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International Association of Risk and Compliance
Professionals (IARCP)
1200 G Street NW Suite 800 Washington, DC 20005-6705 USA
Tel: 202-449-9750 www.risk-compliance-association.com
Top 10 risk and compliance management related news stories
and world events that (for better or for worse) shaped the
week's agenda, and what is next
Dear Member,
My mother believed that there are some things that
money just cannot buy, like manners, morals and
intelligence. Well, the Basel Committee has a different
opinion. In the new paper “Guidelines - Sound
management of risks related to money laundering and
financing of terrorism” we read that sound risk
management requires the identification and analysis of money laundering
(ML) and financing of terrorism (FT) risks present within the bank and the
design and effective implementation of policies and procedures that are
commensurate with the identified risks.
In conducting a comprehensive risk assessment to evaluate ML/FT risks, a
bank should consider all the relevant inherent and residual risk factors at
the country, sectoral, bank and business relationship level, among others,
in order to determine its risk profile and the appropriate level of mitigation
to be applied.
A bank should develop a thorough understanding of the inherent ML/FT
risks present in its customer base, products, delivery channels and services
offered (including products under development or to be launched) and the
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jurisdictions within which it or its customers do business.
This understanding should be based on specific operational and transaction
data and other internal information collected by the bank as well as
external sources of information such as national risk assessments and
country reports from international organisations.
Policies and procedures for customer acceptance, due diligence and
ongoing monitoring should be designed and implemented to adequately
control those identified inherent risks.
Any resulting residual risk should be managed in line with the bank’s risk
profile established through its risk assessment.
The requirement for the board of directors to approve and oversee the
policies for risk, risk management and compliance is fully relevant in the
context of ML/FT risk.
The board of directors should have a clear understanding of ML/FT risks.
Information about ML/FT risk assessment should be communicated to the
board in a timely, complete, understandable and accurate manner so that it
is equipped to make informed decisions.
Explicit responsibility should be allocated by the board of directors
effectively taking into consideration the governance structure of the bank
for ensuring that the bank's policies and procedures are managed
effectively.
The board of directors and senior management should appoint an
appropriately qualified chief Anti- Money Laundering and Countering
Financing of Terrorism (AML/CFT) officer to have overall responsibility for
the AML/CFT function with the stature and the necessary authority within
the bank such that issues raised by this senior officer receive the necessary
attention from the board, senior management and business lines.
As a general rule and in the context of AML/CFT, the business units (eg
front office, customer- facing activity) are the first line of defence in charge
of identifying, assessing and controlling the risks of their business.
They should know and carry out the policies and procedures and be allotted
sufficient resources to do this effectively.
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The second line of defence includes the chief officer in charge of AML/CFT,
the compliance function but also human resources or technology.
The third line of defence is ensured by the internal audit function.
All banks should implement ongoing employee training programmes so
that bank staff are adequately trained to implement the bank’s AML/CFT
policies and procedures.
The timing and content of training for various sectors of staff will need to be
adapted by the bank according to their needs and the bank’s risk profile.
Training course organisation and materials should be tailored to an
employee’s specific responsibility or function to ensure that the employee
has sufficient knowledge and information to effectively implement the
bank’s AML/CFT policies and procedures.
New employees should be required to attend training as soon as possible
after being hired, for the same reasons.
Refresher training should be provided to ensure that staff are reminded of
their obligations and their knowledge and expertise are kept up to date.
Well, Aristotle believed that excellence is not an act, but a habit. Enjoy the
training and the questions from the board.
Read more at Number 1 below. Welcome to the Top 10 list.
Best Regards,
George Lekatis
President of the IARCP
General Manager, Compliance LLC
1200 G Street NW Suite 800,
Washington DC 20005, USA
Tel: (202) 449-9750
Email: [email protected]
Web: www.risk-compliance-association.com
HQ: 1220 N. Market Street Suite 804,
Wilmington DE 19801, USA
Tel: (302) 342-8828
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Guidelines - Sound management of risks related
to money laundering and financing of terrorism
Being aware of the risks incurred by banks of being used,
intentionally or unintentionally, for criminal activities,
the Basel Committee on Banking Supervision is issuing
these guidelines to describe how banks should include money laundering
(ML) and financing of terrorism (FT) risks within their overall risk
management.
The Committee has a long-standing commitment to promote the
implementation of sound Anti- Money Laundering and Countering
Financing of Terrorism (AML/CFT) policies and procedures that are critical
in protecting the safety and soundness of banks and the integrity of the
international financial system.
The Committee supports the adoption of the standards issued by the
Financial Action Task Force (FATF).
A new heart for a changing payments system
Ms Minouche Shafik, Deputy Governor for Markets and
Banking of the Bank of England, Bank of England,
London
“Sometime around 1770, just a few yards from where we are sitting tonight,
two of the commercial banks’ so-called “Walk Clerks” congregated at the
Five Bells Tavern for lunch, weary after a morning spent visiting each of
their competitors in the City of London.
They reflected disconsolately on their increasingly impossible task of
exchanging ever-rising numbers of paper cheques at each individual bank
and settling ever-larger outstanding balances.
The idea occurred to one of them that they might encourage all of their
colleagues – for each bank had such Clerks – to join them for lunch at the
Five Bells every day, where instead of their tiring morning tours they could
carry out a much speedier, more reliable exchange of cheques.”
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Embarking on a new voyage? Solvency II in
context
Text of The Insurance Institute of London Lecture by Mr Sam Woods,
Executive Director of Insurance Supervision of the Bank of England, at
Lloyd's of London, London
“The good ship Solvency II is now afloat.
It has taken a long time to make it seaworthy.
Some might question whether we need this newly improved vessel.
Indeed, some might challenge whether we should have a ship at all.
But that is largely academic, given we are now under way and in light of the
gargantuan efforts insurance firms and regulators have put into getting us
to this point.
In my speech today, I would like to look at this development in the wider
context of insurance history.”
Monetary policy and financial stability - looking
for the right tools
Timothy Lane, Deputy Governor of the Bank of Canada,
to HEC Montreal, Montreal, Quebec
“My remarks will focus on the following question: Should a central bank's
decisions on monetary policy account for the stability of the financial
system and, if so, how?
We at the Bank of Canada are grappling with this question, and it is being
debated by economists and policy-makers around the world.
This topic is not new, but finding the right answer now seems more urgent
than ever. The global financial crisis that began eight years ago has taken an
enormous toll, both economic and, more important, human.”
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Indian banking sector - gazing into the crystal ball
Mr S S Mundra, Deputy Governor of the Reserve Bank of
India, at the Mint Annual Banking Conclave on the theme
"Disruption, Innovation and Competition", Mumbai
“A lot in the Indian banking sector has changed since I first spoke at this
conclave three years ago.
Disruptive events have taken place; innovative practices introduced and
competition as it stands today, is stiffer than ever before and is likely to
intensify further in the coming months.
Some of you who attended this event last year might recall that I had briefly
raised certain issues at the end of my address stating that they could emerge
as potential challenges for the banking sector in the days to come.
Many such challenges which were looking abstract or distant then are
appearing imminent now.”
Post crisis reforms - the lessons of balance sheets
Andrew Bailey, Deputy Governor of Prudential Regulation and Chief
Executive Officer of the Prudential Regulation Authority at
the Bank of England, at the International Financial Services
Forum, Dublin
“We are approaching the ninth anniversary of the
beginning of the global financial crisis.
And we are still talking about it; but not just talking, also publishing books,
reports, holding conferences and of course releasing films.
There is no doubt more than one reason for the continued interest in the
crisis, but as public officials charged with putting into place the measures to
prevent a repeat and thus produce a more stable financial system, the work
is still in progress and thus for us very much a matter of debate.”
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The euro area in 2016 - crucial to set right course
for enhancing growth and stability
Speech by Dr Jens Weidmann, President of the Deutsche
Bundesbank and Chairman of the Board of Directors of the
Bank for International Settlements, at the International Club La Redoute
e.V., Bonn
I am probably partial to requests to speak in Bonn - and I mean that
positively - due to my old ties to the University of Bonn.
“Ladies and gentleman, as you know, 2016 is a leap year.
There have been leap years since the time of Julius Caesar.
They take account of the earth taking a little more than 365 days to orbit the
sun.
According to calculations by the Greek astronomer Hipparchus - which
would have been known in Caesar's time - it took 5 hours, 55 minutes and
12 seconds longer, though he was a few minutes off according to
modern-day calculations.”
Forward guidance in New Zealand
Speech by Dr John McDermott, Assistant Governor and
Chief Economist of the Reserve Bank of New Zealand, to
the Goldman Sachs Annual Global Macro Conference
2016, Sydney
“The focus of my comments today will be the Reserve Bank of New
Zealand’s approach to forward guidance, and in particular, the publication
of an endogenous outlook for the 90-day interest rate.
I’ll touch on the benefits of this approach and how we aim to minimise the
potential costs.”
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In the heart of Europe - Europe in our hearts
Welcoming address by Dr Andreas Dombret, Member of
the Executive Board of the Deutsche Bundesbank, to
mark the unveiling of the plaque listing patrons for the
euro sign, Frankfurt am Main
“When you think of Frankfurt, what comes to mind?
Perhaps the city's famous historical landmarks, such as the Römer (city
hall) or St. Paul's? Or the skyline, featuring its many skyscrapers?
Football fans may think of Attila, the eagle, worn proudly on players' shirts
of Eintracht Frankfurt.
You might also think of Goethe, the Old Opera House, the Main river,
Germany's largest airport, and so on.
All this is Frankfurt; our city is veritably full of world-renowned landmarks.
However, I'm sure that quite a few of us also have in our mind's eye the euro
sculpture, which has graced the Willy-Brandt-Platz square between the
opera house and the Eurotower since the euro was launched - and is thus
located right in the heart this city.
Much as Frankfurt itself is located in the geographic heart of Europe.”
Bridging the Bio-Electronic Divide
New effort aims for fully implantable devices able to connect with up to one
million neurons
A new DARPA program aims to develop an implantable neural interface
able to provide unprecedented signal resolution and data-transfer
bandwidth between the human brain and the digital world.
The interface would serve as a translator, converting between the
electrochemical language used by neurons in the brain and the ones and
zeros that constitute the language of information technology.
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Guidelines - Sound management of risks
related to money laundering and
financing of terrorism
I. Introduction
1. Being aware of the risks incurred by banks of
being used, intentionally or unintentionally, for
criminal activities, the Basel Committee on
Banking Supervision is issuing these guidelines
to describe how banks should include money laundering (ML) and
financing of terrorism (FT) risks within their overall risk management.
2. The Committee has a long-standing commitment to promote the
implementation of sound Anti- Money Laundering and Countering
Financing of Terrorism (AML/CFT) policies and procedures that are critical
in protecting the safety and soundness of banks and the integrity of the
international financial system.
Following an initial statement in 1988, it has published several documents
in support of this commitment.
In September 2012, the Committee reaffirmed its stance by publishing the
revised version of the Core principles for effective banking supervision, in
which a dedicated principle (BCP 29) deals with the abuse of financial
services.
3. The Committee supports the adoption of the standards issued by the
Financial Action Task Force (FATF).
In February 2012, the FATF released a revised version of the International
Standards on Combating Money Laundering and the Financing of
Terrorism and Proliferation (the FATF standards), to which the Committee
provided input.
In March 2013, the FATF also issued Financial Inclusion Guidance, which
has also been considered by the Committee in drafting these guidelines.
The Committee’s intention in issuing this paper is to support national
implementation of the FATF standards by exploring complementary areas
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and leveraging the expertise of both organisations.
These guidelines embody both the FATF standards and the Basel Core
Principles for banks operating across borders and fits into the overall
framework of banking supervision.
Therefore, these guidelines are intended to be consistent with and to
supplement the goals and objectives of the FATF standards, and in no way
should they be interpreted as modifying the FATF standards, either by
strengthening or weakening them.
4. In some instances, the Committee has included cross-references to FATF
standards in this document in order to assist banks in complying with
national requirements based on the implementation of those standards.
However, as the Committee’s intention is not to simply duplicate the
existing FATF standards, cross-references are not included as a matter of
routine.
5. The Committee's commitment to combating money laundering and the
financing of terrorism is fully aligned with its mandate “to strengthen the
regulation, supervision and practices of banks worldwide with the purpose
of enhancing financial stability”.
Sound ML/FT risk management has particular relevance to the overall
safety and soundness of banks and of the banking system, the primary
objective for banking supervision, in that:
• it helps protect the reputation of both banks and national banking systems
by preventing and deterring the use of banks to launder illicit proceeds or to
raise or move funds in support of terrorism; and
• it preserves the integrity of the international financial system as well as
the work of governments in addressing corruption and in combating the
financing of terrorism.
6. The inadequacy or absence of sound ML/FT risk management exposes
banks to serious risks, especially reputational, operational, compliance and
concentration risks.
Recent developments, including robust enforcement actions taken by
regulators and the corresponding direct and indirect costs incurred by
banks due to their lack of diligence in applying appropriate risk
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management policies, procedures and controls, have highlighted those
risks.
These costs and damage could probably have been avoided had the banks
maintained effective risk-based AML/CFT policies and procedures.
7. It is worth noting that all these risks are interrelated.
However, in addition to incurring fines and sanctions by regulators, any
one of them could result in significant financial costs to banks (eg through
the termination of wholesale funding and facilities, claims against the bank,
investigation costs, asset seizures and freezes, and loan losses), as well as
the diversion of limited and valuable management time and operational
resources to resolve problems.
8. Consequently, this paper should be read in conjunction with a number of
related Committee papers, including the following:
• Core principles for effective banking supervision, September 2012
• The internal audit function in banks, June 2012
• Principles for the sound management of operational risk, June 2011
• Principles for enhancing corporate governance, October 2010
• Due diligence and transparency regarding cover payment messages
related to cross-border wire transfers, May 2009
• Compliance and the compliance function in banks, April 2005
9. In an effort to rationalise the Committee’s publications on AML/CFT
guidance, this document merges and supersedes two of the Committee’s
previous publications dealing with related topics: Customer due diligence
for banks, October 2001 and Consolidated KYC risk management, October
2004.
In updating these papers, the Committee has also increased its focus on
risks associated with the usage by banks of third parties to introduce
business (see Annex 1) and the provision of correspondent banking services
(see Annex 2).
Despite their importance and relevance, other specific risk areas such as
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politically exposed persons (PEPs), private banking and specific legal
structures that were addressed in the previous papers have not been
specifically developed in this guidance, since they are the subject of existing
FATF publications.
10. With respect to the scope of application, these guidelines should be read
in conjunction with other standards and guidelines produced by the
Committee that promote supervision of banking groups on a consolidated
level.
This is particularly relevant in the context of AML/CFT since customers
frequently have multiple relationships and/or accounts with the same
banking group, but in offices located in different countries.
11. These guidelines are applicable to all banks.
Some of the requirements may require adaptation for use by small or
specialised institutions, to fit their specific size or business models.
However, it is beyond the scope of this guidance document to address these
adjustments.
12. These guidelines specifically target banks, banking groups (parts II and
III respectively) and banking supervisors (part IV).
As stated in BCP 29, the Committee is aware of the variety of national
arrangements that exist for ensuring AML/CFT compliance, particularly
the sharing of supervisory functions between banking supervisors and other
authorities such as financial intelligence units.
Therefore, for the purpose of these guidelines, the term “supervisor” might
refer to these authorities.
In jurisdictions where AML/CFT supervisory authority is shared, the
banking supervisor cooperates with other authorities to seek adherence to
these guidelines.
13. It should be noted that the FATF standards that require countries to
apply other measures in their financial sectors and other designated
non-financial sectors, or establishing powers and responsibilities for the
competent authorities, are not dealt with in this document.
II. Essential elements of sound ML/FT risk management
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14. In accordance with the updated Core principles for effective banking
supervision (2012), all banks should be required to “have adequate policies
and processes, including strict customer due diligence (CDD) rules to
promote high ethical and professional standards in the banking sector and
prevent the bank from being used, intentionally or unintentionally, for
criminal activities”.
This requirement is to be seen as a specific part of banks’ general obligation
to have sound risk management programmes in place to address all kinds of
risks, including ML and FT risks.
“Adequate policies and processes” in this context requires the
implementation of other measures in addition to effective CDD rules.
These measures should also be proportional and risk-based, informed by
banks’ own risk assessment of ML/FT risks.
This document sets out guidance in respect of such measures.
In addition, other guidelines (see paragraph 8 above) are applicable or
supplementary where no specific AML/CFT guidance exists.
1. Assessment, understanding, management and mitigation of
risks
(a) Assessment and understanding of risks
15. Sound risk management requires the identification and analysis of
ML/FT risks present within the bank and the design and effective
implementation of policies and procedures that are commensurate with the
identified risks.
In conducting a comprehensive risk assessment to evaluate ML/FT risks, a
bank should consider all the relevant inherent and residual risk factors at
the country, sectoral, bank and business relationship level, among others,
in order to determine its risk profile and the appropriate level of mitigation
to be applied.
The policies and procedures for CDD, customer acceptance, customer
identification and monitoring of the business relationship and operations
(product and service offered) will then have to take into account the risk
assessment and the bank’s resulting risk profile.
A bank should have appropriate mechanisms to document and provide risk
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assessment information to competent authorities such as supervisors.
16. A bank should develop a thorough understanding of the inherent
ML/FT risks present in its customer base, products, delivery channels and
services offered (including products under development or to be launched)
and the jurisdictions within which it or its customers do business.
This understanding should be based on specific operational and transaction
data and other internal information collected by the bank as well as
external sources of information such as national risk assessments and
country reports from international organisations.
Policies and procedures for customer acceptance, due diligence and
ongoing monitoring should be designed and implemented to adequately
control those identified inherent risks.
Any resulting residual risk should be managed in line with the bank’s risk
profile established through its risk assessment.
This assessment and understanding should be able to be demonstrated as
required by, and should be acceptable to, the bank’s supervisor.
(b) Proper governance arrangements
17. Effective ML/FT risk management requires proper governance
arrangements as described in relevant previous publications of the
Committee.
In particular, the requirement for the board of directors to approve and
oversee the policies for risk, risk management and compliance is fully
relevant in the context of ML/FT risk.
The board of directors should have a clear understanding of ML/FT risks.
Information about ML/FT risk assessment should be communicated to the
board in a timely, complete, understandable and accurate manner so that it
is equipped to make informed decisions.
18. Explicit responsibility should be allocated by the board of directors
effectively taking into consideration the governance structure of the bank
for ensuring that the bank's policies and procedures are managed
effectively.
The board of directors and senior management should appoint an
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appropriately qualified chief AML/CFT officer to have overall responsibility
for the AML/CFT function with the stature and the necessary authority
within the bank such that issues raised by this senior officer receive the
necessary attention from the board, senior management and business lines.
(c) The three lines of defence
19. As a general rule and in the context of AML/CFT, the business units (eg
front office, customer- facing activity) are the first line of defence in charge
of identifying, assessing and controlling the risks of their business.
They should know and carry out the policies and procedures and be allotted
sufficient resources to do this effectively.
The second line of defence includes the chief officer in charge of AML/CFT,
the compliance function but also human resources or technology.
The third line of defence is ensured by the internal audit function.
20. As part of the first line of defence, policies and procedures should be
clearly specified in writing, and communicated to all personnel.
They should contain a clear description for employees of their obligations
and instructions as well as guidance on how to keep the activity of the bank
in compliance with regulations.
There should be internal procedures for detecting and reporting suspicious
transactions.
21. A bank should have adequate policies and processes for screening
prospective and existing staff to ensure high ethical and professional
standards.
All banks should implement ongoing employee training programmes so
that bank staff are adequately trained to implement the bank’s AML/CFT
policies and procedures.
The timing and content of training for various sectors of staff will need to be
adapted by the bank according to their needs and the bank’s risk profile.
Training needs will vary depending on staff functions and job
responsibilities and length of service with the bank.
Training course organisation and materials should be tailored to an
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employee’s specific responsibility or function to ensure that the employee
has sufficient knowledge and information to effectively implement the
bank’s AML/CFT policies and procedures.
New employees should be required to attend training as soon as possible
after being hired, for the same reasons.
Refresher training should be provided to ensure that staff are reminded of
their obligations and their knowledge and expertise are kept up to date.
The scope and frequency of such training should be tailored to the risk
factors to which employees are exposed due to their responsibilities and the
level and nature of risk present in the bank.
22. As part of the second line of defence, the chief officer in charge of
AML/CFT should have the responsibility for ongoing monitoring of the
fulfilment of all AML/CFT duties by the bank.
This implies sample testing of compliance and review of exception reports
to alert senior management or the board of directors if it is believed
management is failing to address AML/CFT procedures in a responsible
manner.
The chief AML/CFT officer should be the contact point regarding all
AML/CFT issues for internal and external authorities, including
supervisory authorities or financial intelligence units (FIUs).
23. The business interests of a bank should in no way be opposed to the
effective discharge of the above-mentioned responsibilities of the chief
AML/CFT officer.
Regardless of the bank’s size or its management structure, potential
conflicts of interest should be avoided.
Therefore, to enable unbiased judgments and facilitate impartial advice to
management, the chief AML/CFT officer should, for example, not have
business line responsibilities and should not be entrusted with
responsibilities in the context of data protection or the function of internal
audit.
Where any conflicts between business lines and the responsibilities of the
chief AML/CFT officer arise, procedures should be in place to ensure
AML/CFT concerns are objectively considered at the highest level.
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24. The chief AML/CFT officer may also perform the function of the chief
risk officer or the chief compliance officer or equivalent.
He/she should have a direct reporting line to senior management or the
board.
In case of a separation of duties the relationship between the
aforementioned chief officers and their respective roles must be clearly
defined and understood.
25. The chief AML/CFT officer should also have the responsibility for
reporting suspicious transactions.
The chief AML/CFT officer should be provided with sufficient resources to
execute all responsibilities effectively and play a central and proactive role
in the bank’s AML/CFT regime.
In order to do so, he/she must be fully conversant with the bank’s
AML/CFT regime, its statutory and regulatory requirements and the
ML/FT risks arising from the business.
26. Internal audit, the third line of defence, plays an important role in
independently evaluating the risk management and controls, and
discharges its responsibility to the audit committee of the board of directors
or a similar oversight body through periodic evaluations of the effectiveness
of compliance with AML/CFT policies and procedures.
A bank should establish policies for conducting audits of:
(i) the adequacy of the bank’s AML/CFT policies and procedures in
addressing identified risks,
(ii) the effectiveness of bank staff in implementing the bank’s policies and
procedures;
(iii) the effectiveness of compliance oversight and quality control including
parameters of criteria for automatic alerts; and
(iv) the effectiveness of the bank’s training of relevant personnel.
Senior management should ensure that audit functions are allocated staff
that are knowledgeable and have the appropriate expertise to conduct such
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audits.
Management should also ensure that the audit scope and methodology are
appropriate for the bank’s risk profile and that the frequency of such audits
is also based on risk.
Periodically, internal auditors should conduct AML/CFT audits on a
bank-wide basis.
In addition, internal auditors should be proactive in following up their
findings and recommendations.
As a general rule, the processes used in auditing should be consistent with
internal audit’s broader audit mandate, subject to any prescribed auditing
requirements applicable to AML/CFT measures.
27. In many countries, external auditors also have an important role to play
in evaluating banks’ internal controls and procedures in the course of their
financial audits, and in confirming that they are compliant with AML/CFT
regulations and supervisory practice.
In cases where a bank uses external auditors to evaluate the effectiveness of
AML/CFT policies and procedures, it should ensure that the scope of the
audit is adequate to address the bank’s risks and that the auditors assigned
to the engagement have the requisite expertise and experience.
A bank should also ensure that it exercises appropriate oversight of such
engagements.
(d) Adequate transaction monitoring system
28 A bank should have a monitoring system in place that is adequate with
respect to its size, its activities and complexity as well as the risks present in
the bank.
For most banks, especially those which are internationally active, effective
monitoring is likely to necessitate the automation of the monitoring
process.
When a bank has the opinion that an IT monitoring system is not necessary
in its specific situation, it should document its decision and be able to
demonstrate to its supervisor or external auditors that it has in place an
effective alternative.
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When an IT system is used, it should cover all accounts of the bank’s
customers and transactions for the benefit of, or by order of, those
customers.
It must enable the bank to undergo trend analysis of transaction activity
and to identify unusual business relationships and transactions in order to
prevent ML or FT.
29. In particular, this system should be able to provide accurate
information for senior management relating to several key aspects,
including changes in the transactional profile of customers.
In compiling the customer’s profile, the bank should incorporate the
updated, comprehensive and accurate CDD information provided to it by
the customer.
The IT system should allow the bank, and where appropriate the group, to
gain a centralised knowledge of information (ie organised by customer,
product, across group entities, transactions carried out during a certain
timeframe etc).
Without being requested to have a unique customer file, banks should be
able to risk-rate customers and manage alerts with all the relevant
information at their disposal.
An IT monitoring system must use adequate parameters based on the
national and international experience on the methods and the prevention of
ML or FT.
A bank may make use of the standard parameters provided by the
developer of the IT monitoring system; however, the parameters used must
reflect and take into account the bank’s own risk situation.
30. The IT monitoring system should enable a bank to determine its own
criteria for additional monitoring, filing a suspicious transaction report
(STR) or taking other steps in order to minimise the risk.
The chief AML/CFT officer should have access to and benefit from the IT
system as far as it is relevant for his/her function (even if operated or used
by other business lines).
Parameters of the IT system should allow for generation of alerts of unusual
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transactions and should then be subject to further assessment by the chief
AML/CFT officer.
Any risk criteria used in this context should be adequate with regard to the
risk assessment of the bank.
31. Internal audit should also evaluate the IT system to ensure that it is
appropriate and used effectively by the first and second lines of defence.
2. Customer acceptance policy
32. A bank should develop and implement clear customer acceptance
policies and procedures to identify the types of customer that are likely to
pose a higher risk of ML and FT pursuant to the bank’s risk assessment.
When assessing risk, a bank should consider the factors relevant to the
situation, such as a customer’s background, occupation (including a public
or high-profile position), source of income and wealth, country of origin
and residence (when different), products used, nature and purpose of
accounts, linked accounts, business activities and other customer-oriented
risk indicators in determining what is the level of overall risk and the
appropriate measures to be applied to manage those risks.
33. Such policies and procedures should require basic due diligence for all
customers and commensurate due diligence as the level of risk associated
with the customer varies.
For proven lower risk situations, simplified measures may be permitted, if
this is allowed by law.
For example, the application of basic account-opening procedures may be
appropriate for an individual who expects to maintain a small account
balance and use it to conduct routine retail banking transactions.
It is important that the customer acceptance policy is not so restrictive that
it results in a denial of access by the general public to banking services,
especially for people who are financially or socially disadvantaged.
