draghi,
President of the European Central
Bank, at the discussion on
ECB policies with Members of
Parliament, Berlin

***

Dear President Lammert,

Honourable Committee Chairs,

Honourable Members of the Bundestag,

I am deeply honoured to be here today.

As President of the European Central Bank (ECB), it is a privilege for me
to come to the heart of German democracy to present our policy
responses to the challenges facing the euro area economy.

I know that central bank actions are often a topic of debate among
politicians, the media and the general public in Germany.

So I would like to thank President Lammert and all Committee Chairs
most warmly for this kind invitation – and the opportunity it gives me to
participate in that discussion.

It is rare for the ECB President to speak in a national parliament.

The ECB is accountable to the European Parliament, where we have
scheduled hearings every three months and occasional hearings on
topical matters.


24

We take these duties of accountability to the citizens of Europe and their
elected representatives very seriously.

But I am here today not only to explain the ECB’s policies. I am also here
to listen.

I am here to listen to your views on the ECB, on the euro area economy
and on the longer-term vision for Europe.

To lay the ground for our discussion, I would like to explain our view of
the current situation and the rationale for our recent monetary policy
decisions.

I will focus in particular on the Outright Monetary Transactions (OMTs)
that we formally announced in September.

Financial markets and the disruptions of monetary policy
transmission

Let me begin with the challenges facing the euro area.

We expect the economy to remain weak in the near term, also reflecting
the adjustment that many countries are undergoing in order to lay the
foundations for sustainable future prosperity.

For next year, we expect a very gradual recovery.

Euro area unemployment remains deplorably high.

In this environment, the ECB has responded by lowering its key interest
rates.

In normal times, such reductions would be passed on relatively evenly to
firms and households across the euro area.


25

But this is not what we have seen.

In some countries, the reductions were fully passed on.
In others, the rates charged on bank loans to the real economy declined
only a little, if at all.

And in a few countries, some lending rates have actually risen.

Why did this divergence happen?

Let me explain this in detail because it is so important for understanding
our policies.

A fundamental concept in central banking is what is known as “monetary
policy transmission”.

This is the way that changes in a central bank’s main interest rate are
passed via the financial system to the real economy.

In a well-functioning financial system, there is a stable relationship
between changes to central bank rates and the cost of bank loans to firms
and households.

This allows central banks to influence overall economic conditions and
maintain price stability.

But the euro area financial system has become increasingly disturbed.

There has been a severe fragmentation in the single financial market.

Bank funding costs have diverged significantly across countries.

The euro area interbank market has been effectively closed to a large
number of banks and some countries’ entire banking systems.


26

Interest rates on government bonds in some countries have risen steeply,
hurting the funding costs of domestic banks and limiting their access to
funding markets.

This has been a key factor why banks have passed on interest rates very
differently to firms and households across the euro area.
Interest rates do not have to be identical across the euro area, but it is
unacceptable if major differences arise from broken capital markets or the
perception of a euro area break-up.

The fragmentation of the single financial market has led to a
fragmentation of the single monetary policy.

And in an economy like the euro area where about three quarters of firms’
financing comes from banks, this has very severe consequences for the
real economy, investment and employment.

It meant that countries in economic difficulties could not benefit from our
low interest rates and return to health.

Instead, they were experiencing a vicious circle.

Economic growth was falling. Public finances were deteriorating.

Banks and governments were being forced to pay even higher interest
rates.

And credit and economic growth were falling further, leading to rising
unemployment and reduced consumption and investment.

A number of economies could have seen risks of deflation.

All of this meant that the outlook for the euro area economy as a whole
was increasingly fragile.


27

There were potentially negative consequences for Europe’s single
market, as access to finance was increasingly influenced by location
rather than creditworthiness and the quality of the project.

The disruption of the monetary policy transmission is something deeply
profound.

It threatens the single monetary policy and the ECB’s ability to ensure
price stability.
This was why the ECB decided that action was essential.

Restoring the proper transmission of monetary policy

So let me now turn directly to our recent policy announcements.

To decide what type of action was appropriate, we had to make two key
assessments.

First, we had to diagnose precisely why the transmission was disrupted.

And second, we had to identify the most effective policy tool to repair
those disruptions, while remaining within our mandate to preserve price
stability.

In our analysis, a main cause of disruptions in the transmission was
unfounded fears about the future of the euro area.

Some investors had become excessively influenced by imagined scenarios
of disaster.

They were therefore charging interest rates to countries they perceived to
be most vulnerable that went beyond levels warranted by economic
fundamentals and justifiable risk premia.

Clearly, it was not by chance that some countries found themselves in a
more difficult situation than others.


28

It was mainly those countries that had implemented inappropriate
economic policies in the past.

This is also why the first responsibility in this situation is for countries to
make determined reforms and convince markets that they are credible.

But many were already doing this, only for interest rates to rise even
higher.

There was an element of fear in markets’ assessments that governments,
acting alone, could not remove.

Markets were not prepared to wait for the positive effects of reforms to
emerge.

In our view, to restore the proper transmission of monetary policy, those
unfounded fears about the future of the euro area had to be removed.

And the only way to do so was to establish a fully credible backstop
against disaster scenarios.