The FATF Financial Inclusion Guidance provides useful guidelines on
designing AML/CFT procedures that are not overly restrictive to the
financially or socially disadvantaged.
34. Where the risks are higher, banks should take enhanced measures to
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mitigate and manage those risks.
Enhanced due diligence may be essential for an individual planning to
maintain a large account balance and conduct regular cross-border wire
transfers or an individual who is a politically exposed person (PEP).
In particular, such enhanced due diligence is required for foreign PEPs.
Decisions to enter into or pursue business relationships with higher-risk
customers should require the application of enhanced due diligence
measures, such as approval to enter into or continue such relationships,
being taken by senior management.
The bank’s customer acceptance policy should also define circumstances
under which the bank would not accept a new business relationship or
would terminate an existing one.
3. Customer and beneficial owner identification, verification and
risk profiling
35. For the purposes of this guidance, a customer refers, in accordance with
the FATF Recommendation 10, to any person who enters into a business
relationship or carries out an occasional financial transaction with the
bank. The customer due diligence should be applied not only to customers
but also to persons acting on their behalf and beneficial owners.
In accordance with the FATF standards, banks should identify customers
and verify their identity.
36. A bank should establish a systematic procedure for identifying and
verifying its customers and, where applicable, any person acting on their
behalf and any beneficial owner(s).
Generally, a bank should not establish a banking relationship, or carry out
any transactions, until the identity of the customer has been satisfactorily
established and verified in accordance with FATF Recommendation 10.
Consistent with BCP 29 and the FATF standards, the procedures should
also include the taking of reasonable measures to verify the identity of the
beneficial owner.
A bank should also verify that any person acting on behalf of the customer
is so authorised, and should verify the identity of that person.
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37. The identity of customers, beneficial owners, as well as persons acting
on their behalf, should be verified by using reliable, independent source
documents, data or information.
When relying on documents, a bank should be aware that the best
documents for the verification of identity are those most difficult to obtain
illicitly or to counterfeit.
When relying on other sources than documents, the bank must ensure that
the methods (which may include checking references with other financial
institutions and obtaining financial statements) and sources of information
are appropriate, and in accordance with the bank’s policies and procedures
and risk profile of the customer.
A bank may require customers to complete a written declaration of the
identity and details of the beneficial owner, although the bank should not
rely solely on such declarations.
As for all elements of the CDD process, a bank should also consider the
nature and level of risk presented by a customer when determining the
extent of the applicable due diligence measures.
In no case should a bank disregard its customer identification and
verification procedures just because the customer is unable to be present
for an interview (non-face-to-face customer); the bank should also take into
account risk factors such as why the customer has chosen to open an
account far away from its seat/office, in particular in a foreign jurisdiction.
It would also be important to take into account the relevant risks associated
with customers from jurisdictions that are known to have AML/CFT
strategic deficiencies and apply enhanced due diligence when this is called
for by the FATF, other international bodies or national authorities.
38. While the customer identification and verification process is applicable
at the outset of the relationship or before an occasional banking transaction
is carried out, a bank should use this information to build an understanding
of the customer’s profile and behaviour.
The purpose of the relationship or the occasional banking transaction, the
level of assets or the size of transactions of the customer, and the regularity
or duration of the relationship are examples of information typically
collected.
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Therefore, a bank should also have policies and procedures in place to
conduct due diligence on its customers sufficient to develop customer risk
profiles either for particular customers or categories of customers.
The information collected for this purpose should be determined by the
level of risk associated with the customer’s business model and activities as
well as the financial products or services requested by the customer.
These risk profiles will facilitate the identification of any account activity
that deviates from activity or behaviour that would be considered “normal”
for the particular customer or customer category and could be considered
as unusual, or even suspicious.
Customer risk profiles will assist the bank in further determining if the
customer or customer category is higher-risk and requires the application
of enhanced CDD measures and controls.
The profiles should also reflect the bank’s understanding of the intended
purpose and nature of the business relationship/occasional banking
transaction, expected level of activity, type of transactions, and, where
necessary, sources of customer funds, income or wealth as well as other
similar considerations.
Any significant information collected on customer activity or behaviour
should be used in updating the bank’s risk assessment of the customer.
39. A bank should obtain customer identification papers as well as any
information and documentation obtained as a result of CDD conducted on
the customer.
This could include copies of or records of official documents (eg passports,
identity cards, driving licences), account files (eg financial transaction
records) and business correspondence, including the results of any analysis
undertaken such as the risk assessment and inquiries to establish the
background and purpose of the relationships and activities.
40. A bank should also obtain all the information necessary to establish to
its full satisfaction the identity of their customer and the identity of any
person acting on behalf of the customer and of beneficial owners.
While a bank is required to both identify its customers and verify their
identities, the nature and extent of the information required for verification
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will depend on risk assessment, including the type of applicant (personal,
corporate etc), and the expected size and use of the account.
The specific requirements involved in ascertaining the identity of natural
persons are usually prescribed in national legislation.
Higher-risk customers will require the application of enhanced due
diligence to verify customer identity.
If the relationship is complex, or if the size of the account is significant,
additional identification measures may be advisable, and these should be
determined based on the level of overall risk.
41. When a bank is unable to complete CDD measures, it should not open
the account, commence business relations or perform the transaction.
However, there may be circumstances where it would be permissible for
verification to be completed after the establishment of the business
relationship, because it would be essential not to interrupt the normal
conduct of business.
In such circumstances, the bank should adopt adequate risk management
procedures with respect to the conditions and restrictions under which a
customer may utilise the banking relationship prior to verification.
In situations where an account has been opened but problems of
verification arise during the course of the establishment of the banking
relationship that cannot be resolved, the bank should close or otherwise
block access to the account.
In any event, the bank should consider filing a STR in cases where there are
problems with completion of the CDD measures.
Additionally, where CDD checks raise suspicion or reasonable grounds to
suspect that the assets or funds of the prospective customer may be the
proceeds of predicate offences and crimes related to ML/FT, banks should
not voluntarily agree to open accounts with such customers.
In such situations, banks should file an STR with the relevant authorities
accordingly and ensure that the customer is not informed, even indirectly,
that an STR has been, is being or shall be filed.
42. A bank should have in place procedures and material capacity enabling
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front office, customer- facing activities to identify any designated entities or
individuals (eg terrorists, terrorist organisations) in accordance with their
national legislation and the relevant United Nations Security Council
Resolutions (UNSCRs).
43. While the transfer of funds from an account in the customer’s name in
another bank subject to the same CDD standard as the initial deposit may
provide some comfort, a bank should nevertheless conduct its own due
diligence and consider the possibility that the previous account manager
may have asked for the account to be closed because of a concern about
illicit activities.
Naturally, customers have the right to move their business from one bank
to another.
However, if a bank has any reason to believe that an applicant has been
refused banking facilities by another bank due to concerns over illicit
activities of the customer, it should consider classifying that applicant as
higher-risk and apply enhanced due diligence procedures to the customer
and the relationship, filing an STR and/or not accepting the customer in
accordance with its own risk assessments and procedures.
44. A bank should not open an account or conduct ongoing business with a
customer who insists on anonymity or who gives an obviously fictitious
name.
Nor should confidential numbered accounts function as anonymous
accounts but they should be subject to exactly the same CDD procedures as
all other customers’ accounts, even if the procedures are carried out by
selected staff.
While a numbered account can offer additional confidentiality for the
account-holder, the identity of the latter must be verified by the bank and
known to a sufficient number of staff to facilitate the conduct of effective
due diligence, especially if other risk factors indicate that the customer is
higher-risk.
A bank should ensure that its internal control, compliance, audit and other
oversight functions, in particular the chief AML/CFT officer, and the bank’s
supervisors, have full access to this information as needed.
4. Ongoing monitoring
45. Ongoing monitoring is an essential aspect of effective and sound ML/FT
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risk management.
A bank can only effectively manage its risks if it has an understanding of the
normal and reasonable banking activity of its customers that enables the
bank to identify attempted and unusual transactions which fall outside the
regular pattern of the banking activity.
Without such knowledge, the bank is likely to fail in its obligations to
identify and report suspicious transactions to the appropriate authorities.
Ongoing monitoring should be conducted in relation to all business
relationships and transactions, but the extent of the monitoring should be
based on risk as identified in the bank risk assessment and its CDD efforts.
Enhanced monitoring should be adopted for higher-risk customers or
transactions.
A bank should not only monitor its customers and their transactions, but
should also carry out cross-sectional product/service monitoring in order to
identify and mitigate emerging risk patterns.
46. All banks should have systems in place to detect unusual or suspicious
transactions or patterns of activity.
In establishing scenarios for identifying such activity, a bank should
consider the customer’s risk profile developed as a result of the bank’s risk
assessment, information collected during its CDD efforts, and other
information obtained from law enforcement and other authorities in its
jurisdiction.
For example, a bank may be aware of particular schemes or arrangements
to launder proceeds of crime that may have been identified by authorities as
occurring within its jurisdiction.
As part of its risk assessment process, it will have assessed the risk that
activity associated with such schemes or arrangements may be occurring
within the bank through a category of customers, group of accounts,
transaction pattern or product usage.
Based on this knowledge, the bank should design and apply appropriate
monitoring tools and controls to identify such activity.
These could be through alert scenarios for computerised monitoring
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systems or setting limits for a particular class or category of activity, for
instance.
47. Using CDD information, a bank should be able to identify transactions
that do not appear to make economic sense, that involve large cash deposits
or that are not consistent with the customer’s normal and expected
transactions.
48. A bank should have established enhanced due diligence policies and
procedures for customers who have been identified as higher-risk by the
bank.
In addition to established policies and procedures relating to approvals for
account opening, a bank should also have specific policies regarding the
extent and nature of required CDD, frequency of ongoing account
monitoring and updating of CDD information and other records.
The ability of the bank to effectively monitor and identify suspicious activity
would require access to updated, comprehensive and accurate customer
profiles and records.
49. A bank should ensure that they have appropriate integrated
management information systems, commensurate with its size,
organisational structure or complexity, based on materiality and risks, to
provide both business units (eg relationship managers) and risk and
compliance officers (including investigating staff) with timely information
needed to identify, analyse and effectively monitor customer accounts.
The systems used and the information available should support the
monitoring of such customer relationships across lines of business and
include all the available information on that customer relationship
including transaction history, missing account opening documentation and
significant changes in the customer’s behaviour or business profile and
transactions made through a customer account that are unusual.
50. The bank should screen its customer database(s) whenever there are
changes to sanction lists.
The bank should also screen its customer database(s) periodically to detect
foreign PEPs and other higher- risk accounts and subject them to enhanced
due diligence.
5. Management of information
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(a) Record-keeping
51. A bank should ensure that all information obtained in the context of
CDD is recorded.
This includes both
(i) recording the documents the bank is provided with when verifying the
identity of the customer or the beneficial owner, and
(ii) transcription into the bank’s own IT systems of the relevant CDD
information contained in such documents or obtained by other means.
52. A bank should also develop and implement clear rules on the records
that must be kept to document due diligence conducted on customers and
individual transactions.
These rules should take into account, if possible, any prescribed privacy
measures.
They should include a definition of the types of information and
documentation that should be included in the records as well as the
retention period for such records, which should be at least five years from
the termination of the banking relationship or the occasional transaction.
Even if accounts are closed, in the event of ongoing investigation/ litigation,
all records should be retained until the closure of the case.
Maintaining complete and updated records is essential for a bank to
adequately monitor its relationship with its customer, to understand the
customer’s ongoing business and activities, and, if necessary, to provide an
audit trail in the event of disputes, legal action, or inquiries or
investigations that could lead to regulatory actions or criminal prosecution.
53. Adequate records documenting the evaluation process related to
ongoing monitoring and review and any conclusions drawn should also be
maintained and will help to demonstrate the bank’s compliance with CDD
requirements and ability to manage ML and FT risk.
(b) Updating of information
54. Only if banks ensure that records remain accurate, up-to-date and
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relevant by undertaking regular reviews of existing records and updating
the CDD information can other competent authorities, law enforcement
agencies or financial intelligence units make effective use of that
information in order to fulfil their own responsibilities in the context of
AML/CFT.
In addition, keeping up-to-date information will enhance the bank’s ability
to effectively monitor the account for unusual or suspicious activities.
(c) Supplying information to the supervisors
55. A bank should be able to demonstrate to its supervisors, on request, the
adequacy of its assessment, management and mitigation of ML/FT risks; its
customer acceptance policy; its procedures and policies concerning
customer identification and verification; its ongoing monitoring and
procedures for reporting suspicious transactions; and all measures taken in
the context of AML/CFT.
6. Reporting of suspicious transactions and asset freezing
(a) Reporting of suspicious transactions
56. Ongoing monitoring and review of accounts and transactions will
enable banks to identify suspicious activity, eliminate false positives and
report promptly genuine suspicious transactions.
The process for identifying, investigating and reporting suspicious
transactions to the FIU should be clearly specified in the bank’s policies and
procedures and communicated to all personnel through regular training.
These policies and procedures should contain a clear description for
employees of their obligations and instructions for the analysis,
investigation and reporting of such activity within the bank as well as
guidance on how to complete such reports.
57. There should also be established procedures for assessing whether the
bank’s statutory obligations under recognised suspicious activity reporting
regimes require the transaction to be reported to the appropriate law
enforcement agency or FIU and/or supervisory authorities, if relevant.
These procedures should also reflect the principle of confidentiality, ensure
that investigation is conducted swiftly and that reports contain relevant
information and are produced and submitted in a timely manner.
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The chief AML/CFT officer should ensure prompt disclosures where funds
or other property that is suspected to be the proceeds of crime remain in an
account.
58. Once suspicion has been raised in relation to an account or relationship,
in addition to reporting the suspicious activity a bank should ensure that
appropriate action is taken to adequately mitigate the risk of the bank being
used for criminal activities.
This may include a review of either the risk classification of the customer or
account or of the entire relationship itself.
Appropriate action may necessitate escalation to the appropriate level of
decision-maker to determine how to handle the relationship, taking into
account any other relevant factors, such as cooperation with law
enforcement agencies or the FIU.
(b) Asset freezing
59. Financing of terrorism has similarities compared to money laundering,
but it also has specificities that banks should take into due consideration:
funds that are used to finance terrorist activities may be derived either from
criminal activity or from legal sources, and the nature of the funding
sources may vary according to the type of terrorist organisation.
In addition, it should be noted that transactions associated with the
financing of terrorists may be conducted in very small amounts.
60. A bank should be able to identify and to enforce funds freezing
decisions made by the competent authority and it should otherwise not deal
with any designated entities or individuals (eg terrorists, terrorist
organisations) consistent with relevant national legislation and UNSCRs.
61. CDD should help a bank to detect and identify potential FT transactions,
providing important elements for a better knowledge of its customers and
the transactions they conduct.
In developing customer acceptance policies and procedures, a bank should
give proper relevance to the specific risks of entering into or pursuing
business with individuals or entities linked to terrorist groups.
Before establishing a business relationship or carrying out an occasional
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transaction with new customers, a bank should screen customers against
lists of known or suspected terrorists issued by competent (national and
international) authorities.
Likewise, ongoing monitoring should verify that existing customers are not
entered into these same lists.
62. All banks should have systems in place to detect prohibited transactions
(eg transactions with entities designated by the relevant UNSCRs or
national sanctions).
Terrorist screening is not a risk-sensitive due diligence measure and should
be carried out irrespective of the risk profile attributed to the customer.
For the purpose of terrorist screening, a bank may adopt automatic
screening systems, but it should ensure that such systems are fit for the
purpose.
A bank should freeze without delay and without prior notice the funds or
other assets of designated persons and entities, following applicable laws
and regulations.
III. AML/CFT in a group-wide and cross-border context
63. Sound ML/FT risk management where a bank operates in other
jurisdictions entails consideration of host country legal requirements.
Given the risks, each group should develop group-wide AML/CFT policies
and procedures consistently applied and supervised across the group.
In turn, policies and procedures at the branch or subsidiary levels, even
though reflecting local business considerations and the requirements of the
host jurisdiction, must still be consistent with and supportive of the group’s
broader policies and procedures.
In cases where the host jurisdiction requirements are stricter than the
group’s, group policy should allow the relevant branch or subsidiary to
adopt and implement the host jurisdiction local requirements.
1. Global process for managing customer risks
64. Consolidated risk management means establishing and administering a
process to coordinate and apply policies and procedures on a group-wide
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basis, thereby implementing a consistent and comprehensive baseline for
managing the bank’s risks across its international operations.
Policies and procedures should be designed not merely to comply strictly
with all relevant laws and regulations, but more broadly to identify, monitor
and mitigate group-wide risks.
Every effort should be made to ensure that the group’s ability to obtain and
review information in accordance with its global AML/CFT policies and
procedures is not impaired as a result of modifications to local policies or
procedures necessitated by local legal requirements.
In this regard, a bank should have robust information-sharing among the
head office and all of its branches and subsidiaries.
Where the minimum regulatory or legal requirements of the home and host
countries differ, offices in host jurisdictions should apply the higher
standard of the two.
65. Furthermore, according to FATF Standards, if the host country does not
permit the proper implementation of those standards, the chief AML/CFT
officer should inform the home supervisors.
Additional measures should be considered, including, as appropriate, the
financial group closing its operations in the host country.
66. The Committee recognises that implementing group-wide AML/CFT
procedures is more challenging than many other risk management
processes because some jurisdictions continue to restrict the ability of
banks to transmit customer names and balances across national borders.
For effective group- wide monitoring and for ML/FT risk management
purposes, it is essential that banks be authorised to share information about
their customers, subject to adequate legal protection, with their head offices
or parent bank.
This applies in the case of both branches and subsidiaries.
Risk assessment and management
67. The bank should have a thorough understanding of all the risks
associated with its customers across the group, either individually or as a
category, and should document and update these on a regular basis,
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commensurate with the level and nature of risk in the group.
In assessing customer risk, a bank should identify all relevant risk factors
such as geographical location and patterns of transaction activity (declared
or self-stated) and usage of bank products and services and establish
criteria for identifying higher-risk customers.
These criteria should be applied across the bank, its branches and its
subsidiaries and through outsourced activities (see Annex 1).
Customers that pose a higher risk of ML/FT to the bank should be
identified across the group using these criteria.
Customer risk assessments should be applied on a group-wide basis or at
least be consistent with the group-wide risk assessment.
Taking into account differences in risks associated with customer
categories, group policy should recognise that customers in the same
category may pose different risks in different jurisdictions.
The information collected in the assessment process should then be used to
determine the level and nature of overall group risk and support the design
of appropriate group controls to mitigate these risks.
The mitigating factors can comprise additional information from the
customer, tighter monitoring, more frequent updating of personal data and
visits by bank staff to the customer location.
68. Banks’ compliance and internal audit staff, in particular the chief
AML/CFT officer, or external auditors, should evaluate compliance with all
aspects of their group’s policies and procedures, including the effectiveness
of centralised CDD policies and the requirements for sharing information
with other group members and responding to queries from head office.
Internationally active banking groups should ensure that they have a strong
internal audit and a global compliance function since these are the primary
mechanisms for monitoring the overall application of the bank’s global
CDD and the effectiveness of its policies and procedures for sharing
information within the group.
This should include the responsibility of a chief AML/CFT officer for
group-wide compliance with all relevant AML/CFT policies, procedures
and controls nationally and abroad (see paragraphs 75 and 76).
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3. Consolidated AML/CFT policies and procedures
69. A bank should ensure it understands the extent to which AML/CFT
legislation allows it to rely on the procedures undertaken by other banks
(for example within the same group) when business is being referred.
A bank should not rely on introducers that are subject to standards that are
less strict than those governing the bank’s own AML/CFT procedures.
This will entail banks monitoring and evaluating the AML/CFT standards
in place in the jurisdiction of the referring bank.
A bank may rely on an introducer that is part of the same financial group
and could consider placing a higher level of reliance on the information
provided by this introducer, provided this introducer is subject to the same
standards as the bank, and the application of these requirements is
supervised at the group level.
A bank taking this approach should ensure, however, that it obtains
customer information from the referring bank (as further detailed in Annex
1), as this information may be required to be reported to FIUs in the event
that a transaction involving the referred customer is determined to be
suspicious.
70. Relevant information should be accessible by the banking group’s head
office for the purpose of enforcing group AML/CFT policies and
procedures.
Each office of the banking group should be in a position to comply with
minimum AML/CFT and accessibility policies and procedures applied by
the head office and defined consistently with the Committee guidelines.
71. Customer acceptance, CDD and record-keeping policies and procedures
should be implemented through the consistent application of policies and
procedures throughout the organisation, with adjustments as necessary to
address variations in risk according to specific business lines or
geographical areas of operation.
Moreover, it is recognised that different approaches to information
collection and retention may be necessary across jurisdictions to conform to
local regulatory requirements or relative risk factors.
However, these approaches should be consistent with the group-wide
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standards discussed above.
72. Regardless of its location, each office should establish and maintain
effective monitoring policies and procedures that are appropriate to the
risks present in the jurisdiction and in the bank.
This local monitoring should be complemented by a robust process of
information-sharing with the head office, and if appropriate with other
branches and subsidiaries regarding accounts and activity that may
represent heightened risk.
73. To effectively manage the ML and FT risks arising from such accounts, a
bank should integrate this information based not only on the customer but
also on its knowledge of both the beneficial owners of the customer and the
funds involved.
A bank should monitor significant customer relationships, balances and
activity on a consolidated basis, regardless of whether the accounts are held
on-balance sheet, off-balance sheet, as assets under management or on a
fiduciary basis, and regardless of where they are held.
The FATF standards have now also set out more details relating to banks’
head office oversight of group compliance, audit and/or AML/CFT
functions.
Moreover, if these guidelines have been conceived primarily for banks, they
might be of interest for conglomerates (including banks).
74. Many large banks with the capability to do so centralise certain
processing systems and databases for more effective management or
efficiency purposes.
In implementing this approach, a bank should adequately document and
integrate the local and centralised transaction/account monitoring
functions to ensure that it has the opportunity to monitor for patterns of
potential suspicious activity across the group and not just at either the local
or centralised levels.
75. A bank performing business nationally and abroad should appoint a
chief AML/CFT officer for the whole group (group AML/CFT officer).
The group AML/CFT officer has responsibility, as a part of the global risk
management, for creating, coordinating and group-wide assessment of the
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implementation of a single AML/CFT strategy (including mandatory
policies and procedures and the authorisation to give orders for all
branches, subsidiaries and subordinated entities nationally and abroad).
76. The function of the group AML/CFT officer includes ongoing
monitoring of the fulfilment of all AML/CFT requirements on a group-wide
basis, nationally and abroad.
Therefore, the group AML/CFT officer should satisfy him/herself
(including through on-site visits on a regular basis) that there is groupwide compliance with the AML/CFT requirements.
If needed, he/she should be empowered to give orders or take the necessary
measures for the whole group.
4. Group-wide information-sharing
77. Banks should oversee the coordination of information-sharing.
Subsidiaries and branches should be required to proactively provide the
head office with information concerning higher-risk customers and
activities relevant to the global AML/CFT standards, and respond to
requests for account information from the head office or parent bank in a
timely manner.
The bank’s group-wide standards should include a description of the
process to be followed in all locations for identifying, monitoring and
investigating potential unusual circumstances and reporting suspicious
activity.
78. The bank’s group-wide policies and procedures should take into account
issues and obligations related to local data protection and privacy laws and
regulations.
They should also take into account the different types of information that
may be shared within a group and the requirements for storage, retrieval,
sharing/distribution and disposal of this information.
79. The group’s overall ML/FT risk management function should evaluate
the potential risks posed by activity reported by its branches and
subsidiaries and, where appropriate, assess the group-wide risks presented
by a given customer or category of customers.
It should have policies and procedures to ascertain if other branches or
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subsidiaries hold accounts for the same customer (including any related or
affiliated parties).
The bank should also have policies and procedures governing global
account relationships that are deemed higher-risk or have been associated
with potentially suspicious activity, including escalation procedures and
guidance on restricting account activities, including the closing of accounts
as appropriate.
80. In addition, a bank and its branches and subsidiaries should, in
accordance with their respective domestic laws, be responsive to requests
from law enforcement agencies, supervisory authorities or FIUs for
information about customers that is needed in their efforts to combat ML
and FT.
A bank’s head office should be able to require all branches and subsidiaries
to search their files against specified lists or requests for individuals or
organisations suspected of aiding and abetting ML and FT, and report
matches.
81. A bank should be able to inform its supervisors, if so requested, about
its global process for managing customer risks, its risk assessment and
management of ML/FT risks, its consolidated AML/CFT policies and
procedures, and its group-wide information-sharing arrangements.
5. Mixed financial groups
82. Many banking groups engage in securities and insurance businesses.
The application of ML/FT risk management controls in mixed financial
groups poses additional issues that may not be present for deposit-taking
and lending operations.
Mixed groups should have the ability to monitor and share information on
the identity of customers and their transaction and account activities across
the entire group, and be alert to customers that use their services in
different sectors, as described in paragraph 79 above.
83. Differences in the nature of activities and patterns of relationships
between banks and customers in each sector may require or justify
variations in the AML/CFT requirements imposed on each sector.
The group should be alert to these differences when cross-selling products
and services to customers from different business arms, and the
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appropriate AML/CFT requirements for the relevant sectors should be
applied.
IV. The role of supervisors
84. Banking supervisors are expected to comply with FATF
Recommendation 26, which states in part: “For financial institutions
subject to the Core Principles, the regulatory and supervisory measures that
apply for prudential purposes, and which are also relevant to money
laundering and financing of terrorism, should apply in a similar manner for
AML/CFT purposes.
This should include applying consolidated group supervision for AML/CFT
purposes.”
The Committee expects supervisors to apply the Core principles for
effective banking supervision to banks’ ML/FT risk management in a
manner consistent with and supportive of the supervisors’ overall
supervision of banks.
Supervisors should be able to apply a range of effective, proportionate and
dissuasive sanctions in cases when banks fail to comply with their
AML/CFT requirements.
85. Banking supervisors are expected to set out supervisory expectations
governing banks’ AML/CFT policies and procedures.
The essential elements as set out in this paper should provide clear
guidance for supervisors to proceed with the work of designing or
improving national supervisory practice.
National supervisors are encouraged to provide guidance to assist banks in
designing their own customer identification policies and procedures.
The Committee has therefore developed two specific topic guides in
Annexes 1 and 2, which could be used by supervisors for this purpose.
86. Supervisors should adopt a risk-based approach to supervising banks’
ML/FT risk management.
Such an approach requires that supervisors
(i) develop a thorough understanding of the risks present in the jurisdiction
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and their potential impact on the supervised entities;
(ii) evaluate the adequacy of the bank’s risk assessment based on the
jurisdiction’s national risk assessment(s);
(iii) assess the risks present in the target supervised entity to understand
the nature and extent of the risks in the entity’s customer base, products
and services and the geographical locations in which the bank and its
customers do business;
(iv) evaluate the adequacy and effectiveness in implementation of the
controls (including CDD measures) designed by the bank in meeting its
AML/CFT obligations and risk mitigation; and
(v) utilise this information to allocate the resources, scope the review,
identify the necessary supervisory expertise and experience needed to
conduct an effective review and allocate these resources relative to the
identified risks.
87. Higher-risk lines of business or customer categories may require
specialised expertise and additional procedures to ensure an effective
review.
The bank’s risk profile should also be used in determining the frequency
and timing of the supervisory cycle.
Again, banks dealing with higher risk profiles may require more frequent
review than others.
Supervisors should also verify whether banks have adequately used their
discretion with regard to applying AML/CFT measures on a risk-based
approach.
They should also evaluate the internal controls in place and how banks
determine whether they are in compliance with supervisory and regulatory
guidance, and prescribed obligations.
The supervisory process should include not only a review of policies and
procedures but also, when appropriate, a review of customer
documentation and the sampling of accounts and transactions, internal
reports and STRs.
Supervisors should always have the right to access all documentation
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related to the transactions conducted or accounts maintained in that
jurisdiction, including any analysis the bank has made to detect unusual or
suspicious transactions.
88. Supervisors have a duty to ensure their banks maintain sound ML/FT
risk management not only to protect their own safety and soundness but
also to protect the integrity of the financial system.
Supervisors should make it clear that they will take appropriate action,
which may be severe and public if the circumstances warrant, against banks
and their officers who demonstrably fail to follow their own internal
procedures and regulatory requirements.
In addition, supervisors (or other relevant national authorities) should be
able to apply appropriate countermeasures and ensure that banks are aware
of and apply enhanced CDD measures to business relationships and to
transactions when called for by the FATF or that involve jurisdictions where
their AML/CFT standards are considered inadequate by the country.
In this aspect, the FATF and some national authorities have listed a number
of countries and jurisdictions that are considered to have strategic
AML/CFT deficiencies or that do not comply with international AML/CFT
standards, and such findings should be a component of a bank's ML/FT risk
management.
89. Supervisors should also consider a bank’s overall monitoring and
oversight of compliance at the branch and subsidiary level as well as the
ability of group policy to accommodate local regulatory requirements and
ensure that where there is a difference between the group and local
requirements, the stricter of the two is applied.
Supervisors should also ensure that in cases where the group branch or
subsidiary cannot apply the stricter of the two standards, the reasons for
this and the differences between the two should be documented and
appropriate mitigating measures implemented to address risks identified as
a result of those differences.
90. In a cross-border context, home country supervisors should face no
impediments in verifying a bank’s compliance with group-wide AML/CFT
policies and procedures during on-site inspections.
This may well require a review of customer files and a sampling of accounts
or transactions in the host jurisdiction.
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Home country supervisors should have access to information on sampled
individual customer accounts and transactions and on the specific domestic
and international risks associated with such customers to the extent
necessary to enable a proper evaluation of the application of CDD standards
and an assessment of risk management practices.
This use of information for a legitimate supervisory need, safeguarded by
the confidentiality provisions applicable to supervisors, should not be
impeded by local bank secrecy or data protection laws.
Although the host country supervisors and/or other authorities retain
responsibility for the enforcement of compliance with local AML/CFT
requirements (which would include an evaluation of the appropriateness of
the procedures), host country supervisors should ensure they extend full
cooperation and assistance to home country supervisors who may need to
assess how the bank oversees compliance with group-wide AML/CFT
policies and processes.
91. The role of group audit (external or internal) is particularly important in
assessing the effectiveness of AML/CFT policies and procedures.
Home country supervisors should ensure that there is an appropriate
policy, based on the risks, and adequate resources allocated regarding the
scope and frequency of audit of the group’s AML/CFT.
They should also ensure that auditors have full access to all relevant reports
during the audit process.
92. Supervisors should ensure that information about banks’ customers and
transactions is subject to the same confidentiality measures as are
applicable to the broad array of information shared between supervisors on
banks’ activities.
93. It is essential that all jurisdictions that host foreign banks provide an
appropriate legal framework to facilitate the passage of information
required for customer risk management purposes to the head office or
parent bank and home country supervisors.
Similarly, there should be no impediments to on-site visits to host
jurisdiction subsidiaries and branches by home jurisdiction head office
auditors, risk managers, compliance officers (including the chief AML/CFT
officer and/or AML/CFT group officer), or home country supervisors, nor
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any restrictions in their ability to access all the host jurisdiction bank’s
records, including customers’ names and balances.
This access should be the same for both branches and subsidiaries.
If impediments to information-sharing prove to be insurmountable, and
there are no satisfactory alternative arrangements, the home supervisors
should make it clear to the host supervisor that the bank may be subject to
additional supervisory actions, such as enhanced supervisory measures on
the group, including, as appropriate, requesting the parent group to close
down its operations in the host jurisdiction.
94. Where a bank’s head office staff are granted access to information on
local customers, there should be no restrictions on them reporting such
information back to head office.
Such information should be subject to adequate safeguards on
confidentiality and use and may be subject to applicable privacy and
privilege laws in the home country.
95. The Committee believes that there is no justifiable reason why local
legislation should impede the transfer of customer information from a host
bank branch or subsidiary to its head office or parent bank in the home
jurisdiction for risk management purposes, including ML and FT risks.
If the law in the host jurisdiction restricts disclosure of such information to
“third parties”, it is essential that the head office or parent bank and the
home jurisdiction bank supervisors are clearly excluded from definitions of
a third party.
Jurisdictions that have legislation that impedes, or can be interpreted as
impeding, such information-sharing for ML/FT risk management
purposes, are urged to remove any such restrictions and to provide specific
gateways appropriate for this purpose.
Annex 1
Using another bank, financial institution or third party to perform
customer due diligence
I. Introduction
1. In some countries, banks are permitted to use other banks, financial
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institutions or other entities to perform customer due diligence (CDD).
These arrangements can take various forms but in essence usually fall into
one of the following two situations:
Reliance on third parties
2. Banks in some countries are allowed to rely on CDD performed by other
financial institutions or designated non-financial businesses and
professions who are themselves supervised or monitored for AML/CFT
purposes.
In these situations, the third party will usually have an existing business
relationship with the customer, and the banks may be exempt from
applying their own CDD measures at the beginning of the relationship.
The FATF standards permit reliance for these aspects:
(a) Identifying the customer and verifying that customer’s identity using
reliable, independent source documents, data or information.
(b) Identifying the beneficial owner, and taking reasonable measures to
verify the identity of the beneficial owner, such that the financial institution
is satisfied that it knows who the beneficial owner is.
For legal persons and arrangements this should include financial
institutions understanding the ownership and control structure of the
customer.
(c) Understanding and, as appropriate, obtaining information on the
purpose and intended nature of the business relationship.
FATF standards further require that a financial institution relying upon a
third party should immediately obtain the necessary information
concerning these three CDD measures.
3. Some countries restrict the ability to rely in various ways; for example,
limiting reliance to financial institutions, allowing reliance only for third
parties’ existing relationships (and prohibiting chains of reliance) or not
allowing reliance on foreign entities.
Outsourcing/agency
4. Banks may also use third parties to perform various elements of their
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CDD obligations on a contractual basis, often in an outsourcing/agent
relationship (ie the outsourced entity applies the CDD measures on behalf
of the delegating bank).
Typically, there are fewer restrictions on who can act as the agent of a bank,
but this is often offset by prescribed arrangements and record-keeping.
5. For both reliance and outsourcing, banks may choose to limit the size,
scope or nature of transaction types when utilising third parties.
In all cases, supervisors should have timely access to customer information
upon request.
Although these two categories seem similar or related, there are significant
differences between them and banks should ensure they understand those
differences and reflect these in their policies and procedures.
II. Reliance on third parties
6. Banks should have clear policies and procedures on whether and when it
is acceptable and prudent to rely on another bank or financial institution.
Such reliance in no way relieves the bank of its ultimate responsibility for
having adequate CDD policies and procedures and other AML/CFT
requirements on customers, such as understanding expected activity,
whether customers are high-risk, and whether transactions are suspicious.
7. In depending on another bank or financial institution to conduct certain
aspects of CDD, banks should assess the reasonableness of such reliance.
In addition to ensuring there is a legal ability to rely, relevant criteria for
assessing reliance include:
(a) The bank, financial institution or other entity (as permitted by national
law) on which reliance is placed should be as comprehensively regulated
and supervised as the bank, have comparable customer identification
requirements at account opening and have an existing relationship with the
customer opening an account at the bank.
Alternatively, national law may require the use of compensating measures
or controls, in cases where these standards are not met.
(b) The bank and the other entity should have an arrangement or
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understanding in writing acknowledging the bank’s reliance on the other
financial institution’s CDD processes.
(c) The bank’s procedures and policies should document the reliance and
should establish adequate controls and review procedures for such a
relationship.
(d) A third party may be required to certify to the bank that it has
implemented its AML programme, and that it performs CDD substantially
equivalent to or consistent with the bank`s obligations.
(e) The bank should give due consideration to adverse public information
about the third party, such as its subjection to an enforcement action for
AML deficiencies or violations.
(f) The bank should identify and mitigate any additional risk posed by
reliance on multiple parties (a chain of reliance) rather than a direct
relationship with one entity.
(g) The bank’s risk assessment should identify reliance on third parties as a
potential risk factor.
(h) The bank should periodically review the other entity to ensure that it
continues to conduct CDD in a manner as comprehensive as the bank.
For that purpose, the bank should obtain all the CDD information and
documents from the bank, financial institution, or entity that it relies upon
and assess due diligence conducted, including screening against local
databases to ensure compliance with local regulatory requirements.
(i) Banks should consider terminating reliance on entities that do not apply
adequate CDD on their customers or otherwise fail to meet requirements
and expectations.
8. Banks with subsidiaries or branches outside the home jurisdiction
frequently use the financial group to introduce their customers to other
parts of the financial group.
In countries that permit this cross- border reliance on affiliates, financial
institutions that rely on other parts of the group for customer identification
should ensure that the above assessment criteria are in place.
The FATF standards allow countries to exempt country risk from this
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assessment if the financial institution is subject to group-wide AML/CFT
standards and supervised on a group level by its financial supervisor.
III. Outsourcing/agency
9. Banks may choose to apply identification and other CDD processes
directly or can appoint one or more third parties to take these measures on
their behalf, sometimes in an agent relationship.
While AML/CFT compliance functions may be performed by third parties,
the responsibility for complying with CDD and AML/CFT requirements
remains with the bank.
The extent of the use of third parties usually depends on the business model
of the bank; normally, banks that operate by telephone or over the internet
or that have few “bricks & mortar” branches tend to use third parties to a
greater extent.
Banks may use third parties to expand their customer base or improve
customer support and overall access to their services.
10. Banks that choose to use third parties should ensure that a written
agreement is in place that sets out the AML/CFT obligations of the bank
and how these will be executed by the third party.
In some countries, the relationship between banks and their third parties is
regulated.
11. As noted above, it is important for banks to understand the difference
between using a third party as its agent and relying on another bank’s
customer identification and CDD processes.
An agent is usually, under the law of agent and principal, a legal extension
of the bank.
When a bank’s customer or potential customer deals with an agent of a
bank, it is legally dealing with the bank itself.
The third party will therefore be obligated to apply the bank’s policies and
requirements with respect to identification and verification and CDD.
12. In practice, banks’ third parties need to have the necessary technical
expertise, knowledge and training to apply customer identification and
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CDD measures of the bank.
In some cases, where third parties’ business models are based on acting for
several banks, they usually develop significant in-house expertise of their
own.
However, third parties are not always themselves subject to AML/CFT
obligations, although many often are.
Whether or not this is the case, however, the third party is always in the
position of applying its principal’s identification and CDD requirements
(which in turn must conform to legal requirements).
13. Examples of third parties routinely used by banks to apply their
customer identification obligations include retail deposit brokers, mortgage
brokers and solicitors.
ML/FT risk mitigation can be compromised when banks do not ensure that
applicable customer identification requirements and CDD are applied by
their third parties.
14. As noted, there should be a written agreement or arrangement
documenting the third party’s responsibilities, which should include the
following:
(a) requiring the application of the bank’s customer identification and CDD
requirements (including enquiring on source of funds and wealth, as
appropriate);
(b) ensuring that, where the customer is present in person at the time
customer identification and/or CDD measures are conducted, the third
party applies customer identification procedures that include viewing
original identification documents where this is required by regulations or
the bank;
(c) ensuring that, where the customer is not present at the time customer
identification is ascertained, the third party applies any applicable
prescribed or bank-stipulated non-face-to- face identification
requirements; and
(d) ensuring that the third party maintains the confidentiality of customer
information.
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15. Banks should also:
(a) ensure that if the third party is responsible for determining and/or
identifying the beneficial owner or a PEP determination, these
responsibilities are documented;
(b) ensure that the third party provides the bank with customer
identification information in the required time frames; and
(c) periodically review or audit, in a systemic manner, the quality of
customer information gathered and documented by the third party to
ensure that it continues to meet the bank’s requirements;
(d) clearly identify instances that the bank would consider failures on the
part of the third party to perform its duties as contracted and establish a
process for implementing appropriate actions, such as terminating the
relationship in response to identified failures.
16. The bank should obtain all relevant information from the third party in
a timely manner and ensure the information is complete and kept up to
date in the bank’s customer record.
17. Contracts with third parties should be reviewed and updated as
necessary to ensure that they continue to address the third parties’ role
accurately and reflect any updates to duties.
Annex 2
Correspondent banking
I. General considerations on correspondent banking
1. According to the FATF Glossary, “correspondent banking is the provision
of banking services by one bank (the “correspondent bank”) to another
bank (the “respondent bank”)”.
2. Used by banks throughout the world, correspondent accounts enable
respondent banks to conduct business and provide services that they
cannot offer directly (because of the lack of an international network).
Correspondent accounts that merit particular care involve the provision of
services in jurisdictions where the respondent banks have no physical
presence.
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3. The correspondent bank processes/executes transactions for customers
of the respondent.
The correspondent bank generally does not have direct business
relationships with the customers of the respondent bank, who may be
individuals, corporations or financial services firms.
The customer of the correspondent bank is the respondent bank.
4. Because of the structure of this activity and the limited available
information regarding the nature or purposes of the underlying
transactions, correspondent banks may be exposed to specific moneylaundering and financing of terrorism risks (ML/FT risks).
II. Correspondent banking ML/FT risk assessment – information
gathering
5. Banks that undertake correspondent banking activities should conduct
an appropriate assessment of the ML/FT risks associated with
correspondent banking activities and consequently apply appropriate
customer due diligence (CDD) measures.
6. Correspondent banks should gather sufficient information, at the
beginning of the relationships and on a continuing basis after that, about
their respondent banks to fully understand the nature of the respondent’s
business and correctly assess ML/FT risks on an ongoing basis.
7. Factors that correspondent banks should consider include:
(a) the jurisdiction in which the respondent bank is located;
(b)the group to which the respondent bank belongs, and the jurisdictions in
which subsidiaries and branches of the group may be located;
(c) information about the respondent bank’s management and ownership
(especially the presence of beneficial owners or PEPs), its reputation, its
major business activities, its customers and their locations;
(d) the purpose of the services provided to the respondent bank;
(e) the bank’s business including target markets and customer base;
(f) the condition and quality of banking regulation and supervision in the
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respondent’s country (especially AML/CFT laws and regulations);
(g) the money-laundering prevention and detection policies and procedures
of the respondent bank, including a description of the CDD applied by the
respondent bank to its customers;
(h) the ability to obtain identity of any third-party entities that will be
entitled to use the correspondent banking services;
(i) the potential use of the account by other respondent banks in a “nested”
correspondent banking relationship.
8. Information on the AML/CFT policies and procedures may rely on any
questionnaire filled by the respondent or on publicly available information
provided by the respondent (such as financial information or any
mandatory supervisory information).
III. Customer due diligence requirements
9. If correspondent banks fail to apply an appropriate level of due diligence
to correspondent banking relationships, they may find themselves holding
and/or transmitting money linked to illegal activity.
10. All correspondent banking relationships should be subject to an
appropriate level of CDD.
Banks should not treat the CDD process as a “paper-gathering exercise” but
as a real assessment of ML risk.
The gathering of information should be finalised, if necessary, based on
meeting with the local respondent bank’s management and compliance
officer, regulator/supervisor, financial intelligence units and relevant
governmental agencies.
11. CDD information should also be reviewed and updated on a regular
basis, in accordance with the risk-based approach.
This information should be used to update the bank’s risk assessment
process.
IV. Customer acceptance
12. The decision to accept (or continue) a correspondent banking
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relationship should be approved at senior level of the correspondent bank.
13. Information may be provided by FATF mutual evaluation reports and
statements on jurisdictions identified by the FATF as either being subject to
countermeasures or having strategic AML/CFT deficiencies.
Mutual evaluation reports by FATF-style regional bodies (FSRBs) may also
provide such information.
Any publicly available information from competent national authorities
may also be used by banks.
The fact that a country is subject to restrictive measures, particularly if
there are prohibitions on providing correspondent banking services, should
be taken into account.
Correspondent banks should pay particular attention when establishing or
continuing relationships with respondent banks located in jurisdictions
that have deficient AML/CFT standards or have been identified as being
“non-cooperative” in the fight against money laundering and terrorism
financing.
14. Correspondent banks should refuse to enter into or continue a
correspondent banking relationship with a bank incorporated in a
jurisdiction in which it has no physical presence and which is unaffiliated
with a regulated financial group (ie shell banks).
V. Ongoing monitoring
15. A correspondent bank should establish appropriate policies and
procedures to be able to detect any activity that is not consistent with the
purpose of the services provided to the respondent bank or any activity that
is contrary to commitments that may have been concluded between the
correspondent and the respondent.
16. If a correspondent bank decides to allow correspondent accounts be
used directly by third parties to transact business on their own behalf (eg
payable-through accounts), it should conduct enhanced monitoring of these
activities in line with their specific risks.
The correspondent bank should verify that the respondent bank has
conducted adequate CDD on the customers having direct access to accounts
of the correspondent bank, and that the respondent bank is able to provide
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relevant CDD information upon request to the correspondent bank.
17. Senior management should be regularly informed of high-risk
correspondent banking relationships and how they are monitored.
VI. Group-wide and cross-border considerations
18. If a respondent bank has correspondent banking relationships with
several entities belonging to the same group (case 1), the head office of the
group should pay particular attention that the assessments of the risks by
the different entities of the group are consistent with the group-wide risk
assessment policy.
The head office of the group should coordinate the monitoring of the
relationship with the respondent bank, particularly in the case of a
high-risk relationship, and make sure that adequate information-sharing
mechanisms inside the group are in place.
Case 1
19. If a correspondent bank has business relationships with several entities
belonging to the same group but established in different host countries
(case 2), the correspondent bank should take into account the fact these
entities belong to the same group.
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Nevertheless, the correspondent bank should also assess the ML/FT risks
presented by each business relationship.
VII. Risk management
20. A bank should establish specific procedures to manage correspondent
banking relationships.
Business relationships should be formalised in written agreements that
clearly define the roles and responsibilities of the banking partners.
21. Senior management should also be aware of the responsibilities and the
role of the different services (business lines, compliance officers (including
the chief AML/CFT officer or group AML/CFT officer), audit etc) within the
bank relative to correspondent banking activities.
22. A bank’s internal audit and compliance functions have important
responsibilities in evaluating and ensuring compliance with procedures
related to correspondent banking activities.
Internal controls should cover identification measures of the respondent
banks, the collection of information, the ML/FT risk assessment process
and the ongoing monitoring of correspondent banking relationships.
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Annex 3
List of relevant FATF recommendations
Annex 4
General guide to account opening
I. Introduction
1. This annex is a general guide detailing the principles set out in the main
body of these guidelines (paragraphs 35–41). This guide focuses on account
opening.
It is not intended to cover every eventuality, but rather to focus on some of
the mechanisms that banks can use in developing an effective customer
identification and verification programme.
It also sets out the information that should be collected at the time of
account opening and which will help the bank to develop and complete the
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customer risk profile.
2. For the purpose of this Annex, an account is defined as any formal
banking or business relationship established by a bank to provide or engage
in products, services, dealings, or other financial transactions.
This includes demand deposits, savings deposits, or other transaction or
asset accounts, or credit accounts or other extension of credit.
In keeping with the scope of the original document issued by the Basel
Committee in 2003, this guide only covers the opening of new accounts and
not the conduct of occasional transactions.
3. The guidance set out in this annex is therefore intended to assist banks in
defining their approach to account opening.
It may be adapted for specific application by banks in respect of their
AML/CFT policies and procedures, especially in developing sound
customer risk profiles and by national financial supervisors seeking to
further enhance the effectiveness of bank compliance with customer
identification and verification programmes.
Supervisors recognise that any effective customer identification
/verification programme should reflect the risks arising from the different
types of customer, types of banking product and the varying levels of risk
resulting from a customer’s relationship with a bank.
Higher-risk customer relationships and transactions, such as those
associated with politically exposed persons (PEPs) or other higher-risk
customers, will clearly require greater scrutiny than relationships and
transactions associated with lower-risk customers.
Therefore, the provisions in this guide should be read in conjunction with
the main body of the guidelines, and in particular with the provisions
related to assessing and understanding risks (see paragraphs 15–16 of the
guidelines) and should be adapted for identified specific (higher- or lower-)
risk situations.
4. Guidance and best practice established by national financial supervisors
should be commensurate with the risks present in the jurisdiction; for this
reason they will vary between countries.
According to this risk-based approach, jurisdictions may allow simplified
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customer due diligence measures to be applied for lower-risk situations.
For example, some jurisdictions have either taken or supported actions to
encourage financial inclusion by promoting lower-risk financial products
(such as an account with a limited set of services for specific types of
customer).
Conversely, in cases where there is a higher risk, banks should apply
enhanced due diligence.
Examples of such cases include the customer applying for specific products
featuring non-face-to-face transactions, that allow anonymity of certain
transactions, or that are specifically vulnerable to fraud.
5. Similarly, banks’ customer identification and verification policies and
procedures will differ to reflect risks arising from the relevant categories of
customers, products and services.
In designing and implementing customer identification programmes and
establishing a customer’s risk profile, banks should take into account the
risks arising from each type of financial product or service used by the
customer as well as the delivery channel and the location.
6. According to the FATF standards, banks should always identify
customers and verify their identity.
When doing so, banks should be conscious that some identification
documents are more vulnerable to fraud than others.
For those that are most susceptible to fraud, or where there is uncertainty
concerning the validity of the document(s) presented, the verification
requirement should be enhanced and the information provided by the
customer should be verified through additional inquiries or other sources of
information.
7. The rest of this annex is divided into two sections covering different
aspects of customer identification.
Section II describes what types of information should be collected and
verified for natural persons seeking to open accounts.
Section III describes what types of information should be collected and
verified for legal persons and legal arrangements.
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II. Natural persons
A. Identification of individuals who are customers or beneficial
owners or authorised signatories
8. For natural persons, the bank should collect the following information
for identification purposes from the customer or any other available source:
B.1 Information related to the customer’s risk profile
9. When the account opening is the start of a customer relationship, further
information should be collected with a view to developing an initial
customer risk profile (see in particular paragraphs 37–39 of the main body
of the guidelines):
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C. Verification of identity of natural persons
10. The bank should verify the identity of the customer established through
information collected according to paragraph 8 using reliable,
independently sourced documents, data or information.
The measures to verify the information produced should be proportionate
to the risk posed by the customer relationship and should enable the bank
to satisfy itself that it knows who the customer is.
Examples of different verification procedures are given below.
This list of examples is not exhaustive:
(a) Documentary verification procedures
• confirming the identity of the customer or the beneficial owner from an
unexpired official document (eg passport, identification card, residence
permit, social security records, driver’s licence) that bears a photograph of
the customer;
• confirming the date and place of birth from an official document (eg birth
certificate, passport, identity card, social security records);
• confirming the validity of official documentation provided through
certification by an authorised person (eg embassy official, public notary);
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• confirming the residential address (eg utility bill, tax assessment, bank
statement, letter from a public authority).
In some jurisdictions, there may be other verification procedures of an
equivalent nature that will provide satisfactory evidence of a customer’s
identity and risk profile.
(b) Non-documentary verification procedures
• contacting the customer by telephone or by letter to confirm the
information supplied, after an account has been opened (eg a disconnected
phone, returned mail etc should warrant further investigation);
• checking references provided by other financial institutions;
• utilising an independent information verification process, such as by
accessing public registers, private databases or other reliable independent
sources (eg credit reference agencies).
11. Banks should verify that any person purporting to act on behalf of the
customer is so authorised.
If so, banks should identify and verify the identity of that person.
In such a case, the bank should also verify the authorisation to act on behalf
of the customer (a signed mandate, an official judgment or equivalent
document).
D. Further verification of information on the basis of risks
12. Particular attention needs to be focused on those customers assessed as
having higher-risk profiles.
Additional sources of information and enhanced verification procedures
may include:
• confirming an individual’s residential address on the basis of official
papers, a credit reference agency search, or through home visits;
• prior bank reference (including banking group reference) and contact with
the bank regarding the customer;
• verification of income sources, funds and wealth identified through
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appropriate measures; and
• verification of employment and of public positions held;
• personal reference (ie by an existing customer of the same bank).
13. If national law allows for non-face-to-face account opening, banks
should take into account the specific risks associated with this method.
Customer identification and verification procedures should be equally
effective and similar to those implemented for face-to-face interviews.
In particular, banks should
(i) establish that the customer exists; and
(ii) establish that the person the bank is dealing with is that customer.
14. As part of its broader customer due diligence measures, the bank should
consider, on a risk- sensitive basis, whether the information regarding
sources of wealth and funds or destination of funds should be corroborated.
III. Legal persons and arrangements and beneficial ownership
15. The procedures discussed previously in paragraphs 8–14 should also be
applied to legal persons and arrangements.
Banks should identify and verify the identity of the customer, and
understand the nature of its business, and its ownership and control
structure, with a view to establishing a customer risk profile.
A. Legal persons
16. The term legal person includes any entity (eg business or non-profit
organisation, distinct from its officers and shareholders) that is not a
natural person or a legal arrangement.
In considering the customer identification guidance for the different types
of legal persons, particular attention should be given to the different levels
and nature of risk associated with these entities.
1. Identification of legal persons
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2. Information for defining the risk profile of a customer
which is a legal person
18.When the account opening is the start of a customer relationship, further
information should be collected with a view to developing an initial
customer risk profile (see in particular paragraphs 37–39 of the main body
of the guidelines):
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3. Verification of identity of legal persons
19. The bank should verify the identity of the customer established through
information collected according to paragraph 17 using reliable,
independent source documents, data or information.