We designed the OMTs exactly to fulfil this role and restore monetary
policy transmission in two key ways.

First, it provides for ex ante unlimited interventions in government bond
markets, focusing on bonds with a remaining maturity of up to three
years.

A lot of comments have been made about this commitment.

But we have to understand how markets work.

Interventions are designed to send a clear signal to investors that their
fears about the euro area are baseless.


29

Second, as a pre-requisite for OMTs, countries must have negotiated with
the other euro area governments a European Stability Mechanism (ESM)
programme with strict and effective conditionality.

This ensures that governments continue to correct economic weaknesses
while the ECB is active.

The involvement of the IMF, with its unparalleled track record in
monitoring adjustment programmes would be an additional safeguard.

The consequences of the ECB’s actions

So what are the likely consequences of the ECB’s actions?

Before announcing the OMT programme, we considered very carefully
the possible risks – and we designed our operations to minimise them.

But I am aware that some observers in this country remain concerned
about the potential impact of this policy.

I would therefore like to use this opportunity to go through those
concerns – one by one – and explain our views.

First, OMTs will not lead to disguised financing of governments.

We have specifically designed our interventions to avoid this.

They will take place solely on secondary markets, where bonds that have
already been issued are traded.

If interventions take place, they will involve buying government debt from
investors, not from governments.

All this is fully consistent with the Treaty’s prohibition on monetary
financing.


30

Moreover, they will focus on shorter maturities and leave room for market
discipline.

Second, OMTs will not compromise the independence of the ECB.

The ECB will continue to take all decisions related to OMTs in full
independence.

It will decide whether to intervene based on its own assessment of
monetary policy transmission and with the aim of safeguarding price
stability.

The fact that governments have to comply with conditionality will
actually protect our independence.

The ECB will not be forced to step in for a lack of policy implementation.

Third, OMTs will not create excessive risks for euro area taxpayers.

Such risks would only materialise if a country were to run unsound
policies.

This is explicitly prevented by the ESM programme.

And we have been very clear that each time a programme starts being
reviewed, we will routinely suspend operations and resume them only if
the review has been concluded positively.

This will ensure that the ECB intervenes only in countries where the
economy and public finances are on a sustainable path.

Fourth, OMTs will not lead to inflation.

We have designed our operations so that their effect on monetary
conditions will be neutral.


31

For every euro we inject, we will withdraw a euro.

In our assessment, the greater risk to price stability is currently falling
prices in some euro area countries.

In this sense, OMTs are not in contradiction to our mandate: in fact, they
are essential for ensuring we can continue to achieve it.

Moreover, we see no signs that our announcement has affected inflation
expectations.

They continue to be firmly anchored.

This is testament to our track record on price stability over the last decade
and our credible commitment to maintaining price stability.

The citizens of the euro area can be confident that we will remain
permanently alert to risks to price stability.

We have all the necessary tools at our disposal to maintain it and to
withdraw any excess liquidity in case of upward risks to price stability.

Conclusion

Let me conclude these opening remarks.

Three elements are essential for understanding the policies of the ECB:
immutable focus on price stability; acting within our mandate; and being
fully independent.

The ECB’s new measures help to ensure price stability across the euro
area.

They also contribute to improving the economic environment.


32

But completing that task of economic renewal demands continuing
action by the governments of the euro area.

It is governments that must set right their public finances.

It is governments that must reform their economies.

And it is governments that must work together effectively to establish an
institutional architecture for the euro area that best serves its citizens.

We are already moving in the right direction. Across the euro area, deficits
are being cut.

Competitiveness is being improved. Imbalances are closing.

And governments are working seriously to complete economic and
monetary union.

It is important that Europe’s leaders stay on course.

In doing so, they will be able to unlock fully the enormous potential of the
euro to improve living standards and carry forward the project of
European integration.

Thank you for your attention – and I look forward to our discussion.


33

Andreas Dombret: As goes
Ireland, so goes Europe?
Speech by Dr Andreas Dombret,
Member of the Executive Board of the
Deutsche Bundesbank, at the
Institute of International and
European Affairs, Dublin
***
1. Introduction

Ladies and Gentlemen,

Many thanks for inviting me to speak to you. I am delighted to have the
opportunity to be with you here in Dublin today.

One of the issues which the Institute of International and European
Affairs features on its website is “The Future of Europe”. And, indeed,
the future of Europe is at the centre of the current public debate.

After nearly ten very successful years, the European Monetary Union has
encountered a serious crisis.

Over the past few months, we have seen some progress in this regard: a
fiscal compact has been agreed, the ESM has come to life, there is
preliminary agreement on a European Single Supervisory Mechanism,
and – most importantly – more member states of the euro area have
embarked on broader economic reforms.

But the crisis is still not over, and progress is still too often painfully slow.

When talking about the euro, the successes, the setbacks and the way
forward, Ireland plays an important role.

As an open and flexible economy with a highly skilled work force, Ireland


34

has seized the opportunities presented by global and especially by
European economic integration.

When Ireland joined the EU in 1973, it was one of the poorer member
states.

Since then, your real per capita income has increased more than twofold
and is today among the highest in the euro area.

Ireland has benefited from several factors: low barriers in terms of
language and culture vis à vis the US and the UK have certainly helped,
but Ireland also has done a lot to raise its growth potential by improving
the skills of its labour force, lowering corporate taxes and maintaining
flexible labour and product markets.

As a result, you attracted a lot of Foreign Direct Investment and became a
remarkably open economy.

As we all know, this remarkable success story has suffered a number of
setbacks.

In the light of the crisis, some economic developments have proved
unsustainable.

The Irish real estate boom – as so many others – provided a temporary
boost at the time, but raised private debt to worrying levels – to 215 % of
GDP in 2007 – and diverted capital away from potentially more productive
uses.

Exploding unit labour costs have eroded the competitiveness of the Irish
economy, undermining the very core of its growth model so far.

But even though the last few years have been challenging, many signs
point to a silver lining.


35

There has been significant progress in reforms with the results to show for
it: on-track deficit reduction, falling unit labour costs, a positive current
account and last but not least a return to positive growth.

To sum it up: I am very much confident with regard to the Irish case.

And I am more and more convinced that we are witnessing a resurgence
that is instructive for the euro area as a whole.

The problems experienced by Ireland are by no means confined to the
“Green Island”, but are typical of what went wrong in the run-up to the
crisis.

Thus, the reforms undertaken in Ireland hold valuable lessons for the
wider monetary union.

But what exactly did go wrong at the onset of EMU?

2. The origins of the crisis

For many euro-area member states, the introduction of the euro ushered
in a new era of abundant capital.

In the case of Ireland, for instance, capital inflows amounted to about two
trillion euro between 1999 and 2008.

In principle, this is exactly what standard economic reasoning predicts:
capital was flowing from capital-rich to capital-poor economies, where
returns should be higher.

Such flows complemented limited domestic saving in capital-poor
countries and reduced their cost of capital, boosting investment and
growth.

As we all know, it did not always work that way.


36

Overblown financial sectors channeled the capital flows into
unproductive investments.

Ireland is certainly a case in point as light-touch regulation and tax
incentives encouraged the financial sector to balloon.

Overinvestment in real estate as well as in public and private
consumption failed to boost productivity.

Unit labour costs soared, competitiveness declined, and rigid labour and
product markets meant that this process gained additional momentum.

When the financial crisis broke out in 2007, the vulnerabilities became
apparent in Ireland.

Growth imploded, deficits – which were often already too high before the
crisis – exploded, and cracks in the Irish banking system started to show.

As an aside, you may recall that these cracks extended right into
Germany, where Irish subsidiaries or special investment vehicles got their
German parent companies into trouble.

Not surprisingly, investor sentiment began to shift, and also interest rates
in your country started to rise sharply, triggering a major crisis that is still
far from being resolved.

How could it all go so wrong?

Key to understanding the crisis is the euro area’s unique institutional
set-up, a set-up that easily leads to simple, but faulty analogies with other
economies.

As you are well aware the euro area pairs a common monetary policy with
17 national fiscal policies.


37

Firstly, this combination gives rise to a deficit bias, as it allows costs to be
shifted partially on to others.

If a worsening fiscal position in one country has repercussions for our
monetary union as a whole, others may step in and bail out.

And, secondly, central banks’ balance sheets can serve as a conduit for
shifting risks among national taxpayers, even if there are no explicit fiscal
transfers.

The founding fathers of the euro foresaw this risk.

Precautions were taken in the form of the prohibition of monetary
financing of government deficits, price stability as the primary objective,
the no-bail-out clause and the Stability and Growth Pact that was to give
teeth to the rules on sound public finances enshrined in the Maastricht
Treaty.

However, the fiscal rules were breached numerous times, not least by
Germany and France.

In addition, investors made hardly any distinction between the bonds of
individual member states – I leave it to you to decide whether this was
because they neglected the growing differences in the economic
fundamentals or because they never really believed that the no-bail-out
clause would hold once the going got tough.

While the provisions against unstable fiscal positions proved to be
insufficient, the institutional framework took no account of other
macroeconomic imbalances.

Risks stemming from divergences in competitiveness or exaggerations in
national real estate sectors were not considered in the design of the
European Monetary Union.


38

Hence, even countries that had impressive fiscal data before the crisis ran
into deep trouble once the enormous implicit liabilities in their banking
sectors became apparent.

Ireland, unfortunately, was one of those countries.

Assessing the Irish economy in 2007 the IMF – which I quote for
convenience, not to blame it – wrote: “Fiscal policy has been prudent,
with a medium-term fiscal objective of close to balance or surplus, in line
with Fund advice.

In the past couple [of] years, windfall property-related revenues were
saved and the fiscal stance was not procyclical, in line with Fund advice”.

However, once the risks in the financial sector materialised and the
government had to step in, Irelands fiscal position deteriorated very
quickly.

3. The way forward

To overcome the current crisis, and to prevent future crises, we have to
address these problems I have just described.

And this has to happen both nationally and at the European level.

So far, a number of steps have been taken.

At the beginning of my speech I mentioned the ESM, to which I might
add the fiscal compact and the new excessive imbalance procedure that
has been established to prevent macroeconomic developments from
diverging too much in the future.

Nevertheless, the painful task of correcting past mistakes lies mainly with
the member states.


39

In this context I wish to point to Ireland as a good example of what has to
be done and what can be achieved.