The bank should obtain:
The bank should verify the identity of the customer established through
information collected
• a copy of the certificate of incorporation and memorandum and articles of
association, or partnership agreement (or any other legal document
certifying the existence of the entity, eg abstract of the registry of
companies/commerce);
20. The measures to verify the information produced should be
proportionate to the risk posed by the customer relationship and should
allow the bank to satisfy itself that it knows the customer’s identity.
Examples of other verification procedures are given below.
This list is not exhaustive.
(a) Documentary verification
• for established corporate entities – reviewing a copy of the latest financial
statements (audited, if available).
(b) Non-documentary verification
• undertaking a company search and/or other commercial enquiries to
ascertain that the legal person has not been, or is not in the process of
being, dissolved, struck off, wound up or terminated;
• utilising an independent information verification process, such as by
accessing public corporate registers, private databases or other reliable
independent sources (eg lawyers, accountants);
• validating the LEI and associated data in the public access service;
• obtaining prior bank references;
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• visiting the corporate entity, where practical;
• contacting the corporate entity by telephone, mail or e-mail.
In some jurisdictions, there may be other verification procedures of an
equivalent nature that will provide satisfactory evidence of a customer’s
identity and risk profile.
4. Verification of identity of authorised signatories and of
beneficial owners of the customer
21. Banks should verify that any person purporting to act on behalf of the
legal person is so authorised.
If so, banks should verify the identity of that person.
This verification should entail verification of the authorisation to act on
behalf of the customer (a signed mandate, an official judgment or
equivalent document).
22. Banks should undertake reasonable measures to verify the identity of
the beneficial owners, in accordance with the FATF definition referenced in
Table 3 note b and the due diligence procedures for natural persons
outlined in Section II above.
5. Further verification of information on the basis of risks
23. As part of its broader customer due diligence measures, the bank should
consider, on a risk- sensitive basis, whether the information regarding
financial situation and source of funds and/or destination of funds should
be corroborated.
B. Legal arrangements
1. Identification of legal arrangements
24. For legal arrangements, the following information should be obtained:
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2. Information for defining the risk profile of a customer which is
a legal arrangement
25. When the account opening is the start of a customer relationship,
further information should be collected with a view to develop an initial
customer risk profile (see in particular paragraphs 37–39 of the main body
of the guidelines):
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3. Verification of identity of legal arrangement
26. The bank should verify the identify of the customer established through
information collected according to paragraph 23, using reliable,
independently sourced documents, data or information.
The bank should obtain, at a minimum, a copy of documentation
confirming the nature and legal existence of the account holder (eg a deed
of trust, register of charities).
Measures to verify the information produced should be proportionate to the
risk posed by the customer relationship and enable the bank to satisfy itself
that it knows the customer’s identity.
27. Examples of other procedures of verification are given below.
This list of examples is not exhaustive.
In some jurisdictions, there may be other procedures of an equivalent
nature which may be produced, applied or accessed as satisfactory evidence
of a customer’s identity and risk profile.
It includes:
• obtaining an independent undertaking from a reputable and known firm
of lawyers or accountants confirming the documents submitted;
• obtaining prior bank references;
• accessing or searching public and private databases or other reliable
independent sources.
4. Verification of identity of authorised signatories and of
beneficial owners of the legal arrangement
28. Banks should undertake reasonable measures to verify the identity of
the beneficial owners of the legal arrangements, in accordance with
paragraphs 10–11 above.
29. Banks should verify that any person purporting to act on behalf of the
legal arrangement is so authorised.
If so, banks should verify not only the identity of that person but also the
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person’s authorisation to act on behalf of the legal arrangement (by means
of a signed mandate, an official judgment or another equivalent document).
5. Further verification of information on the basis of risks
30. As part of its broader customer due diligence measures, the bank should
consider, on a risk- sensitive basis, whether the information regarding
source of funds and/or destination of funds should be corroborated.
C. Focus on specific types of customer
1. Retirement benefit programmes
31. Where an occupational pension programme, employee benefit trust or
share option plan is an applicant for an account, the trustee and any other
person who has control over the relationship (eg administrator, programme
manager or account signatories) can be considered as beneficial owners and
the bank should take steps to identify them and verify their identities.
2. Mutuals/friendly societies, cooperatives and provident
societies
32. Where these entities are applicants for accounts, those persons
exercising control or significant influence over the organisation’s assets
should be considered the beneficial owners and therefore identified and
verified.
This will often include board members as well as executives and account
signatories.
3. Professional intermediaries
33. When a professional intermediary opens a customer account on behalf
of a single customer that customer must be identified.
Professional intermediaries will often open “pooled” accounts on behalf of a
number of entities.
Where funds held by the intermediary are not co-mingled but
“sub-accounts” are established which can be attributed to each beneficial
owner, all beneficial owners of the account held by the intermediary should
be identified.
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Where the funds are co-mingled, the bank should look through to the
beneficial owners.
However, there may be circumstances – which should be permitted by law
and set out in supervisory guidance – where the bank may not need to look
beyond the intermediary (eg when the intermediary is subject to due
diligence standards in respect of its customer base that are equivalent to
those applying to the bank itself, such as could be the case for
broker-dealers).
34. Where such circumstances apply and an account is opened for an open
or closed-end investment company, unit trust or limited partnership that is
subject to customer due diligence requirements which are equivalent to
those applying to the bank itself, the bank should treat this investment
vehicle as its customer and take steps to identify:
• the fund itself;
• its directors or any controlling board where it is a company;
• its trustee where it is a unit trust;
• its managing (general) partner where it is a limited partnership;
• account signatories; and
• any other person who has control over the relationship eg fund
administrator or manager.
35 Where other investment vehicles are involved, the same steps should be
taken as in paragraph 34 where it is appropriate to do so.
In addition, in cases when no equivalent due diligence standards apply to
the investment vehicle, all reasonable steps should be taken to verify the
identity of the beneficial owners of the funds and of those who have control
of the funds.
36. Intermediaries should be treated as individual customers of the bank
and the standing of the intermediary should be separately verified by
applying the appropriate methods listed in paragraphs 17-23 above.
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A new heart for a changing payments
system
Ms Minouche Shafik, Deputy Governor for
Markets and Banking of the Bank of England,
Bank of England, London
The Bank at the heart of the payment
system
Sometime around 1770, just a few yards from where we are sitting tonight,
two of the commercial banks’ so-called “Walk Clerks” congregated at the
Five Bells Tavern for lunch, weary after a morning spent visiting each of
their competitors in the City of London.
They reflected disconsolately on their increasingly impossible task of
exchanging ever-rising numbers of paper cheques at each individual bank
and settling ever-larger outstanding balances.
The idea occurred to one of them that they might encourage all of their
colleagues – for each bank had such Clerks – to join them for lunch at the
Five Bells every day, where instead of their tiring morning tours they could
carry out a much speedier, more reliable exchange of cheques.
Thus a clearing system for the City of London was born, from which many
of the UK’s modern payment systems descend.
From the start, the Bank of England has stood at the very heart of this
system.
Historically, banks had settled their net obligations to one another in coin.
But coins were an inefficient settlement asset, being difficult and risky to
transport.
So banks increasingly looked to the Bank of England to help settle the
mutual obligations, using Bank of England bank notes as the settlement
asset.
Later, clearing began to take place directly across accounts held at the Bank.
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The Bank’s Archive still holds copies of the ledgers recording the balances
on those accounts – Figure 1 shows example pages from the late 1870s.
A lot has changed in the past 250 years.
Pubs, thankfully, no longer form the hub of the clearing system! Paper –
whether in the form of elegantly-scribed ledgers, or IOUs – is also almost
wholly extinct in interbank clearing, with 98% of payments by value now
made electronically, and only 2% using notes, coins and cheques.
The pace of development of alternative methods of payment for households
and companies has also accelerated dramatically, driven by new and
innovative technology.
It is hard to imagine what one of those Walk Clerks from the 1770s would
make of the range of cashless, real-time, mobile payments options available
in the shops, restaurants and stations in and around Lombard Street today.
Yet, amidst all this change, some things remain the same.
The Bank of England still lies at the heart of the sterling interbank payment
system and banks still value the finality provided by settlement in risk-free
central bank money.
The role of the Bank of England as settlement agent originally arose from
its unique ability to create sterling.
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But the fact that it retains this role after so long a time also reflects the trust
placed in it by financial market participants and the wider public.
Paper ledgers are long gone at the Bank of England.
But in their place lies the Real Time Gross Settlement system (RTGS),
across which all payments between banks are settled.
The amounts involved are immense.
On an average day, RTGS settles around £500 billion between banks; that
is almost a third of the UK’s annual GDP every single day.
In turn, those payments back nearly every other payment that matters to all
of us on a daily basis – from salaries to company invoices, from car
purchases to coffee sales, from pensions to investment flows.
So it is no exaggeration to say that RTGS is the beating heart of the UK
payment system.
Indeed, RTGS is more critical to the UK economy than even these statistics
suggest.
By hosting the reserves accounts of the banking system, RTGS provides the
mechanism through which the Bank provides liquidity for financial stability
purposes and implements Monetary Policy Committee (MPC) decisions on
Bank Rate.
So it is intimately linked to the delivery of every aspect of the Bank’s
mission.
The Bank’s primary motivation in the provision of a high value payment
system has always been to promote stability and resilience.
From today’s vantage point, it is easy to forget how revolutionary the
introduction of RTGS was back in 1996.
Before RTGS, all interbank payments were subject to some element of
settlement risk – the risk that a bank would fail between the time it
promised to make a payment, and the time it delivered on that promise.
By allowing banks to settle high value transactions between each other,
electronically, in real time, RTGS eliminated settlement risk on the largest
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payments flows – the ones most likely to threaten financial stability by
bringing down the system if they failed.
But that is not the only innovation that RTGS has delivered over the years.
As the financial system has evolved, RTGS has been regularly updated,
introducing a raft of new functions and risk mitigants to respond to
changing demands.
Today, we are announcing that the Bank has completed, or agreed steps
that will complete, all the actions in response to the Deloitte report
published in March last year following the RTGS outage in October 2014.
Looking forward, as we celebrate RTGS’ twentieth birthday during 2016, it
is again time to ask fundamental questions about the shape of the Bank’s
settlement operations.
The way payments are made has changed dramatically in recent years,
reflecting changes in the needs of households and companies, changes in
technology, and an evolving regulatory landscape.
The range of payment providers is growing rapidly.
Given the implications of these changes for the Bank’s mission and for
users, businesses and regulators, it is important that the Bank consider how
RTGS will need to evolve to meet and shape payments trends in the coming
decades.
That is why we are today announcing our plan to design a blueprint for a
new heart that can support the future demands placed on the UK’s
high-value sterling settlement system.
In my remaining remarks tonight I want to do three things.
First, set out some of the key drivers of change. Second, explain some of the
strategic questions we want to ask on the future role of RTGS.
And, third, set out how we will go about developing a blueprint for a new
high value payments system.
Evolution in the payments landscape
Much has changed in the UK payments landscape in the past twenty years.
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In particular, I want to highlight two linked drivers of change as being
important in shaping the future demands placed on the Bank’s provision of
real-time settlement: the changing regulatory environment and
developments in payments technologies.
Some of the most important recent changes in the payment landscape have
been catalysed by regulatory intervention, for example the development of
the Faster Payments Scheme (FPS).
In the past, regulatory intervention in retail payments has been targeted,
addressing specific problems as and when they have emerged.
Going forward however, the Payments Systems Regulator (PSR) which
launched in 2015 is likely to create a new dynamic by stimulating a greater
focus on competition and innovation in payment systems.
Alongside this new regulatory focus, the pace of technological change in
payments has picked up sharply.
Recent years have seen huge growth in demand for payments services that
can be accessed in real time, at any time (“24x7x365”), in a wide variety of
locations through mobile phones and tablets.
The software on these devices also makes growing use of so-called
Application Programming Interfaces or “APIs” which allow the seamless
integration of payment into websites, and offer new ways to utilise
payments data to improve services to customers.
The “electronification” of payments and rise of mobile banking has enabled
non-banks to deliver services using existing payments infrastructure and
made it possible for challenger banks to grow without having to build an
extensive branch network.
The emergence of various forms of Distributed Ledger Technology (DLT)
poses much more profound challenges because it enables verification of
payments to be decentralised, removing the need for a trusted third party.
It may reshape the mechanisms for making secured payments: instead of
settlement occurring across the books of a single central authority (such as
a central bank, clearing house or custodian), strong cryptographic and
verification algorithms allow everyone in a DLT network to have a copy of
the ledger, and give distributed authority for managing and updating that
ledger to a much wider group of agents.
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The Bank is undertaking work to understand the implications of new digital
or e-monies and new methods of payments and financial intermediation as
part of the One Bank Research initiative.
Machine learning also promises to transform financial services and widen
the potential players in payments.
Banks will increasingly be able to automate interaction with customers.
As ever more data is analysed and algorithms that “learn” replace
rules-based programming, a number of areas such as credit assessment,
risk management, fraud detection and product personalisation will
increasingly rely on technology.
Many banks are already embracing these changes, but many non-bank
players with ready-made access to a wide range of customers and their data
are well positioned to compete.
Alongside the potential opportunities offered by changes in technology,
there are also potential risks.
For example, the demand for real-time retail payments can make it harder
to implement effective defences against money laundering, terrorist
financing, identity theft or other forms of fraud.
More connected, IT-intensive networks provide more channels for cyber
attackers to target and greater risks of contagion.
And rapid growth of non-bank payment providers could have profound
implications for the business models of banks, challenging their revenue
streams, altering the economics of credit provision and changing the risks
to financial stability.
New payments technologies also pose practical challenges, such as ensuring
they interface effectively with legacy IT systems in banks and payments
infrastructure.
What does all of this mean for the future of RTGS? Because of the changing
context I have described, the Bank of England has decided the scope of the
blueprint should be broad.
We need to understand these trends, whilst recognising that there is
considerable room for debate about the impact of the current wave of
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technological innovation.
We need to think about to whom we give access to the advantages of central
bank money with its unique qualities of finality of settlement.
Trying to predict the future is a risky business, but when we make decisions
about investment in systems that will last for a decade or more, they need to
enable the kinds of changes that users will demand.
So we need to make sure that we have “optionality” built in so that we can
cope with different states of the world.
We may conclude that the right way forward is a like-for-like replacement
of the current RTGS using more modern technology.
Or we may decide that more radical change is needed to meet the needs of
the UK’s future financial system.
We genuinely do not have preconceptions on this question – and will want
to consult closely with all of you, and a wide audience beyond this room, on
the benefits, costs and risks of alternative options.
A blueprint for RTGS and the Bank’s settlement infrastructure
Having set out the context in which we will develop the blueprint, I want to
say a few words about how it will be structured.
The blueprint will seek to answer four overarching questions.
First, what should the Bank’s policy objectives be in the delivery of sterling
settlement in central bank money?
Second, what functions should the UK High Value Payments System have?
Third, who should be able to access it, and how?
And, fourth, what should the role of the Bank of England be in the delivery
of that service?
Let me elaborate a little on each – starting with policy objectives.
The mission of the Bank of England is to promote the good of the people of
the United Kingdom by maintaining monetary and financial stability.
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The Bank promotes stability in sterling payments in four ways: through its
operation of RTGS; through the provision of liquidity insurance to the
banking system; through its supervision of CHAPS, the other recognised
payment systems, CREST and Central Counterparties; and through the
prudential supervision of banks by the PRA.
As discussed at the Open Forum in November, where there are
coordination or market failures the Bank can and has used its unique
position to shape financial markets for the public good.
The Bank of England has a long history of using its convening powers to
solve collective action problems, not least the introduction of RTGS itself in
the mid-1990s.
Around the same time, the Bank also had to step in to take over the design
and construction of the UK’s securities settlement infrastructure CREST,
after the collapse of the Stock Exchange’s TAURUS project.
We were strong supporters of the Continuous Linked Settlement initiative,
which since 2002 has played a major role in reducing settlement risk in
foreign exchange transactions.
More recently, the Bank has taken opportunities to modernise and innovate
in response to the changing external environment.
For example, the Bank has overhauled its framework for liquidity provision
and is preparing to introduce polymer banknotes.
In sum, while our primary concern will always be stability, we recognise
that, given the importance of the Bank’s settlement operations to the overall
system, our decisions will not only reflect but also shape the future
payments landscape.
The second issue is the desired level of functionality.
RTGS has evolved considerably over its twenty years.
Recent examples from a long list include: the introduction of a liquidity
savings mechanism in 2013, reducing the risk that banks will be unable to
settle payments due to liquidity shortfalls; the introduction of “pre funding”
in 2015, ensuring that all net exposures in retail schemes that settle in
RTGS are backed by central bank money; and the planned extension in
June this year of RTGS opening hours.
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Against this backdrop, we will ask what further changes might be required
from a new platform, as the needs of the wider payments universe develop.
There are many potential questions.
What are the implications of growing demand for a “24x7x365” model of
retail payments?
What enhancements to cyber security will be required in future years?
Have we pitched the balance between minimising settlement, liquidity and
operational risk in the right place?
What will be the impact of relatively nascent technologies such as the
distributed ledger?
Should RTGS adopt the latest messaging standards, not least to promote
their use more broadly within the UK’s financial system?
Are stakeholders comfortable that the right types of payments are being
made in real-time across RTGS?
We cannot answer all of these questions in a year – so an early priority, with
your help, will be to identify the most pertinent areas to focus on.
The third theme of the blueprint is access.
Access to a settlement account in RTGS is currently open to any bank,
building society, broker-dealer or CCP that holds a Bank of England
reserves account or any financial market infrastructure whose participation
is judged by the Bank to be enhancing to financial stability.
Compared with similar systems in other major jurisdictions, access to
RTGS is relatively highly “tiered”: almost 90% of the roughly 400 licensed
banks and smaller banks choose to settle indirectly through a
correspondent bank.
In order to enhance financial stability by reducing dependencies between
large banks and smaller banks, the Bank of England and CHAPS Co
undertook a de-tiering initiative which has resulted in a greater number of
banks having direct access to RTGS.
There is a question about whether we should go further and encourage or
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require a much larger number of banks to become direct members of major
UK payment systems and have an RTGS settlement account, in order to
spread the settlement risk benefits of RTGS more widely.
The emergence of a new breed of on-bank payments service providers,
regulated by the FCA, has extended that debate further, since it is currently
a requirement of a number of retail systems – in particular FPS and Bacs –
that direct participants should have a settlement account at the Bank.
Major changes to the access arrangements to settlement accounts raise both
policy and practical questions for the Bank – and could have implications
for market participants and fellow regulators too – so it is right that they
should be considered as part of the development of a broader blueprint.
Targeted extensions in access could bring benefits in terms of innovation.
But we need to think through the implications for stability, market
structure and costs.
The final theme of the blueprint is the role of the Bank.
The Bank developed the RTGS infrastructure itself, and is responsible for
the maintenance and development of all elements of its hardware and
software.
The Bank is also responsible for the day-to-day operation of RTGS,
although these running costs are in turn charged out to its users on a full
cost recovery basis.
The rules and procedures of the various payments systems that settle in
RTGS – CHAPS, Bacs, FPS, LINK, Cheque & Credit, and Visa Europe – are
maintained by their respective private sector members, though there is
close co- operation between the schemes and the Bank’s operational team.
The recognised payments schemes are themselves supervised by the
Financial Markets Infrastructure Directorate of the Bank.
We will want to examine the Bank’s role in delivering payments and
settlement services, looking closely at how the United Kingdom compares
to elsewhere around the world and the international guidance on risk
standards set out in the Principles for Financial Market Infrastructure.
The Bank’s experience, particularly during the financial crisis, has been that
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having direct operational control over RTGS has paid substantial dividends
in terms of the delivery of its mission, so I think it is fair to say we start with
a certain bias in that regard.
But the appropriate model for IT development, service governance and risk
management depends quite heavily on the chosen way forward for the
RTGS infrastructure.
In light of the emerging results of the blueprint, the Bank’s supervisory
function will review whether any changes are necessary to the supervisory
model for the high value sterling payments system.
A blueprint with buy-in
The agenda I have set out today is an ambitious one, with important
implications both for the many institutions and infrastructures that
interface with the system today and for those that might do so in the future.
Our aim is that by the end of 2016 we will have agreed a blueprint for
high-value sterling settlement in the years ahead, with technological
development of that blueprint beginning in 2017.
To reach that deadline, there is a great deal to do – and we cannot do it on
our own.
In the first part of 2016 we will be seeking input from a wide range of
stakeholders, both in the industry and outside it, to help define the
questions and ensure we have identified the right options.
We will be looking overseas to learn what we can from similar exercises
conducted in other jurisdictions.
Later in the year we expect to consult formally and in public on a focussed
set of alternative ways forward.
Throughout that process, we will need your help and guidance – to ensure
we understand how the future payments landscape is likely to develop, to
identify the needs of market participants, and to provide practical guidance
and assistance.
At a time when firms face many competing initiatives, we understand the
importance of minimising uncertainty, and providing rigorous costings for
what we propose.
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Throughout the year and beyond, we will work closely with the industry,
our supervisory colleagues at the Bank of England, the Payment Systems
Regulator and its Payments Strategy Forum, HM Treasury and the
Financial Conduct Authority to develop a blueprint with the broadest
possible buy-in.
Conclusions
In the pursuit of financial stability, the importance of resilience can hardly
be overstated: a persistent disruption to people’s ability to make and receive
payments would cause great damage to the UK economy, so Parliament and
others rightly hold the Bank and the wider financial community to the
highest standards of stability.
It is sometimes claimed that this relentless focus on stability makes central
banks the enemies of innovation, and defenders of the status quo.
I believe that is a fallacy.
Innovation and stability can go hand in hand, as some of the history of
payment systems has shown.
The innovation of meeting in the Five Bells every lunchtime reduced the
risk that Walk Clerks would lose track of their notes and coins while
trooping from one bank to another around the streets of the City of London.
The move to a central ledger at the Bank of England removed the need for
notes and coins to be exchanged between banks at all. The advent of RTGS
removed the risk that a bank would fail before it made a promised payment.
More recent reforms have reduced liquidity risk in RTGS and extended
access and hours of service.
Our challenge will be to navigate a path that redesigns RTGS in such a way
that its resilience is further enhanced, while at the same time enabling
innovation for the public good. Thank you.
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Embarking on a new voyage? Solvency II in
context
Text of The Insurance Institute of London Lecture
by Mr Sam Woods, Executive Director of Insurance
Supervision of the Bank of England, at Lloyd's of London, London
I am grateful to Kayleigh Guinan and Mark Cornelius for their assistance in
preparing this speech. I am also grateful to Norma Cohen (Bank of
England), Dr Adrian Leonard (Cambridge), Professor Philip Rawlings
(Queen Mary) and Robert Thoyts (FCA) for their views and input.
Good afternoon.
The good ship Solvency II is now afloat.
It has taken a long time to make it seaworthy.
Some might question whether we need this newly improved vessel.
Indeed, some might challenge whether we should have a ship at all.
But that is largely academic, given we are now under way and in light of the
gargantuan efforts insurance firms and regulators have put into getting us
to this point.
In my speech today, I would like to look at this development in the wider
context of insurance history.
First, I would like to offer a brief view on why, looked at through the lens of
today, we regulate insurance companies at all.
Second, we will take a very whirlwind tour of 5,000 years of insurance
activity, for the single purpose of pointing out that for at least
four-and-a-half of those five millennia there was very little regulation of
insurance, if any.
Third, I will examine how the British state has involved itself in the affairs
of insurance companies over the past 500 years.
Finally, I will ask what - if anything - we can learn from this as we enter the
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Solvency II era.
My main conclusion, which may make me unpopular with many colleagues
and members of the insurance industry, is a simple one: Solvency II is a big
and important change, but - when viewed in the context of history - we are
still sailing the same ship, in broadly the same direction.
Why do we regulate insurers?
Individuals and institutions give money to insurance companies to transfer
the cost of risks they could not otherwise bear.
In doing so, they trust that the insurer will make good on its promise in the
event that the insured risk crystallises.
Indeed, the word policy comes from the Italian "polizza", which meant a
promise or an undertaking.
Like banks, insurers invest policyholder funds directly onto their balance
sheet thereby exposing customers directly to the risk inherent in those
balance sheets.
Our job at the PRA is to make sure that insurance companies keep their
promises to pay policyholders and do not let them down, often when they
need that money the most.
Insurance companies undertake an activity that matters, often critically for the corporates that rely on protection of insurance for the day-to-day
running of their businesses, and for individuals who invest a significant
portion of their wealth in insurers over their lifetime, or who rely on
insurers to protect them against financial disasters.
It is for these very basic reasons that we are interested in insurance as a
matter of public policy.
However, we cannot justify regulation of an industry just because its
activity is important.
The aim of regulation is always to correct some sort of market failure.
The insurance industry has many characteristics that could lead to the
market producing a sub-optimal outcome, if left alone.
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First, the insurance business model is unusual in that it has an inverse
production cycle - insurers typically receive premia upfront for a service
that may or may not have to be rendered in future (claims), the cost of
which is difficult to calculate.
Policyholders rely on the insurance company to set aside appropriate
provisions to satisfy future claims, but the market may not always be a
reliable mechanism for ensuring that insurance companies do not grow
excessively by taking on too much risk.
Insurance obligations are often long-term and so policyholders trust
insurance companies with their money for considerable periods of time.
It is possible that the behaviour and incentives of an insurance company
evolve in a way that does not take account of the interests of policyholders,
not least because the best interests of the shareholder and the policyholder
are not perfectly aligned.
The receipt of premia before claims have to be paid can introduce perverse
incentives for struggling insurers in particular.
For instance, faced with the prospect of failure, there is a risk that insurers
begin to invest in high-return but riskier assets, or rely on unsustainably
priced new business to ride the tide, without being called to account by the
market.
This looks dangerously like a "gamble for resurrection", which might in
some circumstances be a rational strategy for shareholders but is unlikely to
serve policyholders well.
Moreover, the inability of policyholders to transfer their policy or amend
the terms of what is essentially an infungibile contract limits the extent to
which they can maintain the best deal.
Furthermore, it is difficult for policyholders to assess the true soundness of
any one firm.
The absence of a tough claimholder therefore necessitates the existence of
some objective standard by which insurers can be assessed - in today's
environment, this most often takes the form of being authorised by a
supervisory authority that subjects firms to legal regulatory standards.
Of course, this standard will always be imperfect - but I think it is far better
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than nothing.
The role of the PRA is to make sure that the risks for which insurance
companies provide protection do not revert to the customer when bad
outcomes happen.
It would be grossly unfair if you had paid somebody to take your risks away,
only to find that you had unwittingly acquired a huge credit risk by giving
your money to a financially unsound company.