In this regard I view Ireland as a “role model of the periphery”.

I have already mentioned the decline in competitiveness that occurred
prior to the crisis.

In this respect Ireland certainly had a steep mountain to climb.

In 2008, Irish unit labour costs, as an indicator of competitiveness, were
more than 40% higher than at the launch of EMU.

Still, not least thanks to flexible labour markets, the necessary adjustment
has been swifter in Ireland than in other member states.

There was a similar experience with the bubble in the Irish real estate
market.

Your problems became apparent earlier than in other member states, with
property prices starting to fall in the last quarter of 2007.

Hence, Ireland responded earlier than other countries, and in a
determined manner, to a shock which, as of today, has cut property prices
in half.

As a result, the restructuring of the banking sector is more advanced and
costs for bank loans to firms are now lower than in countries such as Italy
or Spain.

This highlights the fact that it is sometimes better to take a big bath
rather than just a shower.

And it is better to take it as soon as possible because the water typically
gets colder as time passes by.


40

But the situation in your country also highlights something else: the
dangerous link between banks and sovereigns.

Looking to the future, this link has to be broken, or at least to be
weakened considerably, to prevent history from repeating itself.

Let me first step back and take a look at why the close link between banks
and sovereigns has proven to be so problematic and so dangerous in this
crisis.

If many banks run into trouble at the same time, possibly on account of a
large asset bubble bursting, financial stability as a whole is threatened.
The government then often has no option but to step in if it wants to
prevent a meltdown of the real economy.

But such a rescue can place a huge burden on government finances – and
no country knows that better than Ireland, where support for the financial
sector was a major factor why the debt ratio soared from 25% of GDP in
2007 to 108% in 2011.

Conversely, weak government finances can destabilise banks – directly
through their exposure to sovereign bonds, and, indirectly, through
worsening macroeconomic conditions.

That is what we are also witnessing at this very moment.

Thus, breaking the link between banks and sovereigns is vital for making
the euro area more stable.

A banking union can very well be a major step in that direction – but by
harnessing the disciplinary forces of the market, not by doing away with
them.

Core elements of a banking union therefore have to be:


41

First, a comprehensive bail-in of bank creditors, and second, an
appropriate risk-weighting of sovereign bonds.

In order to minimise the risk that bank rescues pose to government
finances, creditors have to be the first in line when it comes to bearing
banks’ losses.

Implicit guarantees have to be removed as taxpayers’ money can only be
the last resort.

By the same token, sovereign bonds need to be risk-weighted
appropriately when it comes to the adequacy of capital buffers.

Riskier bonds have to become more expensive in terms of the amount of
equity that they tie down, as is already the case for non-sovereign bonds.
This serves two purposes: On the one hand, surcharges of this kind
should translate into lower demand and, hence, into larger spreads, which
gives a disciplining signal to the respective sovereign.

And, on the other hand, banks would become more resilient in the event
of market turmoil.

Adequate risk-weighting of sovereign bonds helps to prevent fiscal
difficulties from translating directly into financial instability.

If fiscal autonomy remains with national member states, which is still the
status quo in the EU Treaties, this is crucial.

Banks have to internalise the fiscal position of sovereigns in a similar
manner as they take into account the risk of corporate bonds or loans.

Otherwise, the envisaged recapitalisation of banks via European funds
could turn out to be a backdoor for mutualising sovereign solvency risks.

I therefore believe that these two regulatory reforms – a comprehensive
bail-in of creditors as well as an adequate risk-weighting of sovereign


42

bonds – need to complement the envisaged European supervisory
mechanism.

In principle, this single European supervisor can help prevent future
crises by enforcing the same high standards irrespective of the banks’
country of origin and by taking transnational interdependencies into
account.

At the moment, it looks as though this task shall be carried out by the
European Central Bank.

This is, first of all, an expression of confidence in the competence of
central banks in general and in the ECB in particular.

But conducting monetary policy and financial supervision does not come
without risks.

If the institution responsible for ensuring the financial soundness of
banks simultaneously influences banks’ financing conditions via its
monetary policy, conflicts of interest may arise.

Besides, the resolution of banks implies intervening in property rights,
which requires democratic accountability.

If the ECB is to be tasked with supervising European banks, there will
have to be a strict separation of monetary policy and supervision.

Such a separation will be difficult from both a legal and an organisational
point of view.

In this respect, there still are questions that need to be resolved.

A banking union will contribute to financial stability, if its design
preserves sound incentives for all actors involved.


43

This holds true not only for future risks, but also for risks that have
already materialised.

Economically speaking, a banking union is basically an insurance
mechanism.

And, as with any insurance, only future losses or damages that are
unknown ex ante can be covered.

No doubt, the banking union is an important building block for a more
stable monetary union.

But, as such, it is meant to mitigate future risks and not to cover past
sins.

In this context, I fully understand that Ireland is closely following the
conditions under which euro-area member states will provide financial
assistance to Spain for the recapitalisation of its financial institutions.

One specific point is the degree of bondholders’ participation in the
Spanish restructuring process.

The Eurogroup stated in July with respect to Ireland: “Similar cases will
be treated equally, taking into account changed circumstances.”

However, as this issue is currently under discussion I prefer abstaining
from public comments.

Instead I like to share my view with you on the issue of legacy assets in
general.

Legacy assets are those risks which evolved under the responsibility of
national supervisors.

From what I have already said, it follows that these assets have to be dealt
with by the respective member states.


44

Anything else would amount to a fiscal transfer.

It may be that such fiscal transfers are desired or even deemed necessary.

But then, they should be conducted via national budgets and subject to
approval of national parliaments, rather than under the guise of a banking
union, which would then have to start under a heavy burden.

And, in the event of such transfers the proper sequencing of events is the
key.

We should not end up in a world where risks from bank balance sheets are
rapidly mutualised, while an effective single supervisory mechanism
would be slow in coming.

A banking union will therefore not be a quick fix.

But it can be an important milestone towards a more stable and prosper
monetary union and hence instrumental in regaining confidence in
the euro area.
Ireland has already come a long way in this regard, as your successful
return to the capital markets in July has shown.

Trust has been regained because Ireland has walked the talk.

And I am sure you agree: Any deviation from this climb when the
mountaintop is already in sight would be both short-sighted and costly.

More precisely, when listening to the discussion on more leniency for
Greece, I can understand that demanding similar adjustments to the Irish
programme seem tempting at first glance.

But as we have learned the hard way over the last years, trust is as easily
lost as it is hard to regain.


45

Ireland has made enormous progress in the process of regaining trust and
confidence.

Important financial market indicators are an expression of this fact. CDS
premia for the Irish sovereign have fallen continuously in 2012.

In the meantime Irish CDS premia are below those of Spain and even
Italy.

The same development can be observed for the spread over German
bunds.

All of these developments are the result of “leading by example” with
structural reforms.

Hence, I see no reason for Irish CDS changing the course, and I doubt
that this would truly be in Ireland’s best interest.

I suggest not to jeopardise what has been achieved so far.

4. Conclusion

Ladies and gentlemen,
When we talk about Europe, Ireland is such an interesting example for a
number of reasons.

First, it highlights the benefits of a unified Europe which still leaves its
member states enough room to establish their own model of success –
Ireland has certainly seized that opportunity.

But the Irish experience at the same time also illustrates some of the
things that have gone wrong in Europe over the past decade, and I have
mentioned many of them in my speech.

Nevertheless, and even more importantly, the Irish experience holds
valuable lessons on how to overcome the current crisis.


46

Of course, Ireland has not yet overcome all of its problems – every country
is different and challenges are never exactly the same.

But I believe we all can learn a great deal from the Irish way of handling
the crisis: As goes Ireland, so goes Europe.

Let me conclude my speech with the single most important and most
encouraging lesson we can draw from the Irish experience: “Yes, it can be
done”.

Thank you for your attention.


47

Goldman Sachs Group
Interesting numbers before the Basel III
deadlines

The Goldman Sachs Group, Inc. (NYSE: GS)
reported net revenues of $8.35 billion and net
earnings of $1.51 billion for the third quarter ended September 30, 2012.

Diluted earnings per common share were $2.85 compared with a diluted
loss per common share of $0.84 for the third quarter of 2011 and diluted
earnings per common share of $1.78 for the second quarter of 2012.

Annualized return on average common shareholders’ equity (ROE) was
8.6% for the third quarter of 2012 and 8.8% for the first nine months of
2012.

The firm’s global core excess liquidity was $170 billion as of September 30,
2012.

In addition, the firm’s Tier 1 capital ratio under Basel 1 was 15.0% and the
firm’s Tier 1 common ratio under Basel 1 was 13.1% as of September 30,
2012.

Capital

As of September 30, 2012, total capital was $241.57 billion, consisting of
$73.69 billion in total shareholders’ equity (common shareholders’ equity
of $68.34 billion and preferred stock of $5.35 billion) and $167.88 billion in
unsecured long-term borrowings.

Book value per common share was $140.58 and tangible book value per
common share was $129.69, both approximately 3% higher compared
with the end of the second quarter of 2012.


48

Book value and tangible book value per common share are based on
common shares outstanding, including restricted stock units granted to
employees with no future service requirements, of 486.1 million at period
end.

On September 4, 2012, The Goldman Sachs Group, Inc. (Group Inc.)
issued 5,000 shares of Perpetual Non-Cumulative Preferred Stock, Series
F (Series F Preferred Stock), for aggregate proceeds of $500 million.

During the quarter, the firm repurchased 11.8 million shares of its
common stock at an average cost per share of $106.17, for a total cost of
$1.25 billion.

The remaining share authorization under the firm’s existing repurchase
program is 34.2 million shares.

Under the regulatory capital guidelines currently applicable to bank
holding companies (Basel 1), the firm’s Tier 1 capital ratio was 15.0% and
the firm’s Tier 1 common ratio was 13.1% as of September 30, 2012, both
unchanged compared with June 30, 2012.

Other Balance Sheet and Liquidity Metrics

The firm’s global core excess liquidity was $170 billion as of September
30, 2012 and averaged $175 billion for the third quarter of 2012, compared
with an average of $174 billion for the second quarter of 2012.

Total assets were $949 billion as of September 30, 2012, unchanged
compared with June 30, 2012.

Level 3 assets were $48 billion as of September 30, 2012, compared with
$47 billion as of June 30, 2012 and represented 5.0% of total assets.