Our main job at the PRA is to ensure that firms are safe and sound, and
contribute to policyholder protection.
That way, the shareholder can reap the rewards if the risks pay off, but will
bear the cost if the firm loses money.
This public policy case is well established in many countries, such that the
approach of different regulators is often founded in commonly agreed
principles.
For instance, in the 1970s, the introduction of Solvency I codified these
principles into a set of requirements across the EU.
The birthplace of insurance
However, looked at across the sweep of insurance history, this public policy
case is a new-fangled set of ideas.
I have tried to find out what, if anything, public authorities have thought
about insurance through time.
In my quest to find the answer to this question, I ended up going back
further than anticipated - to around 3000 B.C. - and came across the
curiously-named practice of "bottomry" in the era of Babylon.
Bottomry, it turns out, was a type of contract whereby a lender would, for a
fee, put up money (either in the form of a loan or sometimes a joint stake in
the stock) for the purpose of advancing trade.
This was on the understanding that "the borrower should, in consideration
of a high rate of interest, be freed from liability in the event of certain
accidents happening, e.g. failure of goods to arrive at their intended
destination".
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This looks to me rather like a Babylonian version of today's catastrophe
bond.
The practice of bottomry flourished due to the proximity of another group
of great traders - the Phoenicians, who adapted the basic concept to support
trade expansion on the Greek coastline during the 10th and 9th centuries
B.C., and to the increasing domination in the Aegean Sea after 800 B.C. of
Greek traders who needed indemnity against their cargo.
Hop westward across the Mediterranean Sea to ancient Rome, and citizens
were paying subscriptions to so-called "burial societies" to cover the cost of
expenses associated with their death - a kind of latter-day funeral
insurance.
This activity evolved such that by the second century A.D. it became
common practice instead to pay the relatives of the deceased person a lump
sum (the funeraticium), provided their subscription was not in arrears and
the deceased had not committed suicide.
Despite not being labelled as such, this arrangement seems in some way
similar to a modern-day life insurance policy.
And yet back then, perhaps unsurprisingly, the subscriptions paid by
members were not subject to any protections or oversight - indeed, when a
burial society did run out of money, it was commonplace simply to issue a
notice to convey the demise of the society and the fact that funeral expenses
would no longer be met.
There is also evidence that soldiers in the Roman army were paid a lump
sum at retirement, despite the fact that contributions were not made
throughout the soldier's lifetime.
By medieval times, the Church had become one of the largest employers
and had started occasionally to issue pensions to clergymen.
One such example involved Nicholas Thorne, a former abbot of St
Augustine's monastery, who was living in difficult circumstances.
Thorne had voluntarily retired, apparently stricken by a guilty conscience
after he acquired some documentation on behalf of the abbey through
bribery at the Court of Rome.
The scandal led him to retire to an ordinary monastery in Yorkshire, but
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when his old comrades heard of his infirmity and weakness, they awarded
him an ex gratia pension of 10 marks a year.
It seems unlikely that the Church extended such gestures on a regular basis,
but from this point onwards we can see evidence of pension provision via
employers (the Church and King), particularly for notable individuals in
society where reliance on charity alone would not suffice.
Such examples are not representative of the modern day insurance
companies established since the 19th century.
But I include them to illustrate that the principles of insurance were very
much alive as far back as our earliest civilisations - and mostly without any
controls or regulation around them. So what changed?
Enter the state
This brings us to my main theme today: the interest of the British state in
the affairs of insurance companies.
My aim is not to do full justice to this field of history given the rich body of
academic literature available, but - in order to see Solvency II in context - to
give a flavour of the sorts of philosophies and motivations that seem to me
to have guided the British state's involvement through time.
Most textbooks will reference marine risk as one of the earliest forms of
insurance in the UK.
But evidence of one of the first genuine insurance policies suggests that
whilst the first marine contract may well have been written in nearby
Lombard Street, the risk was not taken on by British underwriters - instead,
it was underwritten by Italian counterparts temporarily resident in London.
Indeed, throughout this period, there are several mentions of insurance
interactions between London and the Italian regions of Lombardy and
Tuscany - hence the development of policy wordings according to the
customs of what would become known as Lombard Street.
The contracts written around this time - which de-coupled the insurance
risk from the financing of voyages such that there was a genuine insurance
element - related to popular, often expensive, commodities like woollens,
iron and grain.
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So it is little surprise that disputes arose when adverse events took hold,
particularly when risks were written across borders.
In addition, it became easy to enter into dishonest practices, for example by
finding multiple brokers to write the same risk and then cashing in several
policies for the same insured event.
This brings us to the first, to my knowledge, serious participation of the
British state in the affairs of insurers: disputes.
These disputes led to the involvement of the judicial system, with high
volumes of cases referred to the Privy Council.
When this situation became untenable, the Privy Council established a
tribunal (later known as the Court of Assurances) to which seven merchants
(along with a Judge of the Admiralty and one civil and one common lawyer)
would report twice a week (Monday and Thursday) to resolve disputes.
This group had authority from Parliament to commit underwriters to
prison if they failed to meet their obligations.
In 1575, the Privy Council ordered the Lord Mayor to compile some rules
since no body of law existed to determine the resolution of insurance
disputes.
Around the same time, Queen Elizabeth granted a monopoly on the writing
of assurance policies to Richard Candeler, who led the newly-created Office
of Assurances.
The Office introduced a system of fees - with the Office receiving a fixed
percentage per £100 insured - for the production of physical written
policies.
Both through the creation of the Office and Court of Assurances, and the
receipt of customs duties from insurers, the Privy Council in the 16th
century - as approved by the monarch - cemented the role of the state in
exercising a judicial function and creating an environment of policy
registration and anti-fraud conducive to commerce.
So, as I see it, this first phase of engagement between the British state and
the insurance sector was effectively a trade: dispute resolution services
were provided by the state, and insurers contributed some revenue to it in
return. Indeed, in the early stages this revenue went directly to Candeler
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himself.
Despite the tight state controls around who could write insurance, the
nature of risks being underwritten was granted little oversight - so much so
that, for many, the practice of insurance became synonymous with
gambling in the 18th century.
Perhaps - and I say this with some trepidation here at Lloyd's - some of the
most egregious examples of such behaviour were evident in the marine
market.
By this point, London had emerged as a centre of excellence in marine risks,
due partly to its strategic location on famous shipping routes.
Marine insurance had become a necessity for trade - without protection, a
bad storm could overturn the entire fortunes of merchants.
But a lack of safeguards paved the way for abuse.
One particularly spectacular example involved John McDougall, a
Glaswegian merchant, who arranged to have a ship called Friends (whose
cargo was valued at £1000) deliberately shipwrecked off the coast of
Denmark - but not before insuring his own stake in the voyage in five
separate policies for £3,475 and insuring the ship and other goods for
£1,660 in a further three policies.
In total, he obtained eight policies on the same risk - spreading the deceit
between unsuspecting underwriters across Glasgow, Dundee, Hull and
London. In doing so, McDougall (and others like him), introduced a
speculative spirit that threatened the more sober motives crucial to
indemnification contracts.
Practices such as those described above ultimately led Parliament to take
action.
This first took the form of the Marine Insurance Act 1745, which rendered
void marine policies made without an insurable interest.
A similar provision was subsequently applied in relation to life insurance
under the Life Assurance Act 1774.
These Acts did leave a gap - namely, non-marine indemnity policies.
However this was filled when gambling contracts were rendered void by the
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Gambling Act 1845, as the existence of an insurable interest served to
distinguish insurance contracts from gambling contracts.
This was not the first time that Parliament had concerned itself with the
affairs of insurance companies, however.
In 1739, Britain entered into a war with Spain.
As a consequence, trade with Spain ceased but - perhaps surprisingly - the
underwriting of Spanish ships by British underwriters continued unabated.
This led to a somewhat perverse situation in which British insurers
compensated enemy merchants for shipping losses suffered at the hands of
British privateers and squadrons of the Royal Navy.
The value of insurance trade was, it seems, considered by many to be too
valuable to forfeit voluntarily as Britain entered a period of sustained
warfare with Spain and then France.
By 1748, attitudes had changed and Parliament passed an Act which
banned the insurance of enemy ships by British insurers.
Yet the Act was expired just a few months later (after the Seven Years War
ended) such that insurers did, in fact, enjoy considerable discretion over
which risks to underwrite, including foreign enemy ships.
I think that what this example ultimately demonstrates is the importance of
trade and competitiveness in shaping the British state's involvement in the
affairs of insurers.
The protection of enemy ships was at direct odds with Britain's foreign
policy - but trade was ultimately considered strategically more important.
In common with the environment in which our eighteenth-century
forebears worked, trade and competitiveness remain important contextual
factors in the debate about how we should regulate insurers today.
Indeed, it is useful to remind ourselves that these debates about
competitiveness have been a feature of the state-business nexus around
insurance for several hundred years.
So, I think that we can see in this phase the emergence of a more complex
set of interests and motivations for the British state in dealing with the
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insurance sector - heightened concern about reckless or dishonest practices
by policyholders, and debates about competitiveness and the importance of
the industry to London and the Exchequer.
But back in the 18th century, the aversion of Governments to getting
involved in the affairs of insurers led to the development of a "freedom with
publicity" approach.
In practice, this meant self-regulation with some element of disclosure in
order to encourage market discipline.
A burgeoning insurance press emerged in the 1840s; initially funded by the
revenue from insurance advertisements, these newspapers quickly emerged
as guides to help the consumer and, indeed, many became increasingly
critical as new companies began to go bust.
It wasn't until the Bubble Act was repealed in 1825 that insurers were able
to organise freely as regular joint stock companies, outside the auspices of
the Office of Assurances.
As a consequence, the number of insurance companies skyrocketed;
following a flurry of formations in the 1820s, more than four hundred
insurers were established over the next four decades12, ranging from small
(often fraudulent) companies to some names still around today.
Somewhat startlingly, of the 219 insurers established between 1843870, 170
were discontinued by 1870 - so over three out of every four new companies
failed.
In 1869, the Albert Life Assurance Company failed, in part due to an
over-ambitious takeover strategy but also to having racked up excessive
expenses, inadequate premia and an unexpectedly high surrender rate.
Despite a suspicion that the Albert had been insolvent for several years, the
company only failed when it ran out of liquid assets to pay current claims thus revealing the limited oversight of insurers more generally and, in this
case, the lack of legal means available to prevent the company from trading
any earlier.
The Albert is therefore often cited as the catalyst15 for a piece of legislation
passed the following year - the Life Assurance Companies Act 1870 - which
attempted to address such problems and establish a scheme of regulation
specifically tailored to insurers.
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This in part reflected the view of the insurance industry by Parliament described by the Select Committee of 1853 as "those useful institutions" - as
playing an important role in the economy.
It is noteworthy that even back in the 19th century, many were outraged by
the introduction of the Act which to them represented "the mephitic
influence of red-tape regulations" - a sentiment that has surely been uttered
in more recent times too.
But ultimately, it was considered too costly for the state to rely on the
effectiveness of market discipline at a time when the reputation of the
industry was so sour it was being satirised in novels by Dickens.
Indeed, for these reasons the 1870 Act was widely welcomed by
professional bodies like the Institute and Faculty of Actuaries.
The 1870 Act introduced a number of elements aimed at regaining the
confidence of policyholders in the insurance sector.
First, insurers now had to stump up £20,000 (roughly £2m in today's
money) as security before they reached a certain size, which curbed the
influx of new companies that, up to this point, had been entering the
market at very rapid rates.
In addition, accounts and balance sheets had to be published in a
prescribed form, thereby introducing a degree of consistency and
comparability between different firms.
Importantly, firms now had to publish an actuarial report on their financial
condition every five years and insurers had to take into account prospective
liabilities under existing policies; in other words, they had to look forward.
The 1870 Act was clearly a major evolution of the state's approach to
insurance and established many of the building blocks that still underpin
the regulation of insurers today - the importance of solvency, the role of the
actuary, the interests of current and future policyholders, and a role for
financial disclosure.
Despite contemporary opinion at the time suggesting that a delicate balance
needed to be struck between the role of the state and the activity of the
market, the willingness of the state to legislate on these matters was a
significant step in that it acknowledged more explicitly than before a
legitimate public interest in insurance.
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Despite this, many thought that the Act was not robustly implemented, nor
did it deliver results overnight.
Indeed, the 1870 Act was relatively non-interventionist compared to how
insurance regulation would evolve throughout the 20th century.
But before we come to developments in the nearer term, it is worth noting
that it wasn't just the private sector that was mobilising itself in the
insurance industry at this time.
In 1865, Parliament passed the Government Annuities Act, which
empowered the Postmaster-General to conduct life assurance business on
behalf of the state.
A year earlier, Gladstone (then Chancellor) delivered a speech to the House
of Commons in which he was particularly scathing of the high lapse rates
and expense ratios which it was felt were giving policyholders a raw deal.
His remedy was for the state to compete directly with these companies in
the mass market in a bid to raise standards or drive them out of business.
The insurance sector today is no doubt relieved that such a strategy is not
being adopted by the PRA.
And, in fact, the scheme was not very successful in the end, largely because
it abandoned the collection of weekly premia by doorstop agents which
ultimately increased lapse risk.
The state would later dabble in annuities once more but motivated by a
different set of reasons this time - the funding of war.
During the early part of the 20th century, I am told the Government
extended annuity provision as a way to access funding for World War.
Indeed, there is evidence that states have used the provision of insurance as
a way to self-fund going as far back as the 15th Century; in 1425, the
city-state of Florence introduced a specialised social insurance system, the
so-called 'Dowry Fund', which enabled fathers to make regular deposits on
behalf of their daughters to accumulate a dowry that would be payable upon
their marriage - all for the purpose of financing the state purse.
Over the course of the 20th century, regulation evolved further but the
concept of supervision had not yet surfaced, at least not in the UK; the UK
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Board of Investment appointed its first actuary in 1917, but by this point the
New York State Insurance Department was already employing 179
(supervision) staff.
By the 1970s, an era of supervision - as distinct from regulation - had begun
in the UK.
The more recent history of insurance regulation over the last century is a
major topic in its own right, so I only propose to outline a few points.
In 1923, the Industrial Assurance Act introduced a Commissioner to
discharge statutory powers on behalf of the Board of Trade, with the idea of
specific regulatory bodies introduced.
By 1946, the regulatory framework had expanded to include motor, aviation
and transit insurance and, significantly, the deposit system was replaced by
a more sophisticated solvency margin which specified that a particular
margin of assets over liabilities should be maintained.
A string of high-profile failures in the 1960s and 1970s - including the
failure of Fire, Auto and Marine which left 400,000 (mostly motor)
policyholders uninsured, and an even bigger failure in 1971 when Vehicle &
General, with 1.2 million policyholders, collapsed - led to demands for
further reform at a time when a wave of consumer protection laws beyond
the insurance sector had put regulation firmly on the agenda in any event.
Relatively speaking, up until the 1970s, individuals running insurance
companies attracted scarce regulatory attention.
This all changed in the 1970s when conditions around the fitness and
propriety of senior individuals were introduced.
In practice, however, the professional conduct of individuals - as well as the
organisation and culture of insurance firms - has always mattered,
particularly in earlier periods when reputation was the only means by
which policyholders could assess the safety and soundness of insurers.
The failure of Equitable Life in 2000 - driven by an over-extension on the
part of the company in offering guaranteed annuity rates on their products
with insufficient reserves to pay out - reinforced the importance of a sound
regulatory and supervisory framework and, once again, the case was reform
was alive.
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But perhaps the single largest factor in determining the nature of state
involvement in the insurance sector towards the end of the 20th century
was the UK's membership of the European Economic Community.
Not only did it require the UK to enact a package of European directives
(colloquially known as Solvency I), but it has had a significant impact on the
British state's involvement in the affairs of insurance companies ever since.
Whilst Solvency I allowed the state to introduce further UK-specific
initiatives for the insurance sector - such as the Individual Capital
Adequacy Standards (ICAS) regime - insurers and regulators alike are now
bound by European-wide maximum-harmonising requirements, most
notably of course through the recent implementation of Solvency II.
Conclusion
What can we learn from this?
As with all history, one can take different views on what happened in the
past, why it happened and whether it has any significance for us today.
Personally, I take three things from it:
First, there is a sound public policy case for the regulation of insurance.
But looked at in the very long context of insurance history, the state's
involvement in the direct regulation of insurance activity is a relatively
recent phenomenon.
Second, coming to the UK, a tidy-minded historian could easily identify
some common themes which appear present in different phases of the
British state's involvement in insurance, and perhaps weave them into a
coherent narrative.
I am less convinced. With the exception of a consistent interest in being
able to raise revenue from insurance activity, the motivations and
philosophies which have guided the British state's involvement in insurance
matters seem to me to have varied very widely through time.
The earliest phase of dispute resolution, the later phase of freedom with
publicity, and our current phase of quite intensive prudential and conduct
supervision seem to me to be very different.
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Third, although there are important technical differences between ICAS
and Solvency II, the basic philosophy remains similar: market-consistent
capital regulation coupled with supervision.
I do not wish to underplay the huge efforts made by many people across the
insurance sector in bringing in Solvency II, but compared to previous shifts
in philosophy, the change appears quite modest.
To return to my marine analogy, the good ship Solvency II has more
up-to-date and useful features than the old one. But it is an evolution, not a
revolution, in ship design.
It still has cabins, a bow, and propellers.
More importantly, we may have tuned up the engine a bit and altered
course by a few degrees, but we have clearly not changed our course or our
destination.
Thank you.
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Monetary policy and financial stability looking for the right tools
Timothy Lane, Deputy Governor of the Bank of
Canada, to HEC Montreal, Montreal, Quebec
Introduction
Thank you for the opportunity to speak here today.
My remarks will focus on the following question: Should a central bank's
decisions on monetary policy account for the stability of the financial
system and, if so, how?
We at the Bank of Canada are grappling with this question, and it is being
debated by economists and policy-makers around the world.
This topic is not new, but finding the right answer now seems more urgent
than ever.
The global financial crisis that began eight years ago has taken an enormous
toll, both economic and, more important, human.
Around the world, including in Canada, the crisis ushered in a period of
subpar economic growth and inflation, which continues to the present day.
So it's easy to see why promoting financial stability - and preventing crises
in the future - is such a high priority for world leaders and all those involved
in the financial system.
This priority has given rise to an ambitious and comprehensive agenda of
reforms to make the global financial system more resilient.
But, in thinking about how to prevent financial crises, it's also natural to
look at monetary policy.
After all, when a central bank influences the cost of financing through
changes in the policy interest rate, its actions affect the economy by
changing asset prices, encouraging or discouraging risk taking, and
influencing credit flows.
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This suggests that monetary policy has the ability to influence financial
stability, for good or ill.
If a central bank eases monetary policy, it stimulates the economy, largely
by encouraging households and companies to borrow more and pushing up
the prices of many types of financial assets.
The increased borrowing, together with the greater wealth that comes with
higher asset prices, encourages households to spend more, generating
income for other households and creating opportunities for companies.
But, at the same time, more debt and higher asset prices may create
vulnerabilities in the financial system.
In Canada in the period since the global financial crisis, the most
concerning vulnerabilities have been in the household sector - notably the
combination of rising indebtedness and elevated house prices.
But a wider set of vulnerabilities, in more than one sector, was important in
setting the stage for previous crises.
For example, heightened risk taking by investors and elevated leverage in
large financial institutions and in shadow banking activities were among
the factors that turned a downturn in the U.S. subprime mortgage market
into a global financial crisis.
While increasing such vulnerabilities at the margin is a normal
consequence of an easing of monetary policy, they may become of
particular concern if interest rates stay low for an unusually long time.
In the presence of such vulnerabilities, an event such as an adverse
macroeconomic shock can stress the financial system or even trigger a
crisis.
Since monetary policy can contribute to financial vulnerabilities, it could
also be argued that it can be adjusted to limit them.
But whether and how to do that can't be considered in isolation from the
central bank's mandate.
For the past quarter century, the Bank of Canada has had the responsibility
of using monetary policy to achieve low, stable and predictable inflation, a
goal cemented in our 2 per cent inflation target.
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This is our primary mission, which guides our setting of the policy interest
rate.
While a failure to maintain financial stability would ultimately impair our
ability to achieve the inflation target, it is generally understood that we
should aim to get inflation sustainably back to target within about two
years.
Within this framework, financial system developments are always part of
monetary policy discussions, because of their importance for the real
economy and especially because of the transmission of the effects of
monetary policy.
We have some flexibility within our inflation-targeting framework: we
might accept a slower return of inflation to target, if necessary, to avoid
adverse effects on financial stability.
But the expectation has been that we would only rarely, if ever, use the
framework's flexibility in this way.
This is not to say that our framework is immutable.
The law governing the Bank since 1935 says we should "regulate credit and
currency in the best interests of the economic life of the nation."
How we fulfill that requirement has evolved over the years.
Inflation targeting was established in Canada in 1991 under an agreement
with the federal government, which we renew every five years.
We are currently working toward the next renewal, which takes place later
this year.
This process gives us an opportunity to re-examine our mandate and
consider other ways of doing things.
Financial stability, and its relationship to monetary policy, figures
prominently in our current research agenda.
In the time I have, I will discuss how our thinking on the interactions
between monetary policy and financial stability has been evolving, tell you
about some interesting recent research by our staff and touch on some
questions that have yet to be resolved.
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Financial Stability, then and now
Let me start by saying that central banks have always had a role in
providing stability to financial systems. Some of our tools are in the
category of crisis management; others for crisis prevention.
When the financial system comes under stress, a central bank may need to
calm financial markets through open market operations or act as the lender
of last resort to financial institutions to forestall bank runs.
These tools were used effectively by many central banks during the global
financial crisis of 2007-09.
Some of the Bank of Canada's financial system activities are also designed,
in part, to make the system less prone to crisis.
An example is the oversight of key financial market infrastructures, such as
payment systems and central counterparties.
Such oversight is intended to bolster their risk management so that they
can support the continued functioning of financial markets in times of
stress.
More broadly, central banks are well placed to analyze systemic
vulnerabilities and how they might play out.
In this vein, in 2002, the Bank of Canada began publishing a semi-annual
Financial System Review to raise awareness of the most important risks to
Canada's financial system.
But the Bank of Canada is only one of several official bodies whose policies
have an influence on financial stability.
Others control many of the relevant tools - such as capital requirements, the
regulation of housing finance, the regulation of financial market conduct
and the framework for resolution of financial institutions.
The Bank's analysis of emerging risks and vulnerabilities can contribute to
informing decisions by those other bodies.
It is in this context that we consider the question I raised at the beginning of
this speech: the possible role of monetary policy in underpinning financial
stability.
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While maintaining stable financial conditions was once understood to be
part of the purview of monetary policy, that changed in the wake of the
period of high inflation in Canada and many other advanced economies
during the 1970s and 1980s.
That experience, together with influential research on monetary policy,
convinced the economics profession that maintaining price stability is the
best - or even the only - contribution monetary policy can make to
promoting a country's economic and financial well-being.
The inflation-targeting regime we have today is an outgrowth of that
experience.
Inflation targets have been very successful at maintaining price stability
because they give everyone an easy way to understand monetary policy and,
over time, create a virtuous circle in which realized inflation and
expectations reinforce each other.
A central tenet of the framework is that a central bank uses the policy
interest rate solely to counter risks to inflation.
If it tried to do other potentially conflicting things, such as keeping
unemployment artificially low or containing volatility in the financial
markets, its credibility could erode, the virtuous circle could break down
and inflation could go back to being unpredictable.
The question of whether central banks can use monetary policy to promote
financial stability as well as price stability has re-emerged from time to
time.
It has often been couched in terms of using monetary policy to prevent or
deflate asset-price bubbles - perhaps to dampen irrational exuberance in
stock markets.
But the question is really more general, related to the use of monetary
policy in countering an excessive buildup of leverage in the economy.
Identifying such financial imbalances is not as straightforward as it sounds,
and using monetary policy to address them was seen as a potential
distraction from the task of targeting inflation.
Moreover, during the Great Moderation, such imbalances were not seen as
a serious obstacle to stabilizing the economy.
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Confronted with the choice of whether to "lean" or to "clean" - leaning
against emerging financial imbalances by keeping interest rates higher than
they otherwise would be or cleaning up in the event the risks they create are
realized by providing stimulus - central bankers at that time generally
agreed that cleaning would be best.
That consensus was shattered by the global financial crisis.
Unlike past episodes in recent history, the crisis began in the world's most
sophisticated financial systems, causing widespread economic devastation.
It stirred up persistent and formidable headwinds to economic growth, also
making it very difficult for central banks to bring inflation back to target.
After this brutal wakeup call, economists went back and re-examined the
possible role monetary policy plays in setting the stage for crises.
Looking at the historical evidence, it would be fair to conclude that few, if
any, crises have been caused by monetary policy alone.
The global financial crisis, like the Great Crash of 1929, also reflected
widespread regulatory shortcomings and other weaknesses in a number of
countries.
But it is likely that monetary policy played at least a contributing role in
encouraging the buildup of leverage and asset prices in a fragile financial
system.
The nature and importance of that role in the run-up to these and other
crises is the subject of ongoing research and debate.
Trade-offs
So, can monetary policy target inflation and still promote financial
stability? This question can be addressed in two parts.
First, let's consider a case in which monetary policy is the only tool available
to promote both macroeconomic and financial stability.
Later, I'll consider how monetary policy might complement other policies
that work more directly on the financial system.
Sometimes inflation targeting and financial stability are complementary.
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For example, if the economy is running above potential, creating
inflationary pressures, while financial vulnerabilities are also building, then
both considerations point to tighter monetary policy.
In retrospect, this appears to have been the case in many countries in the
period leading up to the 2007-09 global financial crisis (Chart 1, see "Case
1").
The chart shows estimates by the International Monetary Fund of output
gaps and credit gaps during that period; while such estimates are obviously
imprecise, they suggest that in most of those countries, inflation targeting
and financial stability may have been complementary, rather than
conflicting goals.
A second example is one in which the economy is in recession, or operating
below potential, and the financial system is going through a phase of
deleveraging and low asset prices (Chart 1, see "Case 2").
In this case, easing monetary policy is the right action for both inflation
control and financial stability purposes.
An example is the United States after the 2007-09 crisis: easy monetary
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policy cushioned the economy and also helped heal a broken financial
system.
In both of these cases, there is no trade-off for monetary policy.
There are other situations, however, where there could be tension between
the two objectives.
One is when the economy has been hit by a highly persistent adverse
foreign demand shock - such as a recession in the economy of a major
trading partner - while the domestic financial system is unimpaired (Chart
1, see "Case 3").
In this case, inflation targeting calls for policy easing to support economic
activity and return inflation sustainably to target.
But that easing would also disproportionately affect domestic sectors that
are highly sensitive to interest rates like housing and other consumer
durable goods, encouraging the buildup of financial vulnerabilities.