49

Basel 3

In addition, the U.S. federal bank regulatory agencies issued revised
proposals to modify their market risk regulatory capital requirements for
banking organizations in the United States that have significant trading
activities.

The modifications are designed to address the adjustments to the market
risk framework that were announced by the Basel Committee in June 2010
(Basel 2.5), as well as the prohibition on the use of credit ratings, as
required by the Dodd-Frank Act.

We expect the federal banking agencies to propose further modifications
to their capital adequacy regulations to address both Basel 3 and other
aspects of the Dodd-Frank Act, including requirements for global
systemically important banks.

Once implemented, it is likely that these changes will result in increased
capital requirements, although their full impact will not be known until
the U.S. federal bank regulatory agencies publish their final rules.

The Dodd-Frank Act also establishes a Bureau of Consumer Financial
Protection having broad authority to regulate providers of credit, payment
and other consumer financial products and services, and this Bureau has
oversight over certain of our products and services.

Management’s Discussion and Analysis

We are currently working to implement the requirements set out in the
Federal Reserve Board’s Risk-Based Capital Standards: Advanced Capital
Adequacy Framework — Basel 2, as applicable to us as a bank holding
company (Basel 2), which are based on the advanced approaches under
the Revised Framework for the International Convergence of Capital
Measurement and Capital Standards issued by the Basel Committee.


50

U.S. banking regulators have incorporated the Basel 2 framework into the
existing risk-based capital requirements by requiring that internationally
active banking organizations, such as us, adopt Basel 2, once approved to
do so by regulators.

As required by the Dodd-Frank Act, U.S. banking regulators have
adopted a rule that requires large banking organizations, upon adoption
of Basel 2, to continue to calculate risk-based capital ratios under both
Basel 1 and Basel 2.

For each of the Tier 1 and Total capital ratios, the lower of the Basel 1 and
Basel 2 ratios calculated will be used to determine whether the bank
meets its minimum risk-based capital requirements.

The U.S. federal bank regulatory agencies have issued revised proposals
to modify their market risk regulatory capital requirements for banking
organizations in the United States that have significant trading activities.

These modifications are designed to address the adjustments to Basel 2.5,
as well as the prohibition on the use of credit ratings, as required by the
Dodd-Frank Act.

Once implemented, it is likely that these changes will result in increased
capital requirements for market risk.

Additionally, the guidelines issued by the Basel Committee in December
2010 (Basel 3) revise the definition of Tier 1 capital, introduce Tier 1
common equity as a regulatory metric, set new minimum capital ratios
(including a new “capital conservation buffer,” which must be composed
exclusively of Tier 1 common equity and will be in addition to the
minimum capital ratios), introduce a Tier 1 leverage ratio within
international guidelines for the first time, and make substantial revisions
to the computation of RWAs for credit exposures.

Implementation of the new requirements is expected to take place over
the next several years.


51

Although the U.S. federal banking agencies have now issued proposed
rules that are intended to implement certain aspects of the Basel 2.5
guidelines, they have not yet addressed all aspects of those guidelines or
the Basel 3 changes.

The Basel Committee has published its final provisions for assessing the
global systemic importance of banking institutions and the range of
additional Tier 1 common equity that should be maintained by banking
institutions deemed to be globally systemically important.

The additional capital for these institutions would initially range from
1%to 2.5% of Tier 1 common equity and could be as much as 3.5% for a
bank that increases its systemic footprint (e.g., by increasing total assets).

The firm was one of 29 institutions identified by the Financial Stability
Board (established at the direction of the leaders of the Group of 20) as
globally systemically important under the Basel Committee’s
methodology.

Therefore, depending upon the manner and timing of the U.S. banking
regulators’ implementation of the Basel Committee’s methodology, we
expect that the minimum Tier 1 common ratio requirement applicable to
us will include this additional capital assessment.

The final determination of whether an institution is classified as globally
systemically important and the calculation of the required additional
capital amount is expected to be disclosed by the Basel Committee no
later than November 2014 based on data through the end of 2013.

The Dodd-Frank Act will subject us at a firmwide level to the same
leverage and risk-based capital requirements that apply to depository
institutions and directs banking regulators to impose additional capital
requirements as disclosed above.

The Federal Reserve Board is expected to adopt the new leverage and
risk-based capital regulations in 2012.


52

As a consequence of these changes, Tier 1 capital treatment for our junior
subordinated debt issued to trusts will be phased out over a three-year
period beginning on January 1, 2013.

The interaction among the Dodd-Frank Act, the Basel Committee’s
proposed changes and other proposed or announced changes from other
governmental entities and regulators adds further uncertainty to our
future capital requirements.

Internal Capital Adequacy Assessment Process

We perform an ICAAP with the objective of ensuring that the firm is
appropriately capitalized relative to the risks in our business.

As part of our ICAAP, we perform an internal risk-based capital
assessment.

This assessment incorporates market risk, credit risk and operational
risk.

Market risk is calculated by using Value-at-Risk (VaR) calculations
supplemented by risk-based add-ons which include risks related to rare
events (tail risks).

Credit risk utilizes assumptions about our counterparties’ probability of
default, the size of our losses in the event of a default and the maturity of
our counterparties’ contractual obligations to us.

Operational risk is calculated based on scenarios incorporating multiple
types of operational failures.

Backtesting is used to gauge the effectiveness of models at capturing and
measuring relevant risks.


53

We evaluate capital adequacy based on the result of our internal
risk-based capital assessment, supplemented with the results of stress
tests which measure the firm’s performance under various market
conditions.

Our goal is to hold sufficient capital, under our internal risk-based
capital framework, to ensure we remain adequately capitalized after
experiencing a severe stress event.

Our assessment of capital adequacy is viewed in tandem with our
assessment of liquidity adequacy and integrated into the overall risk
management structure, governance and policy framework of the firm.

We attribute capital usage to each of our businesses based upon our
internal risk-based capital and regulatory frameworks and manage the
levels of usage based upon the balance sheet and risk limits established.


54

Progress note on the Global LEI
Initiative

This is the third of a series of notes on
the implementation of the legal entity identifier (LEI) initiative.

Following endorsement of the FSB report and recommendations by the
G-20, the FSB LEI Implementation Group (IG) has been tasked with
taking forward the planning and development work to launch the global
LEI system by March 2013.

The IG is collaborating closely with private sector experts through a
Private Sector Preparatory Group (PSPG) of some 300 members from 25
jurisdictions across the globe.

Charter for the Regulatory Oversight Committee (ROC):
The IG has prepared a draft Charter for the Regulatory Oversight
Committee for review and endorsement by the FSB and G20.

The draft was supported by the FSB at its recent meeting in Tokyo for
submission to the early November G20 Finance Ministers and Central
Bank Governors meeting for final endorsement.

Approval of the Charter will initiate the process for the ROC to be formed.

ROC membership will be open to public authorities from across the globe
that assent to the Charter.

Authorities will also be able to apply for Observer status.

The objective is to launch the ROC as the permanent governance body for
the global LEI system in January 2013.


55

Location and legal form of the global LEI foundation:

Formation of the ROC is a necessary step for the creation of the global
LEI foundation which is the legal form for the Central Operating Unit.

The location and exact legal form of the global LEI foundation will have a
bearing on the overall governance framework for the Global LEI System.

The IG and PSPG have analysed potential locations for the foundation
and have now initiated a detailed assessment of a narrow set of potential
candidates.

The results of the assessment will facilitate the drafting of the necessary
legal documentation to establish the foundation and will be presented at
the first meeting of the ROC.

Board of Directors of the LEI foundation:
One of the first tasks for the ROC will be the appointment of the initial
Board of Directors.

PSPG members are working closely with the IG to develop criteria for
fitness, experience, regional and sectoral balance, term of office etcetera
that will support the process for nomination and selection of the first
Board and deliver a governance framework for the global LEI foundation
to help sustain the public good nature of the system.

The PSPG presented a number of initial recommendations and options
related to these criteria for the Board of Directors on 16 October; the
proposals are currently being reviewed by the IG and the final version of
the recommendations will be presented at the first meeting of the ROC.

Operational Solutions Demonstration Day:
The FSB hosted a Global LEI System Operational Solution
Demonstration Day in Basel on 15 October.


56

Thirteen presentations from across the globe were made that contained
proposals and solutions covering all or part of the proposed global LEI
system as set out in the FSB report.

Business Processes and Use Cases:
PSPG members presented an initial set of deliverables containing
business processes and use cases for the operational elements of the
global LEI system at the joint PSPG and IG meeting on 16 October.

PSPG members have already undertaken detailed work in some areas and
will expand on a strong base.

The next phase of the operational work is to build on these specification
documents, focusing on how the system can best address a number of key
issues in relation to areas such as data quality, addressing local
languages, as well as how to draw most effectively on local infrastructure
to deliver a truly global federated LEI system.

The PSPG are requested to prepare clear proposals and recommendations
by the end of the year, in order to support a successful and speedy launch
of the global LEI system.

Number allocation scheme for the global LEI system:

On 12 September, the IG requested an ‘engineering study’ from PSPG
experts to determine which scheme for the management of the issue of
identifiers best serves the purposes of the global LEI system.

Following receipt of response and discussion with private sector experts
at the 16 October PSPG meeting, the IG prepared a recommendation for
the technical specification of the LEI code structure which has been
endorsed by the FSB Plenary.


57

Annex sets out the FSB decision to adopt a ‘structured’ approach to the
number allocation scheme, whereby LOUs are assigned a unique prefix.

The FSB decision is provided now to deliver clarity and certainty to the
private sector on the approach to be taken by potential pre-LEI systems
that will facilitate the integration of such local precursor solutions into the
global LEI system.

Ownership and hierarchy data:
Addition of information on ownership and corporate hierarchies is
essential to support effective risk aggregation, which is a key objective for
the global LEI system.

The IG is developing proposals for additional reference data on the direct
and ultimate parent(s) of legal entities and on relationship (including
ownership) data more generally and will prepare initial recommendations
by the end of 2012.

The IG is working closely with the PSPG to develop the proposals.