This has been the situation in Canada for the past seven years, as reflected
in increasing levels of household indebtedness and elevated house prices although, as I'll discuss later, regulatory measures have been used to
mitigate the resulting financial system risks (Chart 2).
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What can monetary policy do?
Given the situation in Canada, we have focused our research on the
low-demand, high-debt scenario.
Empirical research shows that a buildup of household debt in the economy
makes a financial crisis more probable, so we wanted to understand the
costs and benefits of
leaning against financial imbalances through tighter monetary policy.
Our researchers used several of the Bank's economic models to examine
these issues.
On the benefits side, they estimated that increasing the Bank's policy rate
by 1 percentage point for one year would reduce real household debt by 2
per cent over five years.
Everything else being equal, less household debt reduces the vulnerability
of the economy and the financial system; the results, however, suggest that
this difference may be very small.
On the cost side, the same increase in the policy rate might cut output by up
to 1 per cent and push inflation down by 0.5 percentage point relative to
what it would have been otherwise.
While, like any empirical results, these findings are a product of the
methodology used, it is noteworthy that they are consistent across standard
models - and indeed, similar results have been found using broadly similar
approaches in other countries.
These results suggest that, even though monetary policy could, in principle,
be used to reduce vulnerabilities in the financial system, it may be too costly
in practice.
Interest rates affect all parts of the economy and are too blunt an
instrument to address an imbalance in just one part of the economy household credit.
If you have a specific imbalance, you need a specific tool to address it.
The analysis relies on a number of assumptions about how monetary policy
affects debt and how debt affects financial stability.
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The relationship between monetary policy and financial stability may
depend on the specific economic conditions in which we find ourselves.
Moreover, the processes resulting in financial cycles, with periods of
unsustainable debt buildup, occasional crises and periods of deleveraging,
are not well captured by standard models.
We have more work to do before we can be fully confident about our
conclusions.
Here, I would like to focus on one critical aspect of the discussion: that
monetary policy can affect financial stability only through its effects on
household debt, even though it affects a wide swath of the real economy.
However, we also need to envisage a case where the effects of monetary
policy on financial stability are not limited to one sector, as in the case we
just saw, but spread across many different parts of the financial system.
In that case, monetary policy's ability to get in all the cracks of the financial
system - to paraphrase former Federal Reserve Governor Jeremy Stein would give it a more powerful influence on financial stability.
Another aspect to consider is that risks to financial stability have two
elements: the underlying vulnerability and the trigger that could cause a
risk to materialize.
Both elements are part of our risk-management approach to monetary
policy.
Over time, stimulative monetary policy may cause vulnerabilities to build
up.
That was part of our thinking in late 2013, when inflation was running
persistently below target: we were concerned about the downside risks to
inflation, but decided against easing policy further to avoid exacerbating
growing household indebtedness and elevated house prices.
Failing to ease monetary policy in an economic downturn could, however,
worsen the contraction and cause a crisis.
This scenario was part of our thinking at the beginning of last year, when
Canada's economy was hit by the collapse in oil prices and we cut our policy
interest rate.
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Although we knew that lowering the policy rate could worsen vulnerabilities
related to household debt, we also knew that it would counter the risk that
growth would crater and lessen the probability that the oil price shock
would trigger financial stability risks.
Two tools - or three?
This discussion suggests that any adaptation of monetary policy to financial
stability objectives is, to say the least, far from straightforward.
Fortunately, monetary policy is not the only game in town.
There are also macroprudential tools - regulatory measures that can be
used to promote not just the safety of an individual financial institution, but
also that of the entire financial system.
Macroprudential tools can be used in two ways.
One is to foster a more resilient financial system on an ongoing basis.
To give just one example, regulators can establish ceilings on mortgage
loan-to-value ratios on an ongoing basis, so that any correction in housing
prices is less likely to create stress for the financial system.
With a more resilient system, all of the financial stability concerns I have
been discussing become more manageable.
Authorities could also, in principle, adjust macroprudential tools to
dampen financial cycles - tightening them when leverage is building up and
risk taking is increasing, and easing those requirements when that cycle
turns.
For example, regulators can lower loan-to-value ratios in response to
indications of rising household sector vulnerabilities.
Another example is the countercyclical capital buffer introduced as part of
the Basel III reform of bank capital requirements.
Such countercyclical measures are designed, in part, to weaken the
feedback loop between asset prices and credit growth that can lead to the
kind of financial excesses that set the stage for a crisis.
The track record of countercyclical measures in leaning against a financial
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cycle is not yet nearly sufficient to form a definite view of their practical
effectiveness, however.
The changes in mortgage finance regulations that we have seen in the last
eight years in Canada include a combination of these elements.
When the government successively increased the required down payments
and tightened other regulations, it was partly to reduce the taxpayer's
longer-term exposure to the housing market and partly to restrain the
ongoing buildup of financial system vulnerabilities associated with rising
household indebtedness and housing prices.
If the effectiveness of macroprudential policies could be relied on, would
that mean that monetary policy is off the hook, allowing the Bank to focus
on its inflation target and leave macroprudential policies to take care of
financial stability?
Perhaps, but not necessarily.
There might be significant spillovers between monetary policy and
macroprudential policies.
When the government imposes tighter requirements on mortgage
insurance, for example, it likely reduces demand for housing, which may, in
turn, have a negative effect on growth and inflation.
Household indebtedness may also affect the transmission mechanism of
monetary policy, for instance, by influencing households' willingness to
spend out of their disposable incomes.
On the flip side, if prolonged low interest rates encourage people to take on
more debt, financial stability concerns grow.
So we need a better grasp of how monetary policy and macroprudential
measures interact.
Even if such spillovers are important, a clear assignment of policies could
be effective in achieving both objectives: monetary policy to target inflation,
macroprudential measures to target financial stability.
Each could operate independently, focusing only on its own objective.
The resulting combination of policies - a Nash equilibrium - could both
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achieve the inflation target and ensure an acceptable degree of financial
stability (Chart 3).
Under certain conditions, as long as monetary policy has a larger effect on
inflation than it does on financial stability risk and macroprudential policy
has a larger effect on financial stability risk than it does on inflation, there
would be no need, in theory, for the agencies responsible to coordinate their
actions explicitly.
They would need to share information with each other only so that each
could use its own policy tool to account for the spillovers from the other
policy on its own objective.
This might mean, for example, that the central bank would need to run a
more stimulative policy than it would have otherwise to offset the effect of
macroprudential policies, and the macroprudential authority would impose
more stringent measures than it would have otherwise to counteract the
leverage and risk taking generated by looser monetary policy.
In the end, we could see an increase in the level of households'
indebtedness without a significant deterioration in their creditworthiness.
This has been the situation in Canada over the past few years.
This logic suggests that it is very important to have a public sector body
with both the power and the paramount responsibility to use
macroprudential tools to promote financial stability.
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This setup would leave monetary policy free to target inflation unfettered by
possible financial stability concerns.
The appropriate body might be a committee, as is currently the case in
Canada, where the potentially relevant tools are shared among several
public sector institutions.
However, even with an ideal set of institutional arrangements, there may be
limits to how independently monetary policy and macroprudential policy
can work.
Regulatory measures designed to contain risk might, if carried to extremes,
distort incentives to allocate resources to their most productive uses.
For example, some financial institutions may reduce their lending to riskier
but innovative companies.
It is also possible that, mindful of such adverse consequences, regulators
may refrain from going as far as would be needed to preserve financial
stability.
And that, in turn, could inhibit the central bank from providing sufficient
policy easing to support the economy.
Thus, it is possible that, in a situation of sustained weak aggregate demand,
relying primarily on monetary policy to provide stimulus may lead to
financial vulnerabilities that macroprudential policy cannot, or should not,
offset.
In such circumstances, fiscal policy may be called upon to provide stimulus,
particularly since it is likely to be more effective at low interest rates.
Of course, fiscal policy also has its limits, since an excessive buildup of
public debt can create its own problems for both the economy and the
financial system.
We saw that in Canada in the 1990s.
But these costs need to be set against concerns that prolonged monetary
policy stimulus may result in an excessive buildup of private sector
vulnerabilities.
These issues are relevant to the renewed discussion of fiscal policy that is
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now taking place in Canada.
Conclusion
Allow me to conclude.
During the years since the global financial crisis, we have been doing a lot of
thinking and research to improve our understanding of the nexus between
monetary policy and financial stability.
This is a key question in this year's renewal of our inflation-control
agreement.
We will need to continue to examine these issues in the period ahead.
Indeed, research on the nexus between monetary policy and financial
stability is an important element of the Bank of Canada's 2016-18
medium-term plan.
One thing is clear, though: monetary policy cannot take primary
responsibility for maintaining financial stability.
Other, prudential, tools are required to build a resilient financial system
and, where needed, to address increasing vulnerabilities.
Questions remain, however, about the financial stability effects of monetary
policy itself and what, if anything, should be done to address them.
Some of these questions pertain to how aggressively a central bank should
strive to return inflation sustainably to target in the face of other economic
forces.
When the economy is hit by a large and persistent adverse shock, should we
accept greater downside risks to inflation to avoid exacerbating financial
imbalances?
Or indeed, given such imbalances, should we tighten policy less
aggressively as the economy returns to potential to avoid triggering
financial system risks?
For the foreseeable future, we are not likely to agree on a formula for
addressing these issues.
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We are inevitably in the realm of judgment informed by the available
evidence and analysis.
That element of judgment in weighing financial stability considerations,
including the implications of our own actions, is central to our
risk-management approach to monetary policy.
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Second Speech
Stephen S Poloz: Release of the Monetary Policy Report
Opening statement by Mr Stephen S Poloz, Governor of the Bank of
Canada, at the press conference following the release of the Monetary
Policy Report, Ottawa, Ontario
Good morning, and thank you for coming today.
Let me begin as usual with a few remarks around the issues that were most
important to the Governing Council's deliberations.
At the global level, 2015 was a little disappointing as the world dealt with
diverging economic prospects and shifting terms of trade, but we expect
gradual strengthening to resume in 2016.
There has been considerable attention paid to recent developments in
China, and this has added to volatility in global financial and commodity
markets.
However, it was Governing Council's judgment that China will remain on
its transition to a more balanced and sustainable growth path, from around
7 per cent annual growth to around 6 per cent.
Volatility in equity markets is, of course, not always a reflection of weak
economic fundamentals.
Nevertheless, the global equity-market correction may inject a further
measure of caution into business decision making.
Our global outlook remains positive, albeit cautiously so.
Governing Council believes that the U.S. economy remains solid - the
fourth quarter of 2015 was soft, but we believe this to be largely temporary
for reasons we discuss in the Monetary Policy Report (MPR).
Solid fundamentals, including strong employment gains, high consumer
confidence and very strong investment outside the energy sector should see
U.S. growth return to close to 2 1/2 per cent this year.
Not coincidentally, the Canadian economy appears to have stalled in the
fourth quarter.
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There were some temporary factors at work for us, too, but the main issue
was slower exports to the U.S.
We expect growth to pick up to 1 per cent in the first quarter, along with the
U.S., and then to move back above 2 per cent for the remainder of the year.
Our new annual growth forecast for 2016 is 1.4 per cent; however, much of
the downward revision in that figure is because of the weakness we saw in
the final quarter of last year.
On a fourth-quarter-over-fourth-quarter basis, growth for 2016 is projected
to be a more solid 1.9 per cent.
In its deliberations, Governing Council focused mainly on the implications
of lower prices for oil and other commodities for Canada and for monetary
policy.
This shock is complex because it sets in motion several forces: Canada
earns less income from the rest of the world, our resource sector begins to
shrink, the Canadian dollar depreciates, and the non-resource sector
expands.
That is a lot of structural change.
We are publishing a discussion paper today that offers additional analysis
of this process.
One implication is that it may take up to three years for the full economic
impact to be felt, and even longer for all of the structural adjustments to
take place.
Since our last MPR in October, the magnitude of this shock has clearly
grown.
Firms are still cutting investment spending, but we had already built most
of the downside into our October MPR.
The bigger change in our projection comes from the impact of even lower
oil prices on Canadian income.
As one measure of this change, our base case forecast suggests that it will
now take longer to absorb the economy's excess capacity - probably until
late 2017, perhaps later.
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This is a significant setback compared with our October projection.
Nevertheless, we expect growth to exceed potential through most of 2016
and 2017, so the gap should be substantially closed by late 2017.
When considering our policy options, Governing Council needed to bear in
mind that our base case forecast omits a key consideration; namely, the
government's intention to introduce fiscal measures to stimulate the
economy.
Our convention is not to guess about these things, but to incorporate actual
announcements.
Suffice it to say that were we to incorporate a degree of new fiscal stimulus
in this projection today the output gap would close sooner than in our base
case, but how much sooner would depend on the scale and nature of the
fiscal measures.
It is fair to say, therefore, that our deliberations began with a bias toward
further monetary easing.
The likelihood of new fiscal stimulus was an important consideration others included:
First, the Canadian dollar has declined significantly since October, which
means that the non-resource sectors of our economy are receiving
considerably more stimulus than we projected then.
Let's remember that it typically takes up to two years for the full effect of a
lower dollar to be felt.
Second, past exchange rate depreciation is already adding around 1
percentage point to our inflation rate.
This is a temporary effect, and is currently being offset by lower fuel prices another temporary effect.
However, we must be mindful of the risk that a further rapid depreciation
could push overall inflation higher relatively quickly.
Even if this is temporary, it might influence inflation expectations.
Governing Council continues to see the underlying trend in inflation as
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somewhat below 2 per cent, given the persistent, and recently widening,
slack in the economy.
Inflation expectations remain well anchored at about 2 per cent.
With the economy expected to resume above-potential growth in the near
term, our expectation is that inflation will converge on 2 per cent as the
output gap closes and the temporary effects of low oil prices and past
exchange rate depreciation dissipate.
To summarize, the drop in oil and other commodity prices constitutes a
significant setback for the Canadian economy, and has set in motion a
protracted adjustment process.
That will mean the continuation of a two-track economy, with the resource
sector shrinking and other sectors picking up speed, all facilitated by a
lower Canadian dollar and supported by very stimulative monetary policy.
While that adjustment process sounds mechanical, in fact, it is personal.
It is disrupting the lives of many Canadians, whether through job losses or
through higher prices for imported goods.
Monetary and fiscal policies can help to buffer some of these effects, and
help speed up the process by fostering growth in other sectors of the
economy, but the adjustment must ultimately take place.
Although the economy may grow more slowly than we would like during
that transition, it can still achieve above-potential growth and absorb its
excess capacity.
We are encouraged by the resilience and flexibility of the Canadian
economy as signs of adjustment are already evident.
Meanwhile, the world economy is expected to strengthen on the back of
stimulative policies and low energy costs, the U.S. economy is on a solid
track and our past monetary actions continue to produce results.
These are all positives that should be recognized.
In this context, as complex and uncertain as our situation is, Governing
Council decided that the current stance of monetary policy remains
appropriate.
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Let me conclude by saying publicly "au revoir" to our good friend and
colleague, Deputy Governor Agathe Côté, who served the Bank with
distinction for over 32 years.
Her official end-date is January 31st.
We will miss having her in Governing Council, and wish her well.
With that, I'll now be happy to take your questions.
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Indian banking sector - gazing into the crystal
ball
Mr S S Mundra, Deputy Governor of the Reserve Bank of
India, at the Mint Annual Banking Conclave on the
theme "Disruption, Innovation and Competition",
Mumbai
1. Dr. K. C. Chakrabarty, Former Deputy Governor, Reserve Bank of India;
Smt. Chanda Kochhar, MD and CEO, ICICI Bank Limited; Shri Aditya Puri,
MD, HDFC Bank Limited; Shri B. Sriram, Managing Director, State Bank of
India; Shri P.S. Jayakumar, MD and CEO, Bank of Baroda; Shri Uday
Kotak, Ex- VC and MD, Kotak Mahindra Bank; other senior colleagues from
the banking and financial sector; members of the print and electronic
media; ladies and gentlemen!
2. At the outset, I thank the Mint Management for inviting me to deliver the
keynote address at this Annual Banking Conclave.
The galaxy of speakers that headline this event provides a testimony to the
importance of this event.
A lot in the Indian banking sector has changed since I first spoke at this
conclave three years ago.
Disruptive events have taken place; innovative practices introduced and
competition as it stands today, is stiffer than ever before and is likely to
intensify further in the coming months.
3. Some of you who attended this event last year might recall that I had
briefly raised certain issues at the end of my address stating that they could
emerge as potential challenges for the banking sector in the days to come.
Many such challenges which were looking abstract or distant then are
appearing imminent now.
I have, therefore, chosen to elaborate on few such issues in my address
today.
These issues essentially revolve around "Disruption, Innovation and
Competition" in the banking sector, which is the theme of the Conclave.
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You may also recollect that in my address last year, I had referred to Brett
King's book "Bank 3.0" in the context of a single channel solution to
multiple product offerings.
I would once again invoke him. In the concluding chapter of the book, King
has raised 15 questions as a checklist to assess whether a bank is prepared
to withstand the disruptive process that is currently underway.
According to King, answer to these questions would determine whether you
are in trouble or you are not making the shift.
While some of these questions may not be relevant in the context of Indian
banking today, they will become so, soon.
Many, however, are already relevant for us.
Let me mention a few:
Do you still require a signature card for account opening?
Do you have a distinct Head of social media in an executive role?
Do you have a Head of Mobile, and do you have apps already deployed for
your customers?
Can you approve a personal loan application for an existing customer with a
salaried account in real time, instantly?
4. I acknowledge that some of the banks present here can surely claim that
they are making the necessary shift.
They can move to other eleven questions while remaining ones can make a
beginning to address these four questions.
The predominant message from the foregoing is that digital innovation and
disruption are progressing at a fast pace and are already a subject of huge
debate.
Hence, I would not dwell any further on them but move to few other areas
which can have equal or even greater impact on the way banking is
conducted going forward.
5. So, let me now come to those issues that I want to highlight today.
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(i) Account Number Portability: Just consider the possibility of a
dissatisfied or less than satisfied customer asking for shifting his banking
relationship; lock, stock and barrel to another bank.
He/she would ask "If I can switch my mobile service provider without
changing my mobile number, why not banking service provider without
changing my account number."
This possibility can no longer be dismissed as a wishful thinking.
This would need a "shared" payment system, regulated independently,
where all account number and payment instructions are warehoused (such
as standing instructions/direct debit etc.),an unique customer ID and a
central payment system.
Credits/debits would be linked to the unique ID.
Interesting bit is that some international banks are already supporting the
idea.
With Aadhaar as unique ID and NPCI as a central payment system, we are
quite well placed to translate this into a reality.
Our past record as a country of having swiftly embraced anonymous "screen
based" bond trading or switching from "open cry" system on the bourses,
should portend a much shorter timeline for this transition than a period of
few years many in international arena are presently presuming for this to
happen.
Why can't we be a global first in this?
Imagine how this can empower a customer and give an entirely new
dimension to the competition, ensuring best of the breed customer service
and fair pricing.
Let me give a call today to all the banker friends here to commence a serious
discussion on making "account number portability" a reality.
(ii) Competition from non-bank players in payment system: All along we
have believed that banks would retain the privilege to serve as the sole
payment service providers even while their other traditional functions like
dispensing credit might have competition.
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Ground realities have changed.
Payment system is no longer the sole preserve of banks.
There is competition and how?
Large data companies like Google, Vodafone, Apple have been taking over
transactional roles.
A set of payment banks have been granted licenses and then, there are
non-bank payment system providers.
A massive disruption is possible based on the technology using Block Chain
which would make distributed ledger possible.
For the uninitiated, "distributed ledger" allows a payment system to operate
in an entirely decentralized way, without intermediaries such as banks.
The banks would need to either develop own capability or seek proper
alliances.
I say this, however, with a caveat that we or rather the global regulatory
community elsewhere have not taken a final stance on the use of distributed
ledger technology.
It is important to highlight here that Financial Stability Board has already
started consultations on developing better understanding of the intricacies
involved.
Some of the large institutions like Goldman Sachs or J P Morgan Chase
have set up internal groups to work in this area.
Is it not the time for the Indian banking system to wake up to this
possibility?
(iii) Impact on Lending Business: A key concern that I had briefly hinted at
last year also is whether the large corporates would continue to borrow
from the banks or whether the banks themselves would be keen to fawn
over them after their on-going experience with such lendings?
Many large corporate houses have lately been able to access funds on their
own at cheaper rates without needing to reach out to banks.
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In mature markets, it is usual for the large corporates to access financial
markets directly for their funding requirements rather than through banks.
As the Indian economy and our financial markets mature further, more and
more large corporates are likely to bypass banks for their funding
requirements.
Even medium enterprises may find alternate avenues of finance.
Under the circumstances, banks would need to look at substitutes for
deployment of funds.
This void could most likely be filled by lending to small and micro
enterprises and retail clients.
As you are aware, the assessment of credit needs of small & micro
enterprises and retail, is a different ball game altogether.
A non-disruptive shift would require the bank staff to acquire new
capabilities for credit appraisal of self-employed individuals and people
with little or no credit history.
The competition in the shape of small finance banks, with a mandate to
focus exclusively on small business units, small and marginal farmers,
micro and small industries and other unorganized sector entities, which
would operate through technology-focused, low cost structure, is already on
the anvil.
As part of this strategic shift, banks would also need to improve their
analytical abilities for big data.
As I spoke earlier about lending to customers with little or no credit history,
banks would need to employ some non-conventional tools for assessing
credit worthiness of such customers, which can, among others, include
credit card usage, travel patterns, bill payment history and so on.
Lack of attention to these segments by the banks might allow P2P lenders to
sneak in and compete for the piece of the pie.
Here again, I would like to use the caveat that we are yet to finalise our
regulatory stance on P2P lending.
(iv) IFRS Implementation: With the MCA announcing the much awaited
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Ind AS implementation road map for the financial sector, scheduled
commercial banks (other than RRBs) are required to comply with the
standards for accounting periods beginning from April 1, 2018.
In this endeavour, the banks would need to deal with challenges resulting
from implementation of Expected Credit Loss (ECL) based provisioning
framework, classification and measurement of financial assets and impact
of alignment of the regulatory guidelines with Ind AS on regulatory capital
computations under the Basel III framework, leverage and liquidity ratios,
etc.
As a supervisor, our off-site reporting formats would need to be revisited.
In essence, huge capacity building initiatives at the level of both the
regulator and the regulated are required.
While it may not be possible to precisely quantify the impact of Ind AS
implementation at this stage, rough estimates globally indicate a
transitional impact of 25-50% increase in provisioning levels on account of
implementation of ECL based provisioning framework.
A 2014 international survey1 of select banks indicated that over half of them
expected an impairment provision increase of up to 50 per cent across all
asset classes.
Though our policy stance on ECL impairment provisions including possible
prudential floors remains to be finalized, it is important that our banks start
work on strengthening their data capture and risk management systems to
enable impairment assessment.
In this context, I wish to raise an issue today for larger debate.
The regulatory experience with the internal models employed by the global
banks to assess the risks under the Basel framework has not been very
pleasant.
The assessments carried out since the Global Financial Crisis have pointed
out the complex models used by the banks for risk computation under
advanced approaches had significantly underestimated risks that the banks
had on their books.
Since, the ECL framework would involve principle based assessment of
credit risk (using models), the concern would be around underestimation of
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risks by the institutions.
Hence, I wonder that as we prepare towards IFRS, could we conceive of an
independent, umbrella entity to prescribe or validate models, within the
framework of the accounting standards or to at least examine the approach
adopted by the banks in computing expected losses so as to ensure
consistency in assessment across the sector, besides having supervisory
comfort on the adequacy of accounting provisions.
Finally, one last question is whether we could draw some lessons from how
banks globally have transitioned to IFRS from local GAAP?
While we could get some perspectives about the challenges involved in the
transition, the fact is that the challenges would be much greater here in
India as we do not have an IAS 39 equivalent framework unlike other
jurisdictions which migrated to IFRS from local GAAP largely aligned with
IAS 39 or US GAAP.
In that sense, IFRS transition is a paradigm shift in the Indian context.
(v) Consumer Protection: The profile of the customer that the banks deal
with is undergoing a major transformation.
This also calls for a transformation in the way banks position their products
and services for their customers.
Customers as a group are no longer satisfied with off- the- shelf products
and would rather have products customised to their individual needs.
Towards this end, the banks have to leverage Big Data and proactively offer
products and services that suit the needs of individual customers.
A regulatory red flag I would raise here is around rampant mis-selling in
sale of third party products, especially insurance.
Another recurring consumer grievance is around compensation for failed
transactions/frauds.
Of course, as institutions, banks have more muscle as compared to
"resource poor" individuals, but as guardian of customer rights in our role
as regulators, we would quite closely monitor misuse of such might against
the customers.
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If violations are observed, the banks wound need to not only compensate
the customers, but also be forced to pay penalties.
(vi) Financial Inclusion: I don't want to touch this topic in any detail but
would just like to caution banks on some aspects in dealing with newly
acquired accounts.
A large number of new accounts have been added under RBI's Financial
Inclusion focus and under the PMJDY push.
Periodic updation of the KYC records in these accounts and continuous
monitoring is vital.
Just to give one example- a news item had appeared the other day
mentioning that Rs.1 crore was parked and withdrawn in a labourer's bank
account which he was unaware of till he received an IT demand of a tax of
40 lakh rupees.
Many similar instances are being reported. This means that the recently
opened accounts are susceptible to misuse by money mules and hence,
banks must remain vigilant.
(vii) Other issues: Lot of debate has surrounded the future of brick and
mortar branches and their obituaries been written several times.
However, they have survived and are doing well.
Of course, the functions they undertook earlier, extent of client interface
they had, has undergone a sea change, but my sense is that the brick and
mortar braches would continue to remain relevant in India in the
foreseeable future.
Management would, however, have to think through the future of these
branches in terms of the role and functions they envisage for the branches
going forward.
Another issue is around the future of ATMs and the plastic money.
If Mobile Banking continues to grow at the pace that we see today, would
cards still be needed and what use would be there for the ATMs?
There is a justifiable call for reducing "cash transactions" in the system and
hence, if more and more people moved to mobile/ internet based payments,
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the plastic cards and the investments made thus far in ATM networks
would be rendered useless, unless put to more imaginative uses.
Last but not the least, I would also like to sound another note of caution for
the bankers present here.
With all talks surrounding changing profiles, social habits and
requirements of the gen-next customer (Gen Y or the millennials), the
banks must not lose sight of aging population.
The next 15 years would see approximately 70 mn more people crossing the
age of 60 years.
These old age people would have different banking needs and would need to
be serviced through appropriate delivery channels.
Similarly, the pace of urbanisation in the country is only going to get
heightened in the coming years and hence, banks would need to be geared
up to cater to the requirements of this migrant population also.