Annex: Number Allocation Scheme for the Global LEI System -
implications for local pre-LEI Issuers and other early movers
In response to requests for early clarity and guidance on the
determination of the number allocation scheme for the management of
identifiers for the Global LEI System, the FSB Implementation Group
requested an ‘engineering study’ from the FSB LEI Private Sector
Preparatory Group (PSPG) experts to explore the advantages and
disadvantages of different schemes.

The FSB is very grateful for all of the responses and for the contributions
of members of the PSPG.

While there are a range of different schemes to manage the issue of
identifiers that fit the characteristics of the 20 digit code (including two


58

check digits) approach outlined in the ISO 17442 standard, for simplicity
those schemes can be categorised into two general groups:

- An unstructured numbering system – one where an 18 character
unique identifier fills the whole numbering spectrum;

- A structured numbering system – one where subsets of the spectrum
of possible codes are partitioned for efficient allocation according to a
structural guideline; for instance, an N digit prefix could be assigned
to each Local Operating Unit (LOU) for its exclusive use.

On the basis of the arguments presented, the FSB has concluded that a
structured number offers the best approach for the Global LEI System.

The following method is to be used:

- Characters 1-4: A four character prefix allocated uniquely to each
LOU.

- Characters 5-6: Two reserved characters set to zero.

- Characters 7-18: Entity-specific part of the code generated and
assigned by LOUs according to transparent, sound and robust
allocation policies.

- Characters 19-20: Two check digits as described in the ISO 17442
standard.

Public authorities wishing to sponsor local pre-LEI issuance that would
transition to the LEI system should ensure that new numbers are
allocated according to the above guideline.

Pre-LEI solutions wishing to transition into the Global LEI System upon
its launch shall be required to adopt the numbering scheme outlined
above no later than 30 November 2012.


59

This approach does not affect ISO 17442 compliant numbers issued prior
to that date.

Once the global LEI system is in place, pre-LEI codes issued according
to the ISO 17442 standard (and if issued after November 30, complying
with the above guideline and thus embodying an appropriate 4 digit
prefix) will be transitioned into LEIs, subject to meeting the agreed
global LEI standards, including survival rules adopted by the ROC or the
COU in the exceptional cases where entities have multiple ISO 17442
compliant pre-LEI identifiers.

The LEI will be portable within the global LEI system, implying that the
LEI code may be transferred from one LOU to another.

Each LOU should immediately transfer an LEI to a different LOU
following the request of the LEI registrant or an LOU acting on its behalf
without any financial or operational hindrance.

Each LOU must consequently have the capability to take over
responsibility for LEIs issued by other LOUs.

Given the importance to the system of ensuring high data quality,
recommendation 18 of the FSB LEI report highlighted that the LEI
system should promote the provision of accurate LEI reference data at
the local level from LEI registrants, and that self-registration should be
encouraged as a best practice for the global LEI system.

To provide force to this recommendation, the FSB has agreed that
pre-LEI services should henceforth be based on self-registration.

From November 9, all pre-LEI systems will allow self-registration only.

Authorities sponsoring pre-LEI issuers are expected to sign the ROC
Charter once it is approved by the G20.


60

The FSB welcomes the report
of the Enhanced Disclosure
Task Force

The Financial Stability Board (FSB) welcomes the publication of the
Report of the Enhanced Disclosure Task Force (EDTF) and views it as a
valuable step to improve the quality of risk disclosures.

The EDTF’s principles and
recommendations for improved bank
risk disclosures and leading disclosure
practices are designed to provide timely
information useful to investors and other
users, which together with current
regulatory developments and standard
setter recommendations can contribute,
over time, to improved market
confidence in financial institutions.

The FSB encourages banks to continue to strive to improve risk
disclosures.

The EDTF was formed in May at the initiative of the FSB.

The task force represents a unique private sector initiative – one that
brings together on a global basis, senior officials and experts from
financial institutions, investors, and audit firms – to develop
recommendations for enhancing risk disclosure practices by major banks
starting with end-year 2012 annual risk disclosures and continuing into
2013 and beyond.

1. Background

It has been five years since the beginning of the financial crisis and the
public’s trust in financial institutions has yet to be fully restored.


61

Investors today are more sensitive to the complexity and opacity of banks’
business models and credit spreads for financials remain persistently
higher than for similarly-rated corporates.

Moreover, in some markets, banks still need significant liquidity support
from the public sector.

Many banks are now trading at market values below their book values,
which is in marked contrast to the past.

Investors and other public stakeholders are demanding better access to
risk information from banks; information that is more transparent, timely
and comparable across institutions.

In response, international regulators and standard setters have taken a
range of steps to improve the quality and content of the financial
disclosures of banks, including initiatives by the Financial Stability Board
(FSB)1 in 2011 and the Senior Supervisors Group2 in 2008.

Banks have also made efforts to improve disclosures, both individually
and collectively.

This report differs in one crucial respect: it has been developed among
private sector stakeholders as a joint initiative representing both users
and preparers of financial reports.

By bringing together the perspectives of leading global banks, investors,
analysts and external auditors, this report seeks to establish a benchmark
for high-quality risk disclosures, with specific emphasis on
enhancements that can be implemented in the short term, particularly in
2012 and 2013 annual reports.

High-quality risk disclosures should be viewed as a collective public good
given the systemic importance of banks and the contingent liability they
represent for taxpayers.


Basel 3 News November 2012

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