Conclusion
6. I think I have scared you enough by highlighting the impending
challenges that the banking sector is likely to face going forward.
As Clay Christensen, Harvard Professor puts it "Disruptive Innovation can
hurt, if you are not the one doing the disruption."
Most of the scenarios that are going to play out are external to our system
and hence, you need to be prepared, lest you get hurt.
I believe the elite panel gathered here today would deliberate and reflect on
some of the issues I have raised today.
I once again thank Mint and Tamal for inviting me and wish you all a
fruitful deliberation. Thank you!
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Post crisis reforms - the lessons of balance
sheets
Andrew Bailey, Deputy Governor of Prudential
Regulation and Chief Executive Officer of the
Prudential Regulation Authority at the Bank of
England, at the International Financial Services
Forum, Dublin
Thank you for inviting me to speak this morning.
We are approaching the ninth anniversary of the beginning of the global
financial crisis.
And we are still talking about it; but not just talking, also publishing books,
reports, holding conferences and of course releasing films.
There is no doubt more than one reason for the continued interest in the
crisis, but as public officials charged with putting into place the measures to
prevent a repeat and thus produce a more stable financial system, the work
is still in progress and thus for us very much a matter of debate.
Today, I want to put that work into perspective, looking at banks and the
wider financial system.
I am going to organise my comments around something very basic to the
system, the balance sheets of banks.
It is a striking fact, that the combined balance sheet of the major UK banks
increased by around fourfold between 2000 and 2007.
That's a stark fact: yes, there was an accounting change in that period, but
still this was a massive change.
And other countries often matched that change - the story of Ireland is
sadly well known.
Let me stop the story of the past for a moment and draw out one message:
when we hear people say things like, "credit isn't back to pre-crisis growth
rates", "there is a gap in the stock of credit to the economy relative to the
pre-crisis trend", "the level of national output is this much lower than it
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would have been had the crisis not intervened", "banks' so-called market
making in financial assets is much less than it was immediately pre-crisis",
just pause and consider that all of these statements imply that the pre-crisis
years were sustainable.
They were not.
Let's turn to the balance sheet of banks in a little more detail, starting with
the liabilities side.
In this respect, banks are different from other firms because they provide
deposit contracts.
A deposit is a very particular form of debt contract.
For all of us the essential feature of a deposit contract is simple - we put our
money (our asset) on deposit at a bank, and we expect all of it back, with
whatever rate of return is agreed, and we expect to have access to it, in part
or whole, in line with the terms of the contract.
Some deposit contracts provide for more ready availability than others, and
this affects the return on the deposit.
Of course, there is also insurance on a deposit contract up to a well
publicised level.
Let's contrast that with non-deposit debt (bonds) and equity contracts.
If you invest in either of these, you are not promised all of your investment
back, though of course you expect to make a return.
A debt investor ordinarily expects the full return of their investment, but
viewed from a corporate restructuring perspective this is not assured.
I will come back to this.
Investment in debt and equity can be managed on a collective basis, as asset
management.
You may remember the Woody Allen quote that a stockbroker is someone
"who invests your money until it's all gone".
Cruel I know, but it illustrates the difference between deposits, debt and
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equity.
Turning back to banks, they have deposits, debt and equity on the liabilities
side of their balance sheet.
The problems of the pre-crisis period in this area of bank liabilities can be
summarised quite easily: they had too little equity to absorb losses, and
particularly so given the major expansion of balance sheets (more leverage
of the equity); they had issued forms of hybrid debt-equity that were
supposed to absorb losses after equity but could only do so if the bank
became formally insolvent, something that could not be allowed to happen
in view of the threat to the financial system; they had taken on a very large
increase in short-term wholesale market funding which was assumed by the
providers to have the characteristics of deposits.
Moreover, short-term wholesale funding was footloose, more so than retail
deposit funding.
What have we done to deal with these problems? We have increased the
required equity capital held by banks - the first loss absorbing element of
their liabilities.
We have required that hybrid debt - equity instruments have automatic and
transparent triggers which are not exercised only by an event that cannot
happen.
In the UK, banks have set the trigger for conversion to equity high enough
at a 7% common equity tier one capital ratio to seek to ensure that
conversion happens well before the bank has run out of capital.
This is the right thing to do.
We have introduced liquidity regulation designed to enable banks to
withstand the loss of more footloose, short-term wholesale funding, which
has gone alongside a sharp shrinkage by banks in their use of that funding.
In the UK, we are introducing structural reform or ring-fencing which will
provide for an internal separation inside the major banks so that the
so-called qualifying EU customer deposits must be inside the ring-fence.
Being inside the ring fence does not I should emphasise protect against all
risk; indeed, the crisis saw the failure of a number of banks that were
predominantly of the same nature as a ring-fenced bank will be.
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But it does keep the balance sheet on which most customer deposits will
appear in the large UK banks in a more simple state, and that should be
conducive to effective governance and supervision without being burdened
with great complexity, and also facilitate recovery and resolution actions
should they be necessary.
Also on the policy response to the crisis, we have invested in stress-testing
to examine how the balance sheet performs under stress, and thus establish
whether the bank is robust in terms of its loss absorbency to extreme but
plausible outcomes.
This is a central part of what we describe as our forward looking
judgemental approach to supervision.
I have not so far mentioned one other very important part of the post-crisis
reform package, namely ensuring that banks can be resolved if they fail.
This should be done without recourse to public funds or the disruption of
the critical economic functions provided by banks, such as continuity of
access to deposits.
At the heart of the resolution reforms is the concept of bail-in, which is that
private creditors of a bank absorb the cost and provide the new equity to
sustain the provision of these critical functions in the event that it suffers
large losses that cause failure.
There is nothing radical about the concept of bail-in, which is a debt-equity
conversion should a trigger event occur.
That is consistent with well-established principles of company
restructuring.
But with banks it has to happen very quickly if the trigger event that the
bank is no longer viable occurs.
We cannot wait for a lengthy bankruptcy process.
TLAC (Total Loss Absorbing Capacity) or MREL (Minimum Requirements
on Eligible Liabilities) are used to describe the specific liabilities which
banks will be required to maintain to ensure there are enough liabilities
which can feasibly and credibly be converted.
TLAC and MREL are comprised of debt-instruments and equity.
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The key point here is that this important reform requires a very clear
distinction among debt contracts between forms of subordinated debt
contracts which will bear losses in resolution first and deposit and other
senior funding contracts on the liabilities side of the bank balance sheet.
This may seem like a very simple point, but past arrangements meant it was
unclear, and the moral of the painful story is "don't leave the providers of
debt funding in any doubt about their creditor status."
The lack of clarity about the instruments on the liabilities side of bank
balance sheets and the order and mechanisms by which they would absorb
losses was an important issue in the crisis.
Looking ahead, clear disclosure of creditor hierarchies at a legal entity level
will be a critical component of the resolution regime, so that all creditors
know where they stand before resolution occurs.
Let's turn now to the other side of a bank's balance sheet, the assets side.
The massive increase in balance sheet size pre-crisis accompanied what
came to be known as the "search for yield", which could be re-named the
"search for risk which turns out to be unsustainable".
On the banking, as opposed to trading book side of the assets of major
banks, the search for yield often took the form of loans which included too
much equity-like risk because the equity stakes of the owners of the
companies were too small.
This was not equities themselves, but rather equity components embedded
in loans.
Commercial property lending in the UK is a good example, as it was in
Ireland.
Commercial property prices in the UK have over time tended to vary more
than, say, prime residential house prices and that points to a need for larger
equity-like component of funding to absorb losses from that variability.
The search for yield however meant that banks were more happy to lend
against equity risk of this sort.
Since the crisis in the UK we have seen a shift in commercial property
finance towards a larger share coming from funds which explicitly take this
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equity-like risk.
This strikes me as a good thing in terms of reducing the exposure to such
risks of banks, whose liabilities tend more to be in the form of deposits.
I sometimes hear comments that banks are losing the race to new
innovations such as peer-to-peer lending for the supply of what I would
describe as finance with a heavy equity component.
I think we need both in a well organised financial system because as banks
have a predominance of deposit liabilities with the characteristics I
described earlier they are not on their own natural equity providers.
This brings me to the last part of the story, namely the growth of non-bank
asset management in its broadest sense as the size of bank balance sheets
has tended to reduce post-crisis.
It is striking that if you were familiar only with a chart of the evolution of
global assets under management over the last twenty years, you should be
excused for failing to spot that a global financial crisis had occurred.
It follows from what I have said that this shift from banks to non-banks
makes sense as we seek to achieve a clearer demarcation of the types of
liability or funding contracts and the assets best suited to go with them.
But it only makes sense if a few conditions are met, two in particular.
First, that there is no lack of clarity about the nature of the assets held
under management.
Thus the label on the can is an accurate description.
Take as an example the recent failure in the US of the Third Avenue
Focused Credit Fund (focused on what a comedian might say).
The purpose of the Fund was to invest in high yield debt.
The label seems to have made that clear, and it wasn't therefore in the form
of a AAA label which obscured the reality.
The failure of this Fund has not made major ripples all on its own.
Why?
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I would argue because there was no obvious lack of clarity around the
assets, and this is a reminder against the re-appearance of opaque
instruments and complex tranching.
The second condition to meet is that there is no illusion about the liquidity
of the assets.
It is critical that investor expectations are well adjusted to the prevailing
liquidity conditions.
A lot of work is under way to assess the market liquidity implications of the
expansion of assets under management, and this is important for our remit
in financial stability.
An important part of this work is to do all we can to ensure that investors
understand the characteristics of the assets they hold, and that the liquidity
promised by funds to their investors mirrors the market liquidity of the
underlying investments.
Conclusion
In conclusion, the objective of the financial reform programme is clearly
not to return to the unstable pre-crisis years, however attractive some of the
statistics of that period look in isolation.
The response has been to strengthen the loss absorbency of the banking
system but also to enable greater clarity between the different forms of
bank liabilities consistent with the economic terms of the contracts.
This may seem like dry balance sheet stuff but the benefits are major.
First, greater clarity on liabilities should encourage more appropriate
matching with assets in a way that was absent in the run-up to the crisis some assets suit a deposit contract, some do not.
Second, resolving failed banks without the use of public money depends on
a very strong delineation of bank liabilities to make clear what can be bailed
in.
This is a key to unlocking the answer to the too big to fail problem.
Third, as the Bank of England announced in December, we are now in a
position to clarify the expected steady state regime for bank capital and
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because we can distinguish going concern capital and thus loss absorbency
from resolution or gone concern absorbency, we can put a lower number on
the former.
Clarity is therefore a good thing when it comes to balance sheets.
Put like that, the wonder is that so much was unclear in the previous
system.
And, finally, the same principle holds for assets under management.
Make sure investors know the characteristics of the assets they hold and
that they are not promised access to their investment on terms or with a
promise (explicit or implicit) that is out of line with what financial markets
could deliver.
Thank you.
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The euro area in 2016 - crucial to set right
course for enhancing growth and stability
Speech by Dr Jens Weidmann, President of the
Deutsche Bundesbank and Chairman of the Board of
Directors of the Bank for International Settlements, at
the International Club La Redoute e.V., Bonn
1. Introductory remarks
Gräfin Lambsdorff,
Ladies and gentlemen,
Thank you for your kind welcome and for inviting me to your club. I was
pleased to accept your invitation.
I am probably partial to requests to speak in Bonn - and I mean that
positively - due to my old ties to the University of Bonn.
After all, I studied here for a number of years and obtained a degree in
economics and a PhD here, thus acquiring a large chunk of my economic
"toolkit" in this city.
However, a more important reason for accepting your invitation was the
fact that you regularly address current European policy topics.
I am sure that we will therefore have a lively debate at the end of my speech.
Ladies and gentleman, as you know, 2016 is a leap year.
There have been leap years since the time of Julius Caesar.
They take account of the earth taking a little more than 365 days to orbit the
sun.
According to calculations by the Greek astronomer Hipparchus - which
would have been known in Caesar's time - it took 5 hours, 55 minutes and
12 seconds longer, though he was a few minutes off according to
modern-day calculations.
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There ended up being one leap year too many every 128 years; as a result,
by the mid6th century spring had been brought forward 10 days.
This needed to be corrected, and Pope Gregory XIII did this with his
Gregorian calendar, which is still used today.
The introduction of the Gregorian calendar set the course for a calendar
that keeps track with the seasons.
When we talk today about setting the right course for a more stable and
growth-promoting regulatory framework for monetary union, we get the
impression that this requires a more complex process than the introduction
of the Gregorian calendar.
But we merely need to take a leaf out of Pope Gregory XIII's book of
long-term thinking.
We don't need to look forward centuries in one fell swoop.
It would already be a big step forward if we were to address the challenges
looming in the coming years and decades.
However, we have already been discussing the right course to set in Europe
for seven years now.
Children born at the outbreak of the crisis have now already learnt to read
and write, while in the euro area we are still going through the A to Z of the
terms and conditions that will bring the euro area more stability as well as
more growth.
Against the backdrop of the rise to power of populist parties in many crisis
countries, Italian Prime Minister Matteo Renzi, for instance, said in an
interview with the Financial Times just before Christmas: "We can defeat
this demagogy, apathy and populism by betting on the growth and
employment of a new social Europe."
And he added: "We have to be careful with our finances, but it has to be less
about commas and decimal points."
Ladies and gentleman, are growth and fiscal solidarity really at odds with
each other, as is implicitly assumed by Renzi with his reference to commas
and decimal points? I do not think so.
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A looser fiscal policy can temporarily jump-start economic growth.
However, in the longer run, lasting growth cannot flourish on an ever
growing mountain of debt - this is precisely what the sovereign debt crisis in
Europe has made clear.
Furthermore, numerous empirical studies demonstrate that once debt goes
beyond a certain level it impedes growth.
And is Renzi right in alleging that the discussions in Europe are really just
focused on commas and decimal points?
I get the impression that the fundamental issue here is rather obeying rules.
But rules don't mean anything unless they are obeyed.
In my opinion, confidence in the binding power of the joint agreements is
essential for the functioning and acceptance of monetary union.
And this is all the more the case when Europe's problem-solving skills are
being put to the test and there is an evident tendency among some member
states to go it alone.
Moreover, monetary policy also benefits when fiscal policy rules are obeyed.
The crisis has namely also shown how much pressure monetary policy can
come under if confidence in the soundness of public finances is lost and
risks for financial stability emerge.
However, stable money is a key pillar of our economic system and a
prerequisite for lasting growth.
Before I turn my attention to how to enhance growth in the euro area and
make the regulatory framework of monetary union more stable, I would
first like to say a few words about the current monetary policy.
2. Monetary policy
Ladies and gentleman, there is no doubt that the current monetary policy
situation is not an easy one, with downside risks to inflation in the euro area
having increased recently.
This concern is also evident in the introductory statement of the ECB
Governing Council last week.
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There is no doubt that uncertainty is currently running high.
Given the recent financial market turbulence in China, the continued drop
in oil and commodity prices and the heightened geopolitical risks, doubts
are being raised in some quarters as to whether the international
environment is still providing the stimuli for euro-area growth that were
incorporated into the December Eurosystem staff projection, with
economic growth for 2016 and 2017 expected to be 1.7% and 1.9%,
respectively.
However, we shouldn't paint the economic outlook blacker than it actually
is.
The financial market turbulence in China at the start of January and its
partial transfer to the rest of the world demonstrate the nervousness of the
financial markets.
However, the price falls in China can primarily be viewed as further
corrections to earlier, sharp price rises.
And they were undoubtedly also reinforced by an ill-timed regulatory
measure.
In my opinion, there are currently no signs of a severe economic slump in
China.
Instead, there are indications of a gradual slowdown in economic growth.
This is consistent with China's transition to a more service-oriented,
domestic-driven economic model.
Furthermore, the unusually sharp oil price drop is now weighing heavily on
numerous oil-producing countries.
Many of these countries are on the brink of, or have already tipped over
into, a recession, which is why they need to tighten the reins on public and
private sector expenditure.
As net importers of crude oil, Germany and the euro area are receiving a
boost to their economies, as petrol and heating costs are falling further and
many firms are able to manufacture and produce goods more cheaply.
The fall in energy prices compared with the level included in the December
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Eurosystem staff projection will probably yield estimated savings of just
over half a percentage point for consumers and enterprises this year - both
in Germany and in the euro area as a whole.
The flip side of the oil price drop in monetary policy terms is, however, that
downside risks to the inflation outlook have also increased.
The inflation rate will not rise again until later than previously anticipated
and there will probably need to be a substantial downward revision of the
inflation forecast for this year.
The fact that the Eurosystem will not achieve its price stability goal over an
extended period of time will undoubtedly put the credibility of monetary
policy to the test.
We must therefore pay particularly close attention to longer-term inflation
expectations.
This is because they are an indicator of confidence that the self-imposed
monetary policy goal of an inflation rate below, but close to, 2% over the
medium term will be achieved.
Moreover, we must also carefully monitor possible signs of second-round
effects.
Some believe that the current wage growth rates in the euro area are
already sounding warning bells.
I don't agree, however.
As some crisis countries will still need to increase their price
competitiveness in order to regain lost global market shares, wages there
can only rise moderately.
This employment-oriented wage policy is thus putting pressure on wage
growth.
Yet, on the other hand, the improving labour market situation is boosting
consumption.
When assessing price risks, we shouldn't be like a rabbit caught in the
headlights, fixated on the current consumer price inflation rate.
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This rate could, in fact, temporarily slip back into negative territory during
the spring quarter.
Monetary policy should look beyond these short-term oil-price-induced
fluctuations in consumer prices.
Domestic price pressures are better reflected by the core inflation rate,
which factors out such effects.
Although, at 1%, this rate is currently also below the price stability target, it
is rising and is far removed from the dangerous territory of deflation, that is
to say the territory in which we would have to fear a downward spiral of
sinking prices, falling wages and an economic downswing.
3. Paths leading to stronger growth
Ladies and gentlemen, the purpose of the Eurosystem's highly
accommodative monetary policy is to stimulate economic activity in order
to bringing inflation into alignment with the definition of price stability.
Private consumption in the euro area has been picking up perceptibly, and
not just because financing conditions are favourable - low oil prices and
inflation are another factor.
Investment, meanwhile, is only now gradually getting off the ground.
Investment, of course, is more than just a component of aggregate demand
in the economic process - it also has a bearing on the size and quality of the
economy's capital stock.
Investment in machinery and equipment, especially, keeps production
structures up to speed with technological advances, making it a useful lever
for lifting an economy's output and ultimately its growth as well.
Investment in machinery and equipment may have been back on the
increase since early 2013, but across much of the euro area it has still not
yet returned to pre-crisis levels.
One glimmer of hope, of course, is that the impediments to investment will
gradually peter out over time.
The adjustment and reform processes in the crisis countries are making
headway, and financing conditions are looser again than they were when
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the crisis was raging.
This means that two major burdens on investment have been removed.
However, one major impediment lingers on - the outlook for growth - a
hugely important factor for investment - has been revised downwards in
recent years.
The European Commission projects that, in the absence of further
growth-enhancing reforms, the medium-term growth outlook will be no
better than 1% per annum.
It is this malaise, and not deficit-financed stimulus programmes, that needs
to be addressed by economic policy.
The same can be said for Germany, where negative demographics look set
to play a major role in depressing potential output growth.
Incidentally, Gräfin Lambsdorff, the idea of making each country
individually responsible for creating growth-friendly conditions was
something which your late husband already expounded in his famous
"Lambsdorff paper".
That document back in 1982 spelled out his plan for boosting growth in
Germany and probably sounded the death knell for the SPD/FDP coalition.
Pointing to the stubborn adjustment crisis that was stifling the global
economy at that time, Graf Lambsdorff wrote: "It will only be possible to
find a solution - at least a lasting one - to the worldwide problems if the
individual countries themselves do away with what's making it difficult for
them to adjust."
The efforts needed to clear the debris after the financial and sovereign debt
crisis sometimes addressed shortcomings of a very fundamental nature.
Greece, for instance, urgently needs a reliable and functioning
administration and a more efficient public sector, not to mention measures
to sustainably consolidate its public finances and further reform steps to
make Greece a more competitive economy.
And Italy, too, could place its economy on a much more rewarding growth
path by streamlining its public administration and making its legal system
more efficient.
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It is gratifying to note that the constitutional reforms on which prime
minister Matteo Renzi has staked his political future are moving in the right
direction.
This initiative will enable parliament to adopt legislation more quickly.
Once the reform measures have been formally and fully approved by
parliament, the final step in the process will be a public referendum, most
likely in the autumn.
In some countries, the efforts to mop up the post-crisis carnage have
centred around the question of debt.
High levels of household and corporate debt in some euro-area countries
are continuing to stifle overall economic activity, particularly investment.
But private indebtedness is not the only topic on the agenda - public debt
also needs to be addressed.
A string of euro-area countries have made huge progress in scaling back
their fiscal deficits since the onset of the sovereign debt crisis - indeed,
Greece, Ireland and others deserve plaudits for paring back their annual
deficits by ten percentage points or more.
But more often than not, countries are still crashing through the 3% deficit
ceiling.
And if we factor cyclical gains and temporary measures out of the deficit
numbers, then the structural deficits, as they are known, have been static at
best or even going back up.
Essentially, the opportunity opened up by the low interest rates to bring
down structural deficits particularly quickly was squandered.
In the key area of labour market reforms, countries like Italy, Spain and
France have made tangible progress in the right direction since the crisis
struck.
But employment could be boosted further still if France and Spain, say, act
even more decisively to address the divide splitting their labour markets
into temporary and permanent employment contracts.
The goods markets are another area where key decisions unleashing the
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forces of growth can be made.
For instance, some European countries have rules which inhibit the growth
of small enterprises.
But when highly innovative small businesses are prevented from scaling
new heights, this stunts economic growth.
Another case in point is the red tape involved in setting up a business,
which is a major hurdle across much of Europe and, I might add, especially
so in Germany.
The World Bank's Doing Business Report ranks our country 107th for red
tape, alongside Antigua and Barbuda and behind Nepal and Ghana.
So we're not "best practitioners" in this respect, not by any stretch of the
imagination.
And there are other areas where Germany would be unwise to rest on its
laurels.
Potential growth is just a meagre 1.3%, and globalisation and the "energy
U-turn" are exposing the economy to mounting competitive and cost
pressures.
More importantly, German society is feeling the effects of radical
demographic change, which will take its toll on the country's growth
prospects.
Over time, the working-age population will diminish and the number of
people in work will shrink, causing growth to falter further.
The current influx of refugees will do little to alleviate this problem.
We may be powerless to halt the wheels of demographic change, but we can
at least soften its blow on the economy.
To achieve that goal, we would have to focus more strongly on education
and training - that is, on labour productivity boost the participation of
women and the elderly in the labour force still further improve the way the
long-term unemployed are integrated into the labour market integrate into
our labour market those refugees who are permitted to stay in Germany.
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Our success in integrating refugees into our society will hinge in large
measure on how quickly and smoothly these immigrants can be absorbed
into the labour market.
But that's a task that will take stamina and patience, because language
difficulties won't be the only problem for the vast majority of refugees; their
qualifications will probably be found wanting, too.
Ladies and gentlemen
The individual member states aren't the only ones who can put their
economies on track for stronger growth - the European Commission and
Council can contribute as well.
They could, for instance, work towards bringing together the 28 separate
digital markets that still exist in Europe to finally create a pan-European
digital market that extends from Hammerfest to Heraklion.
Studies suggest that, in Germany alone, a single European digital market
could create more than 400,000 new jobs within the space of a few years.
And the establishment of the capital markets union is another project
where the European Commission is at the wheel.
Broad, well-developed capital markets will offer fresh sources of funding for
businesses, again paving the way towards stronger growth.
4. Architecture of the monetary union and the path to greater
fiscal soundness
A full economic and monetary union should also include a capital markets
union.
As you know, last year, the President of the European Commission
Jean-Claude Juncker and the presidents of four other EU institutions
published a report entitled "Completing Europe's Economic and Monetary
Union".
In it, the five presidents wrote, "Europe's Economic and Monetary Union
today is like a house that was built over decades but only partially finished.
When the storm hit, its walls and roof had to be stabilised quickly. It is now
high time to reinforce its foundations [...]."
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The time has indeed come to strengthen the foundations of the monetary
union, and a sound institutional architecture is undoubtedly also a key
prerequisite for a prosperous euro area.
I would therefore like to take a closer look at the architecture of the euro
area and outline how we might improve its stability.
If we were to try to compare the architecture of the euro area to that of a
real building, I don't think the La Redoute here in Bad Godesberg would
immediately spring to anyone's mind.
This beautiful building is simply too symmetrical.
Instead, you would probably think of structures such as the Guggenheim
Museum in Bilbao or the Gehry buildings in Düsseldorf's Media Harbour,
because one of main features of the euro area is its asymmetry.
It brings together 19 largely autonomous fiscal policies under a single
monetary policy.
Nobody would say that asymmetrical buildings such as those I have just
mentioned cannot be structurally stable, but they are bound to require
complicated calculations.
To a certain degree, the founding fathers of the monetary union also
performed structural calculations and were aware that their asymmetrical
design contained flaws.
The risk of accumulating excessive debt is greater in a monetary union than
in countries with their own currencies.
One reason is because the member states of a monetary union are not
borrowing in their own currency.
Another is that there are greater incentives to borrow in a monetary union
because any consequences of relying too heavily on capital market funding
can be passed on to the other member states - at least in part.
I usually like to compare this to the overfishing of our oceans.
However, here in Bonn, the UN's "climate capital", I would prefer to
compare it to greenhouse gas emissions.
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The damage caused by CO2 emissions is global, whereas the benefits from,
say, the burning of fossil fuels, are local.
This simple logic explains why preventing climate change is so difficult in
practice.
The dilemma can only be solved through international cooperation.
The Kyoto Protocol was intended to protect the atmosphere and reduce
greenhouse gas emissions, and it remains to be seen whether this will
finally be achieved thanks to the agreement recently signed in Paris.
To protect the single currency and prevent excessive debt, the member
states of the euro area have also agreed on a "Kyoto Protocol" of their own the Maastricht Treaty, which includes the Stability and Growth Pact.
Under the terms of the Treaty, the member states pledged to maintain
sound public finances and prohibit central banks from printing money to
fund cash-strapped governments - also known as the ban on monetary
financing of governments.
They also agreed to a "no bail-out clause" that prevents one member state
from assuming liability for the debts of another.
This means that the euro-area member states are individually responsible
for the consequences of their own excessive borrowing.
It is also intended to encourage the capital markets to factor risk into the
interest rates at which they lend to governments.
This regulatory framework based on the principle of liability - the
Maastricht framework - was the starting point for the creation of the
monetary union in 1999.
In its first decade, it proved to be a stable structure.
However, with hindsight, this also turned out to be a period of fine weather
in economic terms.
But then, to quote the five presidents again, the "storm" arrived in the guise
of the financial and debt crisis, which is why "the walls and roof had to be
stabilised quickly".
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The crisis revealed that enormous macroeconomic imbalances had built up
in some countries over the initial period of calm.
Alongside the huge increase in public and private-sector debt, international
competitiveness had also been eroded.
A number of these imbalances exposed the blind spots in the regulatory
framework of the monetary union.
In response to the crisis, a procedure for identifying macroeconomic
imbalances at an early stage was therefore established, in which the
European Commission regularly examines whether, for example, private
sector debt or member states' current account balances are a source of
harmful imbalances.
When trying to repair the damage, however, a great deal of energy was also
devoted to strengthening fiscal soundness.
For instance, a fiscal compact was adopted to make the fiscal rules of the
Stability Pact more stringent and binding, thus boosting confidence in the
sustainability of public finances.
It was this very lack of confidence that was at the heart of the sovereign debt
crisis.
The binding effect of the fiscal rules had already been weakened before the
crisis.
First, the financial markets appeared not to take the no bail-out clause
seriously, and second, Germany and France successfully avoided sanctions
over their excessive deficits in 2005, leading other countries to believe that
they, too, could bend the rules.
While the crisis was being tackled, elements of communitised liability
gained ground.
Although the no bail-out clause still applies in theory, its foundations have
been eroded to some extent in practice, most notably by the European
rescue packages.
At the time, this communitisation of liability helped to stabilise the
situation.
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However, joint liability can only lead to lasting stability in combination with
joint control.
This is because liability and control must be aligned, either at the national
or the European level, or the principle that each member state must "pay its
own way" would be breached.
The financial crisis also illustrates just how serious the consequences of
circumventing the liability principle can be.
For year, banks had taken excessive risks because, for example, they were
too big and too interconnected to fail, and could expect taxpayer-funded
bailouts.
This is why many of the regulatory initiatives in the financial sector rightly
aim to ensure that banks are once more subject to the same liability
principle as any German Mittelstand company.
Transferring liability and control to the European level is not a new idea.
When the treaties were signed, some saw the monetary union as merely an
interim step towards a political union.
Addressing the Bundestag here in Bonn in November 1991, Helmut Kohl
remarked that "the idea of sustaining economic and monetary union over
time without political union is a fallacy".
There are a wealth of proposals as to how liability should be shared.
By saying that "is now high time to reinforce [the] foundations", the five
presidents, too, are aiming to establish joint liability and risk-sharing.
However, when it comes to the necessary transfer of fiscal sovereignty,
practically no concrete proposals have been made.
Although the five presidents wrote that "a genuine Fiscal Union will require
more joint decision-making on fiscal policy," they are relatively short on
specifics - which is understandable.
After all, there is next to no political support for the transfer of fiscal
sovereignty to the European level.
The parliamentary group of the SPD recently adopted a paper on the future
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direction of monetary union which calls for new executive powers at the
euro-area level in the medium term in order to monitor the fiscal rules and
national budgets.
This recognises the need for a balance between liability and control.
I do not, however, perceive any broad-based willingness to relinquish
sovereignty, let alone the majorities for the constitutional and treaty
amendments which that would require.
On the contrary, national politicians get very touchy about warnings from
Brussels and reject any interventions in their fiscal autonomy.
For instance, Matteo Renzi, whom I have already quoted, says that Italy will
not allow a "bureaucrat from Brussels" to dictate its fiscal policy.
In any event, a halfway solution - along the lines of increased joint liability
while leaving national sovereignty in financial matters as it is - would
undermine incentives for sound fiscal action.
That would harbour the risk of monetary policymakers again being called to
the rescue - and far too much has already been demanded of monetary
policy in the current crisis.
As long as liability and control are not aligned at the European level, there
is therefore only one way to stabilise the monetary union in the long run.
That way consists in affirming the decentralised approach of the Maastricht
framework and reinforcing the principle of national responsibility.
At first, that may seem to be a case of looking backwards.
But that impression is deceptive, because it is not about restoring the
monetary union to its pre-crisis condition.
Rather, the asymmetric Maastricht framework should be designed so as to
make the structure stable without depending on a political union.
To do that, the binding force of the debt rules should be strengthened.
Admittedly, that was precisely the objective of the last reform of the
Stability and Growth Pact.
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However, it ended up conceding considerable discretionary scope, mainly
to the European Commission.
Torn in two directions in its dual role as a political institution and guardian
of the treaties, the Commission is frequently inclined to compromise at the
expense of budgetary discipline.
This means that the binding power of the debt rules has ultimately tended
to be weakened.
A more consistent interpretation of the rules could have been achieved if
responsibility had rested with an independent fiscal authority for budgetary
surveillance instead of the Commission.
Please note: an independent authority - a committee which only advises the
Commission, as proposed by the Five Presidents, would fall short.
Past developments have made it abundantly clear that political agreements
alone are not enough to ensure sound public finances.
That was evidently also how the founding fathers saw the situation.
By introducing the no-bail-out clause, they sought to allow the disciplining
forces of the financial markets to come to bear.
But that can only work if the no-bail-out principle is made credible.
"Whoever reaps the benefits must also bear the liability."
This liability principle, as once described by Walter Eucken, also needs to
be applied to sovereign debt.
Investors have to perceive a credible threat of losing their money if they buy
bonds from governments that have unsound public finances.
The crisis has brutally exposed the fact that sovereigns, too, can reach the
brink of insolvency.
An orderly procedure for a sovereign default does not yet exist, however.
But that is precisely what we need.
This is not only about procedural rules, however.
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It is also about a sovereign default not being allowed to jeopardise the
stability of the entire financial system.
To a certain extent, the terror has to be taken out of sovereign debt
restructuring.
Doing this means, in particular, loosening the close links between banks
and sovereigns.
This is because, at present, a considerable part of sovereign debt is held by mostly domestic - banks.
Therefore, if a government no longer serviced its debt, the banks, too,
would encounter massive economic difficulties.
Financial stability would be under threat.
One reason for the large holdings of sovereign debt on the banks' balance
sheets is that, unlike in the case of loans to enterprises and households,
banks currently do not have to hold any capital against euro-area
government bonds.
The idea behind this is that euro-area bonds are believed to be risk-free.
Upon the outbreak of the sovereign debt crisis, if not beforehand, it had
become clear that this assumption was a fiction with no basis in reality.
For that reason, there must be an end to the preferential regulatory
treatment of government bonds.
Giving banks an incentive to maximise their sovereign debt holdings
instead of lending to the private sector is, after all, absurd.
We have come a long way over the past few years towards making the
financial system more robust.
In particular, banks now have to satisfy higher quantitative and qualitative
capital requirements, which has improved their ability to absorb losses.
But, to date, no decisions have been taken with regard to cutting back the
regulatory privileges of government bonds.
The Bundesbank has been calling for this for a number of years now; the
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fact that it is now being negotiated at the global and European levels can be
regarded as a success.
The inherent risks of the strong economic links between sovereigns and
banks have to be limited and, until the key decisions have been taken on
this issue, a European deposit protection scheme would be premature.
What argues against an over-hasty communitisation of deposit protection which the Commission and some member states are calling for - is, not
least, the fact that the member states still hold considerable sway over the
quality of bank balance sheets, say, by virtue of national insolvency law.
Here, too, it holds true that liability and control have to be aligned with one
another.
It is inconsistent to claim national sovereignty while at the same time
calling for more European solidarity.
5. Conclusion
Europe is therefore still facing major challenges.
A large number of fundamental decisions aiming at more economic growth
and a durably stable monetary union still have to be taken.
The sooner they are taken, the better.
Having said that, the description "durably stable" has two sides to it. What
has to be "durably stable" is, first of all, the regulatory framework.
This will only be possible once liability and control are in alignment and
once solidarity and sovereignty are in balance.
Public finances, too, have to be "durably stable", however.
This is because a monetary union is stable only if each country keeps its
own house in order; this has been made abundantly clear by the repeated
discussions on financial assistance for Greece.
This was something that was pointed out in a speech delivered here at your
club, La Redoute, more than 25 years ago.
The former Bundesbank President Hans Tietmeyer was already aware of
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the pitfalls back then and said that "Without sufficient stability policy
convergence and, above all, greater budgetary discipline in a number of
European countries, economic and monetary union will be unable to gain a
sustainable foundation.
No matter what fine words and ambitious statements of intent are
contained in the treaties, it will not be enough if there does not exist the will
to actually change fiscal and budgetary policy itself."
Once we in the euro area have reached the point where balanced budgets
are actually firmly anchored in policy, tenths of a decimal point will indeed
probably no longer be important for confidence in the euro.
Thank you for your attention, and I look forward to your questions.
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Forward guidance in New Zealand
Speech by Dr John McDermott, Assistant Governor and
Chief Economist of the Reserve Bank of New Zealand, to
the Goldman Sachs Annual Global Macro Conference
2016, Sydney, 4 February 2016.
Introduction
I would like to thank Goldman Sachs for the invitation to speak here in
Sydney today.
It is a pleasure to take the trip across the Tasman to be part of your annual
Macro Economic Conference.
The focus of my comments today will be the Reserve Bank of New Zealand’s
approach to forward guidance, and in particular, the publication of an
endogenous outlook for the 90-day interest rate.
I’ll touch on the benefits of this approach and how we aim to minimise the
potential costs.
I’ll highlight the importance of understanding the conditional nature of our
forecasts.
And I’ll finish by providing an illustration of the Bank’s conditional forward
guidance in practice.
Over the past few decades, transparency has become much more valued in
the conduct of monetary policy.
Transparency can improve the effectiveness of monetary policy, and
increases the accountability of the central bank.
Transparency is a value held in high regard at the Reserve Bank of New
Zealand, which is seen as one of the most transparent central banks in the
world.
This value is applied to the way we conduct forward guidance, where the
Bank is very open about its monetary policy outlook.
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In New Zealand, this includes the publication of a forward projection for
the 90-day interest rate, comments on the outlook for policy, discussion of
risks in our Monetary Policy Statement and the presentation of alternative
scenarios.
The Bank is one of only a handful of central banks that publish forecasts for
the short-term interest rate.
This is a practice we have maintained since 1997.
The publication of the 90-day interest rate projection can improve the
effectiveness of monetary policy in a number of ways.
First of all, informing the public on our thinking about the transmission of
monetary policy and a possible path of for interest rates can help
individuals and businesses make more informed decisions.
There are times when the Bank will know more about the economic
situation and outlook than does the public or financial market participants.
Every so often this will relate to some research or insight we hold, but more
typically this extra knowledge relates to knowing what the Bank itself plans
to do.
Second, the entire yield curve, rather than just the current level of the
90-day interest rate, has an influence on economic behaviour.
Publishing the Bank’s projection for the 90-day interest rate can help shift
the entire yield curve towards levels consistent with medium-term price
stability, improving the effectiveness of monetary policy.
Third, the publication of the 90-day interest rate projection helps
accountability.
Under the Policy Targets Agreement (PTA), the Bank is required to keep
future average inflation close to the mid-point of the 1 to 3 percent target
range, whilst avoiding unnecessary instability in output, interest rates and
the exchange rate, and having regard for financial stability.
This multitude of considerations influences the Bank’s judgement about
how monetary policy should be adjusted to help move inflation towards its
medium-term target.
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The publication of a 90-day interest rate projection, together with an
inflation projection, conveys the Bank’s view of what it considers
appropriate when making these considerations, and how this changes when
new information becomes available.
The Bank uses a range of modelling techniques and expert judgement to
prepare a forecast for the 90-day interest rate.
Our structural model is used to summarise all the new information
provided by recent data, financial market developments, indicator models
and our discussions with New Zealand businesses.
Judgement is then added to this framework after the deliberation of our
Monetary Policy Committee and Governing Committee.
The 90-day interest rate projection, based on a range of assumptions,
provides a guide of what monetary policy settings may be needed to return
or keep inflation at target.
We feel that this is a more informative approach than assuming a constant
or market path for interest rates – which may present an interest rate path
that is inconsistent with the Bank’s price stability mandate.
Forward guidance – avoiding potential pitfalls
This transparent approach comes with potential costs.
First, research highlights that increased transparency, in some cases, can be
detrimental to the economy.
This is particularly the case if the public takes the Bank’s information as
definitive, despite it being noisy or imperfect.
We aim to minimise such instances by offering a full discussion of the
assumptions and risks that underpin our projections, to clearly highlight
the limitations in our knowledge.
Second, some research claims that when a central bank provides an
endogenous interest rate projection, fears of credibility loss may lead it to
stick to a previously published policy path, even when faced with new
economic developments.
I can say, from my experience, that this has never been a problem at the
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Bank.
Third, some have argued that it may be difficult for a central bank to reach
consensus on an entire path for interest rates.
Practically, this has not been a problem at the Bank.
Committee practices are efficient enough for the Governing Committee to
reach an agreement on a qualified projection for the 90-day interest rate.
More broadly, it is important that financial market participants and the
public understand the 90-day interest rate is a conditional projection.
It is not a commitment from the Bank to a specific set of actions.
The effectiveness of monetary policy can be hampered if the public and
financial market participants take the forecast as a commitment.
The 90-day interest rate projection shows how interest rates may need to
evolve to achieve price stability if the economy evolves in line with the
Bank’s forecasts.
Of course, the uncertainties faced in forecasting mean that the economy will
almost always evolve differently to what the Bank expects.
Cyclical factors like the strength of the international economy, movements
in oil and other commodity prices, and the exchange rate can develop in
unexpected ways.
For example, at the current juncture, the economy is faced with a number of
unique supply-side developments which add additional uncertainty to the
outlook.
These include reconstruction activity in Canterbury, the recent sharp fall in
oil prices, a rapid rise in inward migration and the potential impacts of
El-Nino.
In addition to these business cycle developments, structural aspects that
may be linked to factors such as globalisation, technology and demography
can also have major impacts on economic growth and inflation.
In normal times these structural aspects move relatively slowly.
However they are important in determining how interest rates might affect
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inflation and the cycle in output and can move sharply in a crisis.
All of these factors can affect the neutral interest rate, potential output and
inflation expectations.
If financial market participants understand the conditional nature of our
forecasts, the 90-day interest rate projection can help participants
understand how we are likely to respond to changes in the economic
outlook.
Every three months we provide a new projection for the 90-day interest
rate.
The changes in this projection, and the analysis in the Monetary Policy
Statement (MPS) on the state of the economy, illustrate how unforeseen
events have shaped the Bank’s outlook for policy.
Over time, this should help financial market participants understand the
Bank’s “reaction function” – that is, how economic events affect the outlook
for inflation and the implications we draw for monetary policy.
If financial market participants have a good understanding of our reaction
function, and share similar views on the economy, interest rates should
adjust to levels consistent with medium-term price stability without the
need for constant comment and intervention from the Bank.
We try to facilitate this understanding by presenting a description of key
judgements and alternative scenarios in our Monetary Policy Statements.
These help illustrate how monetary policy would likely need to respond if
judgements were to prove incorrect or if risks to the outlook were to
crystallise.
Financial market participants seem to have had a good understanding of
the conditional nature of our projections.
Figure 1 illustrates the point for the period since 2004.
The red line in the chart shows how the market implied 1-year-ahead
90-day interest rate moves from the day after a Statement to the day before
the next Statement.
This change represents how market participants have interpreted the
incoming economic data and events and how they think the Bank will
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respond.
The blue line shows how the Bank revised its 1-year ahead 90-day interest
rate projection from one Statement to another.
The blue line gives an indication of how the Bank interpreted new economic
events and the subsequent monetary policy response.
Generally, market participants change their outlook for interest rates in a
similar way to the Bank as new economic and financial information
becomes available.
The majority of the move in interest rates occurs before we have provided
financial market participants with our interpretation of new events.
This suggests market participants have a good understanding about how
new information changes the Bank’s own outlook, the conditionality of the
Bank’s projections and the Bank’s reaction function.
Conditional commitment in action – changes in the policy
outlook since 2014
The changes in the Bank’s policy stance since the beginning of 2014 provide
a good illustration of the conditional nature of forward guidance in practice.
At the March 2014 Statement, the 90- day interest rate had averaged 2.85
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percent in Q1 2014, and the Bank was projecting it to rise to 5.5 percent by
Q3 2017.
However, a number of factors led to a moderation in the outlook for
inflationary pressure over the quarters that followed.
Both cyclical and structural aspects of the New Zealand economy evolved in
unforeseen ways.
These events included significant falls in the prices of oil and New Zealand’s
commodity exports, a stronger-than-expected exchange rate, weaker-thanexpected capacity pressures (and stronger potential growth), and weaker
non-tradables inflation.
Despite these developments, by the December 2015 Statement the Bank
was projecting even stronger economic growth than had been expected in
March 2014 (figure 2).
This is not because the fundamental outlook had improved, but because
this new information led the Bank to change its outlook for monetary policy
and provide more stimulus to the economy.
Indeed, the December 2015 Statement projected that the 90-day interest
rate would be 2.6 percent in Q3 2017, almost 300 basis points lower than
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was forecast in March 2014 (figure 3).
Given the weaker starting point for inflation, stronger growth was needed
to bring inflation back to target.
However, as discussed, this projection for stronger growth is conditional on
a set of certain assumptions, and the Bank may need to change its activity
and policy outlook if new events were to unfold.
The changes in the 90-day interest rate projection over this time illustrate
how flexible inflation targeting operates in practice.
The forecasts evolved to ensure that medium-term price stability would be
maintained.
Therefore, despite inflation being weaker than expected and the revision to
the 90-day interest rate outlook, the credibility of the monetary policy
framework has been maintained.
Medium-term inflation expectations have fallen over the past six months,
but are currently near the 2 percent target midpoint (figure 4).
External forecasters also expect inflation to return to target over the
medium term.
Crucially, the Bank is – and perceived to be – committed to its inflation
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target, which helps anchor inflation expectations.
When formulating monetary policy, the PTA directs the Bank to have a
forward-looking focus, irrespective of past inflation outcomes.
The projection, at any time, seeks to ensure that price stability can be
achieved while avoiding unnecessary instability in output, interest rates
and the exchange rate.
The Bank will continue to adjust monetary policy as conditions evolve to
ensure that price stability is achieved over the medium term.
Conclusion
When it comes to communication, central banks use a diverse range of
practices, and best practices differ from country to country.
For New Zealand, we find it beneficial to publish a projection for the 90-day
interest rate.
It supports transparency, and its evolution over time contributes to market
participants’ understanding of how the Bank responds to unexpected
economic events.
The projections are conditional in nature, reflecting the many challenges
faced in forecasting the New Zealand economy.
It is important financial market participants understand that these
forecasts are not a commitment to a certain path of policy.
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Indeed, financial market participants generally have a very good
understanding of the conditional nature of our forecasts.
The experience since the beginning of 2014 highlights the conditional
nature of our interest rate forecasts.
Unforeseen economic events led to weaker-than-expected inflationary
pressure in the economy.
As a result, we significantly revised down the outlook for short-term
interest rates.
The Bank will continue to adjust monetary policy as conditions evolve to
ensure that price stability is achieved over the medium term.
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In the heart of Europe - Europe in our hearts
Welcoming address by Dr Andreas Dombret,
Member of the Executive Board of the Deutsche
Bundesbank, to mark the unveiling of the plaque
listing patrons for the euro sign, Frankfurt am Main
1. Introduction
Ladies and gentlemen
I am extremely pleased that you are joining me in celebrating a very special
occasion today - the unveiling of the plaque listing patrons of the euro
sculpture.
When you think of Frankfurt, what comes to mind?
Perhaps the city's famous historical landmarks, such as the Römer (city
hall) or St. Paul's?
Or the skyline, featuring its many skyscrapers?
Football fans may think of Attila, the eagle, worn proudly on players' shirts
of Eintracht Frankfurt.
You might also think of Goethe, the Old Opera House, the Main river,
Germany's largest airport, and so on.
All this is Frankfurt; our city is veritably full of world-renowned landmarks.
However, I'm sure that quite a few of us also have in our mind's eye the euro
sculpture, which has graced the Willy-Brandt-Platz square between the
opera house and the Eurotower since the euro was launched - and is thus
located right in the heart this city.
Much as Frankfurt itself is located in the geographic heart of Europe.
2. In the heart of Europe
For nearly 15 years, the euro sculpture stood guard before the European
Central Bank, making it clear to all visitors that they were standing at the
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heart of Europe.
The sculpture has certainly seen a great deal in that time.
When its lights came on for the first time in 2001, the euro area comprised
only 12 member states; the number has now risen to a total of 19.
The average forex trading volume that changed hands every day between
traders round the world amounted to some €450 billion in 2001; it now
stands at €1.7 trillion according to the latest available figures.
The euro is undoubtedly the world's second most important currency after
the US dollar.
Yet it has not always been smooth sailing.
We all remember the sometimes dramatic events in connection with the
recent financial crisis, which dealt a significant blow to the euro area and, in
some cases, raised massive doubts about the continued existence of our
single currency.
It was not least these events which also led to the activists of the Occupy
movement, in 2011, pitching camp in the shadow of the euro sculpture,
where they held out for more than a year - even as their political message
was fading into the background as time passed by.
However, that is all history now.
The euro area has returned to stability, even though we cannot yet say with
certainty that the crisis has been entirely overcome.
The ECB has long since taken up residence in Frankfurt's Ostend district,
and the last traces of the Occupy activists have been gone for quite a while.
And yet it is right that the euro sculpture will be marking the centre of our
monetary union, now and in the future.
For, after all, the monetary union no longer rests solely on monetary policy.
Around one and a half years ago, the Single Supervisory Mechanism (SSM)
for Europe's banks was launched, heralding a key step towards the
completion of this monetary union.
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You see, the financial crisis exposed the weaknesses of our existing
framework.
One such weakness was the tendency of national supervisors to train their
sights primarily on the institutions based in their own jurisdiction, meaning
that risk that spilled over to other countries sometimes went undetected
until it was too late.
The SSM is addressing this problem by taking an explicitly European
approach and comparing banks from different countries, for example.
In addition, the SSM prevents banks in different countries from being
supervised with varying degrees of strictness because, for instance, national
supervisory regimes are too heavily influenced by national interests.
This means that the SSM is, in many ways, impressive.
One aspect sets it apart from everything else, however.
Never before have sovereign states merged their banking supervisory
functions in an independent agency.
Our experience of the first year of SSM has been quite positive - especially if
one stops to think of the magnitude of this project and how short the
preparation time was prior to getting the SSM actually up and running.
There is room for improvement in some areas, of course, but the SSM has
already earned the respect of the institutions it supervises today.
Our SSM colleagues are sitting today in the Japan Center, not far from here,
and in future will be supervising the euro area's largest banks from the
Eurotower - where, every day, the euro sculpture will make it clear to them
what they are working for: a stable euro area, home to some 340 million
people.
3. Europe in our hearts
Hans-Dietrich Genscher once said that "Europe is our future, we have no
other."
Europe belongs to Frankfurt like almost no other city, apart from Brussels
and Strasbourg.
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The euro sculpture has taken its place alongside the ECB, the SSM, EIOPA
and also the Bundesbank as an expression of this belonging.
Thanks to your support, the sculpture is now shining again in due
splendour.
I personally wish to thank all of you very sincerely - and I firmly believe
that, in expressing my gratitude, I also speak for many of Frankfurt's
residents as well as its innumerable international visitors.
It remains to be hoped that Europe, too, will shine in future with the same
lustre as the restored euro sculpture.
Let us all do what we can to achieve this goal going forward.
Thank you very much.
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Bridging the Bio-Electronic Divide
New effort aims for fully implantable devices able to connect with up to one
million neurons
A new DARPA program aims to develop an implantable neural interface
able to provide unprecedented signal resolution and data-transfer
bandwidth between the human brain and the digital world.
The interface would serve as a translator, converting between the
electrochemical language used by neurons in the brain and the ones and
zeros that constitute the language of information technology.
The goal is to achieve this communications link in a biocompatible device
no larger than one cubic centimeter in size, roughly the volume of two
nickels stacked back to back.
The program, Neural Engineering System Design (NESD), stands to
dramatically enhance research capabilities in neurotechnology and provide
a foundation for new therapies.
“Today’s best brain-computer interface systems are like two
supercomputers trying to talk to each other using an old 300-baud
modem,” said Phillip Alvelda, the NESD program manager. “Imagine what
will become possible when we upgrade our tools to really open the channel
between the human brain and modern electronics.”
Among the program’s potential applications are devices that could
compensate for deficits in sight or hearing by feeding digital auditory or
visual information into the brain at a resolution and experiential quality far
higher than is possible with current technology.
Neural interfaces currently approved for human use squeeze a tremendous
amount of information through just 100 channels, with each channel
aggregating signals from tens of thousands of neurons at a time.
The result is noisy and imprecise. In contrast, the NESD program aims to
develop systems that can communicate clearly and individually with any of
up to one million neurons in a given region of the brain.
Achieving the program’s ambitious goals and ensuring that the envisioned
devices will have the potential to be practical outside of a research setting
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will require integrated breakthroughs across numerous disciplines
including neuroscience, synthetic biology, low-power electronics,
photonics, medical device packaging and manufacturing, systems
engineering, and clinical testing.
In addition to the program’s hardware challenges, NESD researchers will be
required to develop advanced mathematical and neuro-computation
techniques to first transcode high-definition sensory information between
electronic and cortical neuron representations and then compress and
represent those data with minimal loss of fidelity and functionality.
To accelerate that integrative process, the NESD program aims to recruit a
diverse roster of leading industry stakeholders willing to offer
state-of-the-art prototyping and manufacturing services and intellectual
property to NESD researchers on a pre-competitive basis. In later phases of
the program, these partners could help transition the resulting technologies
into research and commercial application spaces.
To familiarize potential participants with the technical objectives of NESD,
DARPA will host a Proposers Day meeting that runs Tuesday and
Wednesday, February 2-3, 2016, in Arlington, Va. The Special Notice
announcing the Proposers Day meeting is available at
https://www.fbo.gov/spg/ODA/DARPA/CMO/DARPA-SN-16-16/listing.h
tml.
More details about the Industry Group that will support NESD is available
at
https://www.fbo.gov/spg/ODA/DARPA/CMO/DARPA-SN-16-17/listing.ht
ml.
A Broad Agency Announcement describing the specific capabilities sought
is available at: http://go.usa.gov/cP474.
DARPA anticipates investing up to $60 million in the NESD program over
four years.
NESD is part of a broader portfolio of programs within DARPA that support
President Obama’s brain initiative.
For more information about DARPA’s work in that domain, please visit:
http://www.darpa.mil/program/our-research/darpa-and-the-brain-initiati
ve
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https://www.whitehouse.gov/the-press-office/2013/04/02/fact-sheet-brai
n-initiative
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The International Association of Risk and Compliance
Professionals (IARCP)
